Inappropriate Investments, Excessive Fees, Self-Dealing Most Common Reasons for ERISA Lawsuits

The rise in lawsuits is prompting more sponsors to turn to lower-cost index funds—and could prevent them from offering lifetime income products.

Lawsuits against 401(k) plans have been on the rise in the past two years, according to a report, “401(k) Lawsuits: What Are the Causes and Consequences,” issued by the Center for Retirement Research at Boston College. In 2016 and 2017, there were 107 lawsuits filed, the highest since 2008 and 2009, when 169 lawsuits were filed.

The Center says it is important to understand the causes and potential consequences of these lawsuits, since 73% of workers in 2016 were offered a workplace retirement plan, up from a mere 12% in 1983—and 401(k) plans now hold over $5 trillion in assets.

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Rather than spell out specific guidance on how plan fiduciaries should act, the Department of Labor (DOL) has historically emphasized enforcement over regulation and guidance, the Center says. This “means that fiduciaries are often left to guess what practices comply with ERISA [the Employee Retirement Income Security Act] and may only become aware of an alleged violation from a DOL investigation or lawsuit,” the Center says.

There are three main reasons for lawsuits, including inappropriate investment choices, excessive fees and self-dealing, the Center says. The DOL only says that fiduciaries should exercise a prudent process when selecting investments “so as to minimize the risk of large losses.” Lawsuits arise when funds persistently deliver poor performance compared to their benchmarks. Another issue arises when fiduciaries include the employer’s own stock in the 401(k) plan and it performs badly. However, in Dudenhoeffer v. Fifth Third Bancorp in 2014, the Supreme Court ruled that absent “special circumstances,” fiduciaries cannot be held liable for failing to predict the future performance of the employer’s stock, thereby setting a tough standard for plaintiffs to succeed.

Excessive fees are another reason for 401(k) lawsuits. Here, too, the DOL says fiduciaries should employ a prudent process, select funds that charge no more than a reasonable fee and periodically assess whether that fee is still reasonable by comparing the fees to funds with similar risk/return and asset class characteristics. However, in addition to this, the Center says, the fiduciary must ensure it has taken steps to select  the lowest-cost share class of a given fund. One way they can open themselves up to a lawsuit is by selecting a retail share class when an otherwise identical but lower-cost institutional share class is available.

Fiduciaries must also ensure that administrative fees, which include recordkeeping fees, are reasonable. They can do this by leveraging the plan’s size to negotiate lower administrative costs, ensuring that the plan’s recordkeeping fees do not subsidize services other than the retirement plan and asking the recordkeeper to offer transparency into the fees they charge.

In the case of self-dealing, this is when a fiduciary acts in their own best interest, rather than in the best interest of the plan and its participants. More than 40 financial firms’ 401(k) plans have been associated with lawsuits alleging self-dealing, i.e. choosing their own investment funds that had poor performance potential, excessive fees, or both. Since 2015, excessive fees and self-dealing lawsuits have dominated the lawsuits brought against 401(k) plans.

Consequences of litigation

As a result of these lawsuits, many retirement plans have gravitated to low-cost passive mutual fund options, which also track very closely to their benchmarks. In 2016, 24.9% of equity mutual fund assets were in index funds, a dramatic rise from 9.9% in 2001, data from the Investment Company Institute (ICI) shows.

Plans have also dropped specialty asset class funds, such as industry-specific equity funds, commodities-based funds and narrow-niche fixed income funds, as these potentially charge higher fees and carry highest investment risks.

Fiduciaries have also been demanding better fee disclosure from service providers, and this has resulted in lower fees. Additional ICI data shows that the average mutual fund fees as a percentage of assets for 401(k) participants has declined from 0.77% in 2000 to 0.48% in 2016.

However, one downside, the Center says, is that fiduciaries may stay clear of new innovations out of fiduciary fear, such as investment vehicles that provide lifetime income streams. “After all, offering an annuity option would involve more complexity than passive investments, and, thus, higher fees, and would require the plan to choose a provider, which itself entails more risk,” the Center says. Policymakers can counter this with more clarification on how plans can offer drawdown products while protecting themselves from litigation.

The full brief can be downloaded here.

Investors Want to Discuss Risk and Retirement Income

While 80% of investors say their adviser discusses risk tolerance, only 50% say they bring up the subject of guaranteed lifetime income.

Investors are interested in discussing how they can protect themselves in times of market volatility, but they are also interested in discussing guaranteed retirement income, AXA found in a survey of more than 1,000 individuals and 300 financial professionals.

Seventy-nine percent of individuals are interested in learning about an option that offers principal protection and the potential for growth. However, only 50% of people say their adviser has discussed guaranteed lifetime income, whereas 80% say they have discussed risk tolerance.

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When their financial professional brings up the topic of lifetime income, 56% of individuals rate them highly. When they do not, only 34% do so.

Additionally, the survey found that 66% of investors prefer investments with a certain return, 83% say that not losing principal is extremely or very important, 73% are concerned that their income will not last throughout retirement, and 92% expect inflation to negatively impact their retirement expenses.

“Financial professionals play a key role in supporting their clients in reaching their retirement goals,” says Kevin Kennedy, head of the individual retirement business at AXA U.S. “Clients want their financial professionals to move beyond the standard risk tolerance questionnaire and engage them in a thorough discussion of options, including income planning for health care expenses.”

The research also found that nearly 60% of individuals say they are only somewhat or not at all well prepared for a major health event and only 20% say their adviser has helped them estimate retirement health care costs.

“This research underscores financial professionals’ pivotal role in helping retirement savers to gain comfort around their ability to withstand market volatility and the potential role of high quality annuity products in helping to achieve financial security,” says Catherine Weatherford, president and CEO of the Insured Retirement Institute. “In return, financial professionals will be rewarded with higher client satisfaction.”

Greenwald & Associates conducted the survey in the fourth quarter of last year.

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