The Need to Investigate Alternatives

Art by Tim Bower

Some recent court decisions have taken different approaches to the issue of a plan fiduciary’s obligation to consider collective trusts and insurance company separate accounts as alternative investments to mutual funds. This is an issue for the applicable fiduciaries of tax qualified plans, as Internal Revenue Code (IRC) Section 403(b) plans may not, in general, invest in collective trusts or separate accounts. Take last year’s decision in the case of Johnson v. Provident Health and Services, 403(b) (Value Plan).

In Re M&T Banks Corp. ERISA Litigation, also last year, plaintiffs argued that defendants had failed to adequately investigate the availability of collective trusts and separate account alternatives for several non-proprietary mutual funds in the plan. Further, they argued that the mutual funds offered no material service or other advantage to plan participants but cost the plan millions of dollars in unnecessary fees.

Defendants, citing Spano v. Boeing, argued that Employee Retirement Income Security Act (ERISA) plan fiduciaries are not required to choose separate accounts over mutual funds and that mutual funds carry additional reporting governance and transparency requirements that might make them more attractive than collective trusts and separate accounts to plan participants.

The District Court indicated that even if true, at the motion to dismiss stage of pleadings, these arguments did not preclude plaintiffs from proceeding with the litigation. When explaining its decision, the District Court stated that “plaintiffs’ alternative investment argument is not a generalized grievance that the plan lacked collective trusts and separate accounts: It is based on allegations that [the] defendants breached their fiduciary duties by selecting particular mutual funds over specific lower-cost, but otherwise materially indistinguishable, alternatives.”

The District Court would, in all likelihood, have rejected a generalized grievance, based on the proposition recognized by all courts that, as summed up in Hecker v. Deere, “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).”

To give context, the district courts are rendering decisions at the earliest stage of the proceedings, and the same type of analysis applies in this context as with respect to institutional share classes vs. retail share classes. Defendants may ultimately be able to persuade the court that they had legitimate reasons for selecting mutual funds rather than collective trusts or separate accounts, but that determination is made at a later stage in the proceedings.

Note also that, in the event that, for a particular service, a collective trust charged more than did a mutual fund, the same analysis would be applicable. For example, in Baird v. Blackrock Institutional Trust Co., a collective trust charged a higher securities lending fee than did a mutual fund.

In contrast, in Larson v. Aliana Health Systems and White v. Chevron, the District Courts concluded that it was not a breach of fiduciary duty to fail to offer lower-cost collective trust funds and insurance company separate accounts. Defendants indicated that mutual funds offer greater transparency than do the other two investment alternatives and have important regulatory safeguards attached such as diversification requirements, limitations on leverage, and mandatory oversight by a largely independent board of directors.

These courts concluded that ERISA requires neither the inclusion nor exclusion of collective trusts and separate accounts. In White v. Chevron, the District Court stated that the comparison was apples to oranges, because, while the fees for the collective trusts would have been less, these would have been at the expense of factors that warranted the higher fees. Rather, it is a judgment call for the applicable plan fiduciary to provide some context to these cases.

In Terraza v. Safeway, the plaintiff alleged, unsuccessfully, that the placement of collective trusts and separately managed accounts into an ERISA plan was a per se ERISA violation because these alternative investments were not subject to prospectus and Securities and Exchange Commission (SEC) registration requirements and, therefore, were necessarily inferior to mutual funds.

Takeaway: While the failure to consider collective trusts and separate accounts may not be a breach of fiduciary duty, it may be an evolving best practice for the applicable plan fiduciary to at least consider such alternatives.

Marcia Wagneris an expert in a variety of employee benefits and executive compensation areas, including qualified and nonqualified retirement plans, and welfare benefit arrangements. She is a summa cum laude graduate of Cornell University and Harvard Law School and has practiced law for 32 years. Wagner is a frequent lecturer and has authored numerous books and articles.