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.

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.