Fees are looming as the basis
for the next wave of lawsuits against 401(k) sponsors
» Not in Plain View
» The "Prudent Process"
For a long time, no one cared that much about mutual
fund fees. Good investment returns through most of the
1980s and 1990s obscured the costs participants bore and
since, for the most part, participants paid the fees,
defined contribution plan sponsors paid little attention as
well. However, plan sponsors had better start caring,
because mutual fund fees most likely will be the focus of
the next generation of ERISA class action lawsuits, some
prominent pension attorneys say.
Mutual fund fees are ripe for lawsuits because the
three-year market downturn has made participants aware that
high fees could have a negative impact on retirement
savings. Debra Davis, an associate at the Los Angeles law
firm Reish Luftman Reicher & Cohen, points out that,
according to SEC estimates, each additional 1% in annual
fees on an investment held for 20 years is estimated to
lower final yield by 18%. "Discontent leads to litigation,"
Davis says.
All it will take for any sponsor to face a lawsuit is
one disgruntled employee or former employee, warns Sherwin
Kaplan, of counsel with Thelen Reid & Priest LLP in
Washington. "There's a lot of money involved," he says.
"Virtually every 401(k) fund uses mutual funds, and
plaintiffs' class action lawyers go where the money
is."
Excessive mutual fund fees already have been the focus
of class action lawsuits, points out Eli Gottesdiener, a
plaintiffs' ERISA class action attorney in Washington. Fund
fees were at issue in a case brought by employees against
First Union Corporation, which had bought another bank and
transferred employees into a First Union plan that only
invested in First Union funds.
Employees were miffed at being forced out of
well-performing investments into underperforming funds with
high fees, and sued. That lawsuit was settled in 2001 for
$25 million, with $8 million going to plaintiffs' law
firms. Another suit, against New York Life Insurance
Company, is ongoing. The litigation against New York Life
challenges its use of excessively priced mutual funds in
the company's 401(k) plan.
With both the Labor Department and regulators, including
New York State Attorney General Eliot Spitzer, shining a
spotlight on mutual fund fee excesses, more class action
suits are sure to be filed, experts say. While most of the
ERISA class action litigation to date has affected a
limited number of sponsors, the suits over mutual fund fees
will likely have a much broader sweep.
Although ERISA became law in 1974, it was not until the
mid-1990s that plaintiffs' attorneys discovered that 401(k)
plans were lucrative fields to plowand plow they did,
filing hundreds of class action suits. First Union was
probably the first. Shortly after that case settled, Enron
collapsed, and the discovery that its 401(k) plan was
invested heavily in company stock provided fodder for
another class action, as did similar revelations about
other troubled plans.
The Enron litigation has partially settled, and all the
lawsuits over 401(k) plan employer stock that could be
brought have probably been filed, Kaplan says. More than
100 have been filed over the issue of late trading as well,
Kaplan says. So now, plaintiffs' attorneys are focusing on
mutual fund fees as the next lucrative area to pursue.
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Not in Plain View
Plaintiffs can assert liability using several legal
arguments. One theory, says Kaplan, is that sponsors and
mutual fund companies failed to disclose the true amount of
the fees that participants paid on their accounts. Another
theory centers on conflicts of interest. For example,
Kaplan says, a consultant or service provider may recommend
certain funds over others because it receives a fee or
better commissions. Sponsors can be brought in under this
theory on the argument that they failed to ask all the
necessary questions that would have revealed this conflict
of interest.
Another possible basis for suit is that participants
were charged too much for administrative fees compared to
benchmarks, Kaplan says. ERISA requires fiduciaries to
ensure that fees and expenses are reasonable and to select
and monitor investment options prudently.
"Sponsors are always fiduciaries with respect to the
selection of investment options," Gottesdiener points out.
"If they use unnecessarily high-priced investment vehicles,
based on an insufficient due diligence and not commensurate
with the buying power of their plans, they are liable even
if there was no profit motive on their part."
Traditionally, sponsors have not asked too many
questions about fees participants paid. In the past,
sponsors generally were concerned only about the fees the
sponsor actually paid, and the direct costs of various
services, such as recordkeeping and consulting, that were
paid out of plan assets, Kaplan says. Sponsors, for the
most part, he says, even if they were interested in finding
out the costs often were thwarted
by the providers who were not forthcoming about fees and
other payments that did not come directly from plan
assets.
The problem with mutual fund fees is that most plan
sponsors really do not know what fees their participants
are paying. Data is not readily available, and different
providers tend to structure pricing quite differently,
making an apples-to-apples comparison nearly impossible.
Further complicating plan sponsors' choices, Kaplan says,
many fees are either hidden or disguised, because there are
no requirements as to how fees are paid or disclosed.
However, the hidden nature of fees is what makes them
vulnerable to lawsuits. "People think that they must be
doing something wrong if they hide them," Davis says. Plans
with funds that have performed poorly are particularly
vulnerable to suit, she adds. Moreover, while service
providers often tell sponsors that "recordkeeping is free,"
explains Kaplan, the reality is that it is not: Employees
bear the cost in the form of higher management fees.
Bundled products that shift costs away from sponsors
onto employees also could be particularly vulnerable.
Sponsors often select overpriced investment options because
the vendor assured them they would face "no cost,"
Gottesdiener says: "That's a breach of duty. It's one thing
to pass administrative costs onto participants, but it's
another to make them pay more than they have to."
Just what are "reasonable" fees? Figuring this out is
not easy, says Robert Liberto, a vice president at Segal
Advisors in New York. "They range all over the place." The
largest components are investment management and
administrative fees, but there are others. For example,
12b-1 or revenue sharing fees finance the marketing of the
fund, usually going to brokers, consultants, and other
vendors. Providers also charge fees to include a providers'
investment vehicle on their platforme.g., including a
Vanguard fund in a Fidelity planand, of course, there are
so-called pay-to-play arrangements and soft dollar and
directed brokerage agreements.
Segal, which analyzes expense ratios on behalf of its
clientsmostly larger plansplaced the average expense
ratio on a balance fund as of last December at 100 to 120
basis points. For a small-cap fund, it averaged 150 basis
points.
Fees at these levels for 401(k) participants are not
excessive, Liberto argues, because, for the most part, they
compare well with what most retail customers pay. However,
Gottesdiener notes that a retail investor with $3,000 pays
only 18 basis points for a Standard & Poor's 500 index
fund from Vanguard. Participants in New York Life's 401(k)
plan, which has more than $100 million invested in the
MainStay S&P 500 Index Fund, pay as much as 59 basis
points by contrast.
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The "Prudent Process"
Regulators are trying to clarify plan sponsors' duties
with regard to mutual fund fees. "Understanding and
evaluating plan fees and expenses associated with plan
investments, investment options, and services are an
important part of the fiduciary's responsibility," the DoL
said in a guidance published in April.
Plan sponsors should go through a process of determining
what the fees are for funds they want to offer in their
401(k)s, analyzing them to determine if they are
reasonable, and then documenting the process, Davis
recommends. "It's not so much what decision you reach, but
that you went through a 'prudent process,'" she says.
Kaplan counsels writing to your service provider to ask for
a detailing of its fees and any potential conflicts, as
well as all fees the fund company pays to its own service
providers.
Why in writing? Because the chances of receiving a
response in writing are greater, and this documents that
you carried out your fiduciary duties and got the response.
"Do a thorough due diligence," Gottesdiener says. "Use
someone independent and document decisions, and the factors
weighed and not weighed in making those decisions. No
plaintiffs' lawyer can make something out of nothing in the
face of that kind of record."
While service providers in the past were not forthcoming
in revealing details about fees, Kaplan says, the current
wave of scandals has changed the landscape. One outcome of
the scandals is that mutual fund companies are more open
now to discussing their fee arrangements, and many mutual
fund companies now have form answers to questions about
fees. However, Kaplan says, it is not just mutual fund
companies that need to be questioned about fee
arrangements.
Consultants, brokers, and other service providers also
should be asked about any revenue-sharing arrangements that
might exist. "For example," he says, "when a consultant
recommends 10 funds for a plan sponsor to include in its
401(k) menu, it makes a huge difference whether those 10
funds are the ones the consultant thinks are the best for
this particular plan as opposed to being the 10 funds that
offered the consultant the biggest commissions." Once you
understand all the fees your plan is paying and to whom,
you can benchmark those fees to determine whether or not
they are excessive. "You have to make sure the fees are
reasonable," Kaplan says. "It doesn't have to be the
cheapest, but there has to be justification for what you
pay."
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