Fiduciary Papers #9: 401(k), Non-Governmental 403(b) Plan Sponsors: Risks from Class Action Claims for Unreasonable Fees

THE IMPACT OF HUGHES V. NORTHWESTERN

In early 2022, the U.S. Supreme Court considered a class action lawsuit that was brought against Northwestern University’s retirement plan, which was subject to ERISA’s requirements. The U.S. Supreme Court’s decision addressed the threshold for plaintiffs to get past the “Motion to Dismiss” stage of such litigation when the “best” (and often lowest-cost) retirement mutual funds (or other forms of investments) were not found in the retirement plan. The most common allegation is that the defined contribution plan paid “excessive fees” by not choosing lower-cost equivalent mutual funds, or by paying record-keepers unreasonable fees given the size of the plan.

Since the U.S. Supreme Court’s decision, the various U.S. Circuit Courts of Appeal and District Courts have approached these cases differently. Motions to Dismiss in the First Circuit (covering Massachusetts, New Hampshire) have rarely been granted. While in most other circuits, class action plaintiffs have fared less well.

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WHAT ERISA-BASED PLANS ARE AT RISK?

Plaintiffs used to pursue cases just against billion-dollar plans. But in recent years, smaller defined contribution plans [401(k), non-governmental 403(b) plans] have been targeted in these class action cases alleging investment and/or record-keeper fees were too high.

These cases demonstrate that even small plans with low asset levels can be subject to ERISA lawsuits. As a result, it is important for plan sponsors to be aware of their fiduciary obligations and to take steps to minimize their risk of being sued.

Even if the risk of class action is low (in your geographic area, or because your defined contribution plan assets are relatively small), most plan sponsors will want to “do the right thing” and seek to provide the best investment options for their employees.

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THE TOUGH DUTIES IMPOSED UPON PLAN SPONSORS

Sponsors of defined contribution plans face enormous responsibilities. This text addresses one of the primary areas for class action litigation against plan sponsors, both large and small – the selection of investments for inclusion in the 401(k), 403(b), or 457 plan lineups.

Often delegation for decisions on investments is undertaken by a plan sponsor to an Investment Committee.[i] Members of the Investment Committee assume potential liability for the investment decisions made by the committee in connection with the plan.

Key responsibilities of plan sponsors (and Investment Committee members) include:

• Acting solely in the interest of plan participants with the exclusive purpose of providing benefits to them;
• Carrying out duties prudently;
• Following the plan documents (unless inconsistent with ERISA);
• Diversifying plan investments; and
• Paying only reasonable plan expenses.[i]

As fiduciaries of the plan charged with duties regarding investments, plan sponsors and Investment Committee members must act “prudently.” As stated by ERISA: “[A] fiduciary shall discharge his duties [by] defraying reasonable expenses of administering the plan[i] … [and] with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims.^[ii]“

Even though defined contribution plan participants are responsible for selecting their plan investments,[iii] “plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options.”[iv]

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DELEGATION: OFTEN REQUIRED, BUT NOT ALWAYS DONE CORRECTLY

Yet, neither plan sponsors nor Investment Committee members are experts in investments (except very rarely), nor do they often possess detailed knowledge of the requirements of the prudent investor rule and the due diligence necessary to meet those requirements. Lacking such expertise, they necessarily turn to those with a high degree of professional knowledge to guide them in the investment decision-making processes.

Three different levels of delegation to qualified investment advisers may occur:

1. No delegation may occur, as often exists when a plan sponsor receives recommendations from a non-fiduciary “platform provider” or “custodian” or “retirement plan consultant.” Let’s be clear about this … in my opinion, no plan sponsor (who is a fiduciary) should EVER utilize, for investment recommendations or advice, any person and/or firm who is not a fiduciary to the plan sponsor at all times. And, plan sponsors should avoid those who promote “fiduciary guarantees” – which are often fairly worthless, as I pointed out in an earlier post. In summary, don’t be that plan sponsor “left holding the bag” while defending an ERISA claim, and finding out that the individual and firm providing investment recommendations is dismissed from the lawsuit as they were not ERISA fiduciaries.
2. Some aspects of liability may be avoided when an investment adviser is hired as an ERISA §3(21) “investment advisor.” The majority of fiduciary investments advisers who provide investment recommendations to plan sponsors operate as §3(21) fiduciaries. These fiduciaries provide investment recommendations to the plan sponsor, but the ultimate decision is left up to the plan sponsor.
3. Under several recent court decisions, a much greater likelihood of liability avoidance for plan sponsors occurs when a §3(38) “investment manager” is engaged. §3(38) fiduciaries are investment managers or outsourced chief investment officers. In the defined contribution plan space, §3(38) investment managers most often are given the responsibility to choose target-date funds (TDFs) and other funds for inclusion in the plan. An increasing number of plan sponsors are choosing to utilize §3(38) fiduciaries, in large part as a means to mitigate litigation risk.

Even when a §3(21) investment advisor or a §3(38) investment manager is retained, the plan sponsor still possesses duties relating to retains advisor or manager selection and oversight. For this reason, plan sponsors should possess a sound understanding of core investment principles, as they relate to the selection of mutual funds and other investments for defined contribution plans.

Additionally, I urge plan sponsors should scrutinize service agreements for attempts to disclaim fiduciary status and/or the core fiduciary duties of due care and loyalty.

Likewise, plan sponsors should never hire a “conflicted” §3(38) Investment Manager or §3(21) Investment Advisor, who recommends proprietary products for which the firm (or its affiliates) will receive greater compensation. A true investment fiduciary cannot wear “two hats.”

[For an overview of §3(16), §3(21) and §3(38) plan fiduciaries, I recommend a recent guide published by the The Defined Contribution Institutional Investment Association entitled, “Defined Contribution Plan Governance Models: A Guide for Plan Sponsors.”

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TIPS FOR COMPLIANCE WITH ERISA’S TOUGH PRUDENT INVESTOR RULE

ERISA’s “prudent investor rule” is a very tough investment standard to meet. Key requirements of the prudent investor rule include: (1) Permit plan participants (employees) to possess investments which minimize “diversifiable risk”; and (2) Limit the “waste” of plan assets, by paying extremely close attention to the total fees and costs of each mutual fund or other investment product selected should occur.

Here are some tips for adhering to the prudent investor rule’s requirements:

• Many forms of “active fund management” – via either stock selection or market timing – possess very high probabilities of long-term underperformance relative to index and other passively managed funds; actively managed funds are often challenged as not meeting the requirements of the prudent investor rule.
• Carefully selected evidenced-based investment strategies, for which there exists substantial academic support and which can be implemented through low-cost funds and/or other investment vehicles, can meet the prudent investor rule’s tough requirements. Such strategies should possess a substantial probability of outperforming the carefully chosen benchmarks over multi-decade periods of time. However, education and one-on-one advice to plan participants should be considered when such investment options are included in a plan, given the altered nature of the risks and potential returns of these investment strategies.
• Possessing a limited menu of investment options, including approximately 12 to 24 mutual funds (in addition to eight to ten target date funds), is appropriate. However, too few funds should be avoided.
• I especially recommend that plan sponsors include, as part of their investment line-up, low-cost multi-factor funds in U.S., foreign developed, and emerging markets. Well-designed and well-implemented multi-factor funds possess a substantial probability of outperformance of the broad equity markets, over any given 20-year time period.
• A stable value fund should be included in the plan lineup. The  financial strength of the issuer(s) of the stable value fund should be carefully considered and monitored.
• Target date funds should be included in the plan lineup, but should be carefully selected. Additional education of, and/or one-on-one investment advice to, plan participants may be warranted to establish appropriate investor expectations for such funds.
• The inclusion of ESG funds in defined contribution plan lineups has been fostered by U.S. Department of Labor rule-making activities, at present. Yet, ESG funds should still be scrutinized given the strict requirements of the prudent investor rule. Additional disclosures to plan participants regarding ESG funds should be considered.
• Recent legislation provides “safe harbors” to plan sponsors to provide lifetime and other annuity options to plan participants. However, the magnitude of the decision to annuitize a portion of her or his “nest egg” possesses a huge impact upon a plan participant’s future. This fact, together with the ever-changing macroeconomic environment, the varying payouts of immediate and deferred annuities, all suggest that default options should not be included in defined contribution plans. Rather, it is recommended one-on-one consultations between a plan participant and a fiduciary investment adviser to ascertain appropriateness of the strategy. When the strategy is appropriate, then the plan participant should engage a fiduciary investment adviser to assist in shopping the evolving marketplace of suitable products, with due consideration given to the financial strength of issuers as well as the limits set by state guarantee programs (and the fact that state guarantee programs are usually not funded in advance).
• The culmination of investment due diligence should always be evidenced in the Investment Policy Statement adopted by the defined contribution plan’s plan sponsor or Investment Committee.
• Additional materials regarding the investment due diligence undertaken each year should be supplied by the §3(38) Investment Manager or §3(21) Investment Adviser, and the receipt and discussion of such materials should reflected in the minutes of Investment Committee meetings.
• By carefully selecting investment advisers who appropriately apply academic research and back-testing methods during the investment due diligence processes, plan sponsors’ risk exposures can be substantially reduced, and plan participants’ success in their attainment of their individual lifetime financial goals can be better assured.

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Ron A. Rhoades, JD, CFP(r) is the Principal of Scholar Financial, LLC, a fee-only, fiduciary investment advisory firm. He also serves as Director of the Personal Financial Planning at Western Kentucky University. His book, Mastering the Art and Science of Investing, is due to be published in late 2023.