In May, I wrote about the wrong turn the Department of Labor has made in developing its view of ERISA fiduciary law as it applies to the typical 401(k) plan—that is, an individual account, Employee Retirement Income Security Act (ERISA) Section 404(c) plan in which participants choose investments from a fund menu. Instead of adopting the traditional trust law principle that focuses on “other people’s money” issues—possible abuses where person A is investing money on behalf of person B—it claimed that the tax benefits associated with retirement savings provided a basis for its comprehensive regulation of the retirement savings industry.
This approach is most problematic with respect to 401(k)/404(c) plans—in which participants choose their own investments. In my humble opinion, the only “fiduciary” issue in these plans is whether the fund menu choices the sponsor/sponsor fiduciary has made available provides the participant with a reasonable suite of investment choices.
In this column, I’d like to consider how courts are handling these same ERISA fiduciary issues—in litigation challenging plan fiduciary decisions with respect to fund menu construction, manager and fund selection and monitoring, fund fees and performance. I’ll conclude with some ideas on how to bring some order out of the current chaos.
Litigation targeting fees
401(k) fiduciary litigation began (more or less) with fees and an argument over how high the ERISA fiduciary bar should be with respect to them: what sort of deal (on fees) must the fiduciary get for plan participants on the funds included in the plan fund menu?
In these cases, plaintiffs typically argue that plan fiduciaries have an obligation to get plan participants the “best deal” available—often producing tables that go on for pages comparing expense ratios for the target plan’s funds with those of other allegedly comparable, lower-priced funds.
Defendants counter that ERISA doesn’t impose this sort of strict standard, that they only need to get participants a “good enough” deal, and that “nothing in ERISA requires every fiduciary to scour the market to find and offer the cheapest possible fund (which might, of course, be plagued by other problems)” (citing the 7th U.S. Circuit Court of Appeals decision in Hecker v. Deere & Company (2009)).
There is, currently, no consensus on which of these standards—a “best” or a “good enough” deal—is the “law of the land.” Some courts appear to be applying a fairly strict standard. Others have rejected claims based solely on an allegation that plan fiduciaries could have “offered cheaper share classes … standing alone” (quoting the U.S. District Court for the Northern District of California in White v. Chevron (2016)).
Litigation targeting performance
More recently we have seen the emergence of litigation claiming that plan fiduciaries have imprudently included underperforming funds in the plan menu.
I would say, as a threshold matter, that, just as with fees, offering a reasonable suite of investment choices should be an adequate (and complete) defense to this sort of “underperformance” claim. But where, e.g., the plan offers only one large cap equity fund, the performance of that fund may be an issue.
The obvious problem is: How and by what standard do you determine that a fund will be “so underperforming” that including it in a fund menu is imprudent, when all the stocks in it are trading at current fair market value? As many courts have noted, most of plaintiffs’ arguments in these cases depend on hindsight—no one sues when a particular strategy pays off, only when it doesn’t. But legitimate criticism of a fiduciary decision can only be made on the basis of the facts at the time of the decision, when the future is uncertain, and (generally) market participants are on both sides of any particular investment strategy.
This litigation is in part fueled by the fact that most diversification and “defensive” asset allocation strategies have significantly underperformed U.S. large cap equity. And one angle of attack by plaintiffs in these cases has been that the complained-of investment strategy employed by plan fiduciaries (e.g., defensive investments in alternatives) is “novel.” Which raises the question: are these plaintiffs arguing that innovation, or contrarian-ism, are themselves imprudent under ERISA, at least when they don’t pay off?
My guess is that most professionals would argue that prudence here should be tested not by comparing investment results in hindsight but by evaluating the process used to select the funds. The question then becomes: what sort of facts should a court require a plaintiff to allege about the plan fiduciary’s process, given that plaintiffs generally don’t have any access to the key information? Letting the plaintiffs go on a fishing expedition based merely on hindsight-underperformance cannot be the right answer.
With respect to this issue, I have a friend who suggests that fiduciaries should simply video their meetings and publish them.
These issues become more acute when plaintiffs target the plan’s default investment target-date fund (TDF). It’s certainly possible that a poorly designed or poorly executed TDF can “hurt” a lot of participants—these funds are getting most of the new money in 401(k) investments.
Evaluating the performance of a TDF is, however, especially difficult. They are (in effect) fund-of-funds, allocating assets over time based on a (in some cases unique) glide path. What possible benchmark can you use to even establish that a particular TDF has “underperformed?” The biggest TDF providers use different asset allocation strategies and significantly different glide paths, with different results. And—by the way—if you’re looking at the last 10 years, whichever TDF had the most aggressive allocation to U.S. large cap won any such comparison.
What about simply applying Dudenhoeffer to these cases?
In the (relatively) recent decision in the Disney ERISA Litigation, plaintiffs challenged the inclusion of the Sequoia Fund in the Disney plan’s 26-fund investment menu. The Sequoia Fund had invested heavily in Valeant Pharmaceuticals and sustained significant losses in 2015.
The court, in dismissing plaintiffs’ claims, relied principally on the Supreme Court’s market price = prudence rule (for company stock litigation) in Fifth Third Bancorp et al. v. Dudenhoeffer. What is interesting about this decision is that it involved a fund not company stock.
In a similar vein, the 7th Circuit Deere court explained its holding in favor of plan fiduciaries based in part on the fact that “all of [the challenged] funds were also offered to investors in the general public, and so the expense ratios necessarily were set against the backdrop of market competition.”
Why isn’t that a good enough standard? Other people are investing their own money in these funds—why doesn’t that make their inclusion in an ERISA plan “prudent enough.”
The Barry’s Pickings Rules
This is all something of a mess—there’s no clear guidance, and the victims don’t find out what they did wrong until after they’ve been sued.
Here’s my bottom line: A participant should be able to get at least as good a deal from her plan as she could walking into, say, a brokerage or mutual fund “store” run by, e.g., Fidelity, Vanguard, or T. Rowe Price.
Under this standard, a fiduciary would satisfy its fund menu obligation if it offered a “breadth of investments and range of fees” (quoting White v. Chevron, again). It would help if the Department of Labor (DOL) published regulations specifying what constitutes such “breadth”—otherwise we’ll just have to fight it out in the courts. But a reasonably robust brokerage window should constitute the outer limit of this requirement.
TDFs should be reasonably constructed—that is, the plan fiduciary should be able to describe a defensible theory why it made the choices it made. And that rationale should be transparent (fully disclosed) to participants. If a participant doesn’t like the TDF’s investment mix or glide path theory, he is free to invest in some other fund from the plan’s “breadth of investments”—he shouldn’t be free to sue just because he doesn’t like the TDF.
Fiduciaries should—at the motion to dismiss stage—make available investment committee minutes—and should prepare these minutes with a view to producing them in court. If—based on those minutes—the plaintiff cannot make a plausible argument that a fiduciary decision was clearly unreasonable, the case should be thrown out.
What is the alternative? There can only be one “lowest priced fund.” Should everyone just invest in that one fund? You sometimes wonder—when the same people that rail against the current 401(k) system propose folding it into Social Security or the Federal Thrift Savings Plan—whether that is in fact what these people actually want.
Michael Barry is president of O3 Plan Advisory Services LLC. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly http://moneyvstime.com/ about retirement plan and policy issues.This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
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