by Fred Reish
It’s no secret that plan sponsors are concerned about getting sued because of the investments and expenses of their 401(k) and 403(b) plans. That worry is well founded because of the many ERISA fiduciary lawsuits that are filed every year.
To reduce the risk of being sued or, if sued, of being liable, it is critical for plan sponsors to know what claims are being made and to understand which claims are succeeding and which are not. This article discusses some of the most common claims and whether the plaintiffs’ attorneys are generally successful with those claims. Unfortunately, though, there are nuances and the outcomes are often fact-specific, so this article should be viewed as educational, but not a substitute for individualized legal advice.
A Claim that the Cost of Plan Investments and Services Aren’t the Lowest
Plaintiffs’ attorneys often assert that a plan could have used lower cost mutual funds (or other investments) or cheaper services. Fortunately, those claims, standing alone, have not be successful.
The law, ERISA, requires that fiduciaries pay no more than reasonable amounts for investments and services. However, contrary to common thinking, “reasonable” is not a fixed amount; instead, it is the range of costs established by the competitive marketplace. In other words, a transparent and competitive private sector market establishes a reasonable range of costs for a particular service or investment.
In addition, the range of costs for a type of service is not always the same. For example, if an investment adviser provides more services or higher quality services, the adviser’s compensation should not be compared to others who provide more limited or less valuable services. The issue is whether the plan is receiving value that is commensurate to what it is paying.
Benchmarking data is often used to help with this cost/value analysis. Most plan advisors have access to benchmarking services that can help plan sponsors fulfill the fiduciary responsibility to determine appropriate costs for plan services.
While some plans benchmark every year, others benchmark every two or three years. The only “rule” is that the evaluation should be done at reasonable intervals.
Another approach is to use RFPs for determining whether the pricing of service providers is competitive. While that is effective, it can also be costly and time consuming. As a result, RFPs are most often used when a plan sponsor is seriously considering switching providers.
Calculating Recordkeeping Fees: Percent of Assets, Per Participant, or Flat Dollar Amount
The charges for services providers are usually paid by the plans. In some cases, those fees are covered by revenue sharing from investments that is paid to the plan’s recordkeeper. In other cases, part or all of the recordkeeping (and other service provider) fees are paid directly from the plans.
In both cases, though, plan sponsors need to decide if the fees are reasonable and to know how the service provider fees are calculated. That is part of the fiduciary responsibility to monitor the plan’s service providers.
It is common for the recordkeeping fees of smaller plans to be calculated as a percent of the plan assets. (And, in most of those cases, part or all of the recordkeeping fees through revenue sharing from the investments.) The recordkeeping fees for some larger plans are also calculated as a percent of plan assets (but the fees may be paid directly from plan assets and charged to the participants’ accounts).
Other plans calculate their recordkeeping fees either as per-participant charge or as a flat dollar amount. (The larger the plan, the more likely that the fees will be a flat dollar amount.) In those cases, most or all of the fees are charged to the participants’ accounts.
What do plaintiffs’ attorneys have to say about that?
It is common in fiduciary breach complaints for plaintiffs’ attorneys to assert that recordkeeping fees should be calculated on a per-participant basis (e.g., $50 per participant). (As a comment, the smaller the plan, the higher the dollar amount per participant.). The basis for the plaintiffs’ attorneys argument is that most of the costs of recordkeeping are incurred on a per-participant basis, and therefore the recordkeeper’s fees should be calculated that way.
What do the courts say about that?
The courts consistently apply the law as written. That is, the rule is that fees for plan services must be reasonable. In other words, so long as the fees are reasonable, the method of calculation doesn’t matter. So, the message for plan fiduciaries is that they should regularly assess the reasonableness of the being charged by their service providers, but that the method of calculating those fees is up to the fiduciaries.
Passive Investments Versus Active Investments
Plaintiffs’ attorneys have a preference for passive, or index, investments. Their complaints often assert that a plan should have offered low-cost index funds, rather than higher-cost actively managed funds.
That argument is based on the lower costs of index funds and, in some cases, on the relatively good performance of index funds.
However, the courts have having none of that. First, the courts view the index-versus-active funds comparison as “apples-to-oranges.” That is, the expenses of actively managed funds will be higher, and the issue is how the expenses of the actively managed fund stacks up against the expenses of other similarly managed funds. Second, the courts focus on the process used by the fiduciaries to select the actively managed fund. Is the manager and the investment firm well-qualified? Does the firm have solid research capabilities? Does the track record reflect a consistent application of the manager’s investment style? And so on.
The bottom line is that the courts are consistently deciding that, if an actively managed fund satisfies reasonable selection and monitoring criteria, it can be prudently selected and retained by a plan.
Institutional Share Classes versus Retail Share Classes
Perhaps the most common, and most successful, claim today is that a plan should have used institutional share classes of a mutual fund rather than retail share classes of the same fund. More accurately, the issue is whether the plan fiduciaries selected the lowest cost share class available to a plan of that size. (A “share class” is just a type of share ownership in a mutual fund—generally based on either the type of investor or the amount to be invested.) Some mutual funds have many share classes. It’s not uncommon the have 5 or more. There is just a single pool of investments—one mutual fund, but the expenses vary by share class.
As a general statement, some higher cost share classes pay “revenue sharing” to a plan’s recordkeeper to offset the cost of the recordkeeper’s fees to the plan. In that case, the plan benefits from the revenue sharing and, in a manner of speaking, the share class is less expensive to the plan than first appears.
What do the plaintiffs’ attorneys say in their complaints?
Plaintiffs’ attorneys almost always argue that the plan sponsor breached its fiduciary duties by not selecting the least expensive available share class.
And, what do the court’s say?
It is more nuanced. Generally, courts agree that plan fiduciaries have a duty to select the lowest cost available share class. (I say “available” because, depending on the size of a plan, some share classes may or may not be available to that plan.) But there is more to it. The courts also say that, if a higher cost share class was selected, but an revenue sharing is paid to the recordkeeper to offset its fees to the plan, and the revenue sharing is equal to or greater than the difference between that share class and the lowest cost available share class, the fiduciaries did not have a duty to select the superficially lower cost share class. In other words, a share class that appears to be more expensive at first blush can actually be less expensive after payments to the recordkeeper, for the benefit of the plan, are taken into account.
But, of course, the expectation is that plan fiduciaries will learn about the lowest cost available share class and then compare it to the more expensive share class, taking into account the revenue sharing paid to the recordkeeper. That would likely require the help of a knowledgeable retirement plan advisor.
Concluding Thoughts
The fiduciary “job” requires a deep understanding and evaluation of plan investment expenses and service provider charges. That’s not an easy job. The Supreme Court recognized that in its recent Northwestern University decision. However, the fiduciary responsibilities can be successfully navigated with an understanding of the decisions that fiduciaries need to make and with help and data support from a knowledgeable advisor.
In some ways, the hardest part is to know the decisions that have to be made and the process and information for making those decisions. This article is designed to help with that part.
This content was authored by Fred Reish. Fred Reish is a partner with the law firm of Faegre Drinker who specializes in retirement law, focusing on fiduciary and best interest standards of care, prohibited transactions, conflicts of interest, and retirement plans.
The views expressed in this article are those of Fred Reish, and not necessarily of Faegre Drinker or HUB International. The article is for general information only and is not intended to provide investment, tax or legal advice, or recommendations for any particular situation. Please consult with a financial, tax or legal advisor on your circumstances.
HUB International’s retirement plan fiduciary advisors provide ongoing guidance on your plan’s setup and management to ensure it meets regulatory compliance guidelines and the interests of your employees. Contact HUB to request an assessment of your organization’s retirement plan.