In the first class action over 401(k) fees to be tried and decided on its merits, a Missouri federal district court ruled on March 31 that manufacturer ABB Inc. breached its Employee Retirement Income Security Act (ERISA) fiduciary duties. The court’s opinion is a must read for all plan sponsors and service providers.

The company must pay $35.2 million to the plaintiff class for (1) failing to monitor the recordkeeping fees and revenue-sharing payments made to the plan’s trust company, (2) failing to negotiate rebates to offset or reduce the cost of providing administrative services to plan participants, and (3) replacing an actively balanced mutual fund with the trust company’s target date fund that generated more in revenue sharing for the trust company. (Note: Revenue sharing refers to any portion of the expense ratio fees as a percentage of plan assets that is used to pay administrative fees other than investment costs.)

In so holding, the court emphasized, above all other considerations, the importance of implementing and adhering to prudent processes and focusing on the merits of the investments.

The court acknowledged that ERISA fiduciaries may use revenue sharing to pay for administrative fees (rather than paying with a “hard dollar” per-participant fee). But it held that if a fiduciary opts for revenue sharing, “it also must have gone through a deliberative process for determining why such a choice is in the Plan’s and participants’ best interest.”

Such analysis was particularly critical, the court stated, because the plan’s Investment Policy Statement (IPS) required that revenue sharing “be used to offset or reduce the cost of providing administrative services to plan participants.” According to the court, without calculating the dollar amount of the recordkeeping fees, ABB could not know whether revenue sharing was offsetting or reducing the cost.

In that regard, the court noted that ABB’s monitoring of the reasonableness of the overall expense ratio was insufficient because it did not show how much revenue was flowing, did not show the competitive market for comparable funds, and failed to take into account the size of the plan. Also, the court held that the IPS was part of the plan document, and by failing to comply with the IPS provision, ABB breached its fiduciary duty to operate the plan in accordance with the plan document’s terms.

The court’s opinion describes in detail many actions it views as failing to achieve a deliberative process and evaluation, failing to follow plan documents such as the IPS, failing to follow up the findings of an adviser that the plans were overpaying fees, and making decisions not in the best interests of the plan.

Also, with the Labor Department’s fee-disclosure rules nearing their July 1, 2012, effective date, it is even more important that plan fiduciaries understand the fees, including revenue sharing, being paid by and through plans, particularly 401(k) plans. It’s also crucial for fiduciaries to examine the process and procedures for evaluating and approving investment options and provider arrangements, and the documentation of those actions.

Failure to Monitor Recordkeeping Expenses
All investment options offered by the plan paid revenue sharing to a trust-company affiliate. According to the court, ABB never calculated the dollar amount of the recordkeeping fees the plan paid to the trust company via revenue-sharing arrangements, nor did it consider how the plan’s size could be leveraged to reduce recordkeeping costs.

In fact, said the court, ABB did not obtain a benchmark cost of services prior to choosing revenue sharing as the plan’s method for compensating the trust company, even though an outside consulting firm told ABB it was overpaying for recordkeeping and that it appeared the plan was subsidizing the corporate services provided to ABB by the trust company.

The court said it was also unconvinced that ABB monitored the reasonableness of the trust company’s recordkeeping fees by monitoring the reasonableness of the expense ratio for the retail investments chosen for the plan. According to the court, the expense ratio did not show how much revenue was flowing from the investment company to the recordkeeper. Also, it did not portray the competitive market for recordkeeping fees of comparable funds.

Most importantly, said the court, “in this case, it fails to take into account the size of the retirement plan and the competitive benefit that an investment company acquires when it is selected to be on a retirement plan platform. Participant choices are generally limited to those investments on the platform, substantially increasing the visibility of these investments and limiting competition from other funds. While there are legitimate reasons for limiting choices, the reality is that being put on a platform is a valuable benefit and gives a large plan the opportunity to negotiate for rebates in exchange for that benefit.”

Moreover, the court emphasized that the IPS clearly states that revenue sharing should be used to offset or reduce recordkeeping costs. Thus, in accordance with the IPS, ABB was required to leverage the plan’s size and assets to reduce recordkeeping costs. In other words, said the court, ABB had to use its purchasing power to negotiate for rebates from the trust company, either in the form of basis points or hard-dollar amounts, if the amount of revenue sharing generated exceeded market value for the trust’s services. 

In that regard, the court emphasized that a fair negotiation for such rebates cannot occur without determining the amount of income generated from revenue sharing, knowing the market costs for comparable services, affirmatively evaluating the quality provided by the trust company, and evaluating the costs and benefits of risk sharing. “ABB did none of this,” said the court, “and did not even ask the Trust Company for a rebate or even discuss the issue with them.”

The court also found that the plan overpaid for the recordkeeping services provided by the trust company, since the revenue sharing generated by the plan’s assets far exceeded the market value for recordkeeping and other administrative services provided by the trust company.

Failure to Negotiate Rebates
According to the court, ABB permitting the trust company to take the revenue sharing resulted in the above-market costs. That was in violation of the IPS, which requires that at “all times, rebates will be used to offset or reduce the cost of providing administrative services to plan participants.” ABB did not use the rebates/revenue sharing to offset or reduce the cost of the plan’s administrative services, in violation of the IPS.

That was particularly disturbing, said the court, because the IPS is a governing plan document under ERISA Section 404(a)(1)(D), a statutory duty of prudence requiring that fiduciaries discharge their duties in accordance with governing plan documents. According to the court, to assess the prudence of a revenue-sharing arrangement, ABB had to determine the market rate for the recordkeeping services provided to the plan.

Without such a baseline, it would be impossible to determine whether a revenue-shar­ing arrangement would add value to the plan. Also, such a baseline was necessary for ABB to evaluate whether the trust company was justified when seeking additional hard-dollar fees to replace lost revenue from declining plan assets in investment options that provide revenue sharing.

While revenue sharing is accepted industrywide as a method of paying for plan recordkeeping services, said the court, the prudence of choosing that option must be evaluated according to the circumstances of each plan. Here, the process by which ABB determined to use revenue sharing as the plan’s payment model was imprudent, since ABB did not analyze how revenue sharing would benefit the plan, oor negotiate revenue sharing by leveraging the plan’s size to offset or reduce recordkeeping costs.

As the IPS is a governing plan document within the meaning of ERISA
Section 404(a)(1)(D), said the court, ABB breached its fiduciary duties when it failed to comply with this provision of the IPS.

The court emphasized that “if a plan sponsor opts for revenue sharing as its method of paying for recordkeeping services, it must not only comply with its governing plan documents, it must also have gone through a deliberative process for determining why such a choice is in the Plan’s and participants’ best interest. Such an inquiry involves more than a raw assessment of the reasonableness of expense ratios; particularly, given the inherent difficulty of identifying how expense ratios are broken down between administration and investment services and the fact that the expense ratio doesn’t show whether there is a revenue sharing agreement with the recordkeeper or for how much. Nor does it show what the market value is for recordkeeping services.”

Generating More Revenue Sharing by Replacing Funds
The court also found the ABB fiduciaries liable for transferring assets invested in an actively balanced mutual fund to the trust company’s target-date fund. The court found that the fiduciaries had deleted the actively balanced mutual fund not because of performance concerns, but because the trust company’s target-date fund that replaced it generated greater revenue sharing. The court also found that ABB breached its fiduciary duties by selecting share classes with more revenue-sharing loads in order to maintain the revenue-sharing level to the trust company.

Monetary Relief
The court found that the plan suffered losses of $13.4 million as a result of ABB’s failure to monitor recordkeeping costs and to negotiate for rebates. The court also assessed $21.8 million in damages against ABB for losses to the plans caused by the “improper” transfer of assets that generated greater revenue sharing.

Lost Float Income
While the court largely exonerated the trust company from liability for the ABB fiduciary breaches, the court found the trust company liable to the plan for float income paid from the plan accounts. Finding that the trust company acted as a fiduciary when it handled the plan’s assets, the court found that the trust company engaged in self-dealing, in violation of ERISA prohibited transaction rules. In that regard, the court relied on the testimony of an expert in concluding that the plan suffered total losses of $1.7 million for trust-company breaches concerning the float.

Jeff Mamorsky is co-chair of the global benefits practice at law firm Greenberg Traurig.

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