Weather the Storm of 401(k) Lawsuits

By Gregory L. Ash Sep 1, 2007

HR Magazine, September 2007 Can you withstand the all-out assault on excessive and hidden 401(k) fees?

Employers of every size should prepare for a wave of legal and regulatory challenges to the way their 401(k) plans are administered. And unlike the 401(k) crisis that grabbed headlines in recent years in which only large plans with company stock funds were affected, small and mid-size plans also will feel the brunt of this storm.

A group of lawsuits filed in late 2006 and early 2007 attacks the basic fee structure used by most 401(k) plans. The lawsuits have received significant media attention, leading to increased scrutiny from legislators as well as plan participants. They have the potential to dramatically alter the way plans are administered, and already are accelerating proposals to require greater transparency by service providers in their 401(k) fees.

Threatened Nest Eggs

According to the complaints, investment-related fees paid by the plans to the 401(k) service providers—and indirectly paid by plan participants—were excessive, improperly diluting the returns on participants’ 401(k) investments. The lawsuits seek to recover what could amount to many millions of dollars out of the pockets of company officials who were responsible for administering the plans. Although the employers and plans sued so far are very large, including Kraft, International Paper, Caterpillar and Boeing, the legal theories advanced by the plaintiffs would apply to almost every 401(k) plan and plan sponsor. 

The 401(k) fee system was already undergoing a transformation before this wave of litigation, with several judicial and regulatory actions also focusing on the issue of fee transparency. These developments make it critical for HR professionals responsible for 401(k) administration to understand what’s at issue and how to protect themselves and their employers from similar claims, even while the courts sort out the validity of the lawsuits. 

With more than $2.9 trillion in the 401(k) industry at stake and baby boomers on the cusp of retirement, it’s clear these issues are not going away soon.

Fee Practices Challenged

The challenged fee practices, pervasive in the 401(k) industry, include both direct payments plans make to their service providers and “revenue-sharing” arrangements between mutual funds and other outside parties. Often employers are unaware that the latter arrangements even exist. 

The complaints characterize these fees as “hidden,” largely because they are difficult to understand and rarely disclosed to participants. 

The plaintiffs in the class complaints argue that some direct, or “hard-dollar,” payments are not adequately disclosed to participants. For example, they say that this is the case when plans participate in master trust arrangements (which are trusts that pool the assets of multiple plans) and payments are made to service providers from the master trust. The lawsuits suggest that fees paid directly from the master trust—rather than from a component plan—are not disclosed to plan participants, making it appear that plan expenses are very low or even nonexistent. 

The plaintiffs also challenge “soft-dollar” fees. These generally are asset-based fees charged by mutual funds, fund managers and other service providers, including 12b-1 fees and revenue-sharing payments. The class complaints characterize revenue-sharing payments as “the big secret of the retirement industry.” They assert that such payments are really assets of the plans that should be used only to benefit plan participants.

Excessive Fees

Although a single St. Louis-based law firm is primarily responsible for the current wave of lawsuits, other plaintiffs’ firms also have joined the fray. These include Employee Retirement Income Security Act (ERISA) powerhouse Keller Rohrback, which is targeting 401(k) and 403(b) service providers such as ING, Bisys and MetLife as well as plan sponsors who offer variable annuity investment options in their plans. 

Those who have been sued include employers that sponsor the plans, their boards of directors, investment and administrative committees assigned to run the plans, and individual executives. Under ERISA, if those defendants are found to be plan “fiduciaries,” they may be held personally liable for any losses their actions caused. 

In each of these cases, the plan participants allege that revenue-sharing payments and other expenses associated with the plans were both excessive and not disclosed to them. They say that by accepting these fee arrangements, the defendants breached a variety of fiduciary responsibilities under ERISA. 

For instance, some of the plans offered participants the ability to invest in mutual funds that charge a fee for active management but that allegedly behave like passively managed index funds. The complaints assert that the returns participants earned on those funds were virtually identical to the returns they could have obtained from an index fund that has a much lower management fee. They argue that the management fees imposed by these alleged “shadow index funds” were therefore excessive, and that the plans’ fiduciaries should not have accepted them. 

The complaints in some of the cases also challenge fees and other practices associated with employer stock funds. These funds allow (and in some cases require) plan participants to invest in the stock of the plan sponsor. 

In many of the class complaints, the participants contend that the employer stock funds charged improper management and administration fees, when there really was no “management” of the fund at all. They also argue that fiduciaries allowed excessive cash to be held in unitized employer stock funds, thus diluting returns. 

Explaining their theory, the plan participants claim that:

  • 401(k) plans have become the primary vehicle for private retirement savings.

  • Even small reductions in the return on 401(k) investments are devastating to participants.

  • The most certain means of protecting 401(k) returns—and the factor most within employer control—is to reduce the fees and expenses attributable to those accounts.

  • The fee structures used by investment fund managers, recordkeepers, consultants and other 401(k) service providers are complex, excessive, undisclosed and illegal.

  • By accepting those fee structures, plan fiduciaries breach their obligations to participants under ERISA.
Each complaint seeks a recovery of excessive fees and investment losses that could add up to tens or even hundreds of millions of dollars.

Undisclosed Fees

Common to all of the lawsuits is the plan participants’ assertion that they were not fully informed about the expenses associated with their accounts. This, they say, vitiates the protection from liability that plan fiduciaries might otherwise have had under Section 404(c) of ERISA. 

Most plans that allow participants to choose how to invest their money do so in reliance on Section 404(c). That statutory provision protects fiduciaries from liability for any losses participants may incur when making those investment choices. 

However, this protection applies only if participants are given sufficient information with which to make investment decisions. According to the participants, by failing to provide adequate information about plan expenses, the fiduciaries did not comply with Section 404(c), and thus they remain responsible for any investment losses the participants may have suffered. 

Although two courts already have rejected this theory of recovery (in Loomis v. Exelon Corp., 06-C-4900 (N.D. Ill. 2007), and most recently in Hecker v. Deere & Co., 06-C-719-S (W.D. Wis. 2007)), at least two others have allowed the plaintiffs to proceed with it.

Business Model Challenged

The defendants are mounting a vigorous defense to these cases. Pointing to the high factual hurdle that the participants will have to overcome to prove both that fees were excessive and that they were harmed as a result, some industry commentators have suggested that there is little reason to pay attention at this point. That attitude is shortsighted. 

These lawsuits can do significant damage to the 401(k) industry even if the participants cannot prove their own damages at trial. For instance, because of the inherently factual nature of the claims, proceedings in these cases are likely to be extensive and early dismissal unlikely, driving up the cost of defense for the plan sponsors. Though the defendants have filed a litany of procedural motions seeking to have the claims dismissed, they have had little success convincing the courts to do so. 

Most of the originally filed cases still are proceeding, although Deere & Co. now has prevailed in one of the lawsuits at the district court level. The participants have already vowed to appeal that ruling. 

For most employers, the participants’ success in court is now largely irrelevant. Regulators, 401(k) service providers and Congress already are taking action of their own to address perceived deficiencies in the 401(k) industry that were first highlighted by the lawsuits. Those initiatives will affect plan sponsors regardless of the outcome of the litigation. 

Even if the cases are settled before trial without the defendants admitting any wrongdoing, settlement could validate a new risk of plan sponsorship. This risk, coupled with regulatory reaction from Washington that already is brewing, may cause employers or regulators to push for fundamental changes in the way that 401(k) service providers are compensated. 

And although only very large plans and employers have been targeted so far, success in one case—even a favorable settlement—could encourage copycat suits against smaller plans and employers. Those employers are less likely to have devoted significant time and resources to fiduciary compliance initiatives, and thus may be more vulnerable.

How To Protect Your Plan

Until the courts resolve the merits of the claims in these cases, however, there are measures that employers and plan fiduciaries can take to reduce their risk of liability. For instance, the Department of Labor has prepared a sample 401(k) plan fee disclosure form that is designed to help fiduciaries compare investment product fees and administrative expenses charged by competing service providers. 

In addition, 401(k) fiduciaries should consider initiating a comprehensive evaluation of the fees they pay. Such an evaluation should include the following preventive measures:

  • First, determine when your plan’s investment options, including their expense ratios, were last evaluated. If it was more than 12 to 18 months ago, engage in another detailed analysis of those options, with a particular emphasis on fees. Are expense ratios substantially higher or lower than those for comparable funds? Has investment performance met the funds’ benchmarks? Are you receiving value for active management fees?

  • Review your contracts with your 401(k) providers, evaluating whether fees have been paid in a way that is consistent with those agreements. Have you overpaid or underpaid? Do you know how much you are paying for plan administration, both directly and indirectly?

  • If existing fee arrangements are asset-based, evaluate whether those arrangements continue to be appropriate. This is especially important if the plan is relatively new and account values have increased substantially since the fees were established. What was once an appropriate fee may have grown into an excessive one.

  • Identify all of the services for which you are paying. This will help document the “value” component of the fee equation.

  • Engage in thorough fact-finding about revenue-sharing and soft-dollar fee payments. Attempt to determine exactly how much is being paid to administer your plan, and to whom. Of course, merely asking those questions is not enough. Fiduciaries must understand how fees are paid, to whom and in what amounts. In this regard, ERISA holds 401(k) fiduciaries to the standard of a prudent expert, not merely a prudent lay person. Thus, it may be necessary to engage the services of an investment consultant or attorney to help explain complicated 401(k) fee structures.

  • If service providers receive revenue-sharing payments that were not disclosed at the time the service agreement was negotiated, attempt to negotiate a more favorable deal, offsetting hard-dollar payments with revenue-sharing dollars. Don’t leave money—or negotiating leverage—on the table.

Once this information is obtained, fiduciaries should be prepared to disclose it to plan participants. Whether detailed information like revenue-sharing payments must be provided to all participants as a matter of course, as suggested in the class-action lawsuits, is an issue that will be resolved by the courts and regulators. 

Plan fiduciaries should be ready to provide it, however, should participants ask for it.

All of these measures should be well-documented in the form of meeting minutes, so that fiduciaries will have contemporaneous written evidence that they followed a prudent process should their decisions be challenged later. 

Editors Note: This article is not intended as legal advice; for specific factual situations, please seek qualified employment counsel.

Gregory L. Ash is a partner in the Kansas City-based law firm of Spencer Fane Britt & Browne LLP, where he is a member of the firms Employee Benefits Group and co-chair of its ERISA Litigation Group.

Web Extras

SHRM web page: Workplace Law Focus Area home page

Online sidebar: Heightened Focus on Fees

SHRM article: Excessive 401(k) Fees Fought (HR News)

SHRM article: 401(k) Fee Litigation: Assessing the Complaints, Plan Sponsors' Duties (SHRM Online Compensation & Benefits Focus Area)

SHRM article: GAO Calls for Major Changes in 401(k) Fee Disclosure (SHRM Online Compensation & Benefits Focus Area)

SHRM article: Associations Call for Clarity in 401(k) Fee Disclosures (HR News)

Sample form: 401(k) Plan Fee Disclosure (U.S. Department of Labor)


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