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Recent Supreme Court Ruling Highlights the Trustees’ Duty to Monitor 401(k) Plan Investment Options
Recent Supreme Court Ruling Highlights the Trustees’ Duty to Monitor 401(k) Plan Investment Options
By: Stewart M. McGough, Esq.
Participant-directed retirement plans (usually, 401(k) plans for private employers and 403(b) plans for public employees) have proliferated for over 40 years, driven in part by employers’ desire to shed their fiduciary responsibility for investing the plan’s assets. The financial industry has encouraged this shift by offering hundreds of investment options, including brokerage accounts for individual stock and bond holdings, mutual funds and ETFs, and annuity contracts. Often, the plan sponsor pays no or little attention to those options once the plan is first set up, and as shown in a recent United States Supreme Court ruling, that inattention can prove hugely expensive to the fiduciaries in charge of arranging the investment options.
In Hughes et al. v. Northwestern University et al, decided on January 22, 2022, the Administrative Committee for two Northwestern University retirement plans allowed participants to choose from among 400 mutual funds and annuity contracts (under a recent study, the average number of investment options was only 17). The options included both retail mutual funds and funds which, although exactly the same as their retail fund counterpart, could only be offered by the fund sponsor to institutional investors.
Their only difference was in the amount of fees charged to the funds internally for investment management services, marketing expenses, brokerage fees and transfer fees. The sum of these fees, as a percentage of the value of the fund itself, comprises an “expense ratio” that is identified in each fund’s prospectus. In the Hughes case (and generally), the difference in the expense ratios between the retail funds and their institutional counterpart often exceeded one-half percent (50 basis points) each year. Any participant who chose to invest in a retail fund, when the institutional fund was also available, suffered a much lower rate of return over time. The plaintiff in Hughes complained that the retail funds should not even have been offered, and the Committee was liable for the losses the participants incurred by not investing in the institutional funds.
Plan trustees and administrators have often justified retail funds by employing expense sharing arrangements between the mutual funds/brokerage service company and the third party recordkeeper for the plan. Under these arrangements, the mutual funds will cause a portion of the revenue they collect to be transferred to the recordkeeper to apply against (if not fully pay) the recordkeeper’s charges for its services. In theory, that frees the Plan from having to pay for those services out of the general pool of plan assets, resulting in a net rate of return that is comparable compared to the returns using institutional funds. It also shifts more of the burden for administrative costs to those participants with higher account balances under the theory that they are benefitting more from the plan than the other participants.
The plaintiff in Hughes argued that even though the plaintiff was given the choice between retail and institutional funds, the Committee breached its duty by offering retail funds knowing that the institutional versions would provide a higher rate of return, and that the recordkeeper’s fees (although paid in part under the expense sharing arrangement) were unreasonably high, therefore the retail funds were imprudent options. The Committee argued that because it offered the choice between the two versions, it was the plaintiff’s responsibility to choose the better one for herself, and the Committee had exercised sufficient prudence. Further, it argued that the sheer array of mutual fund options was enough to counter any argument that the Committee did not act prudently.
The Supreme Court held that the Committee could not rely on the vast number of investment choices as a complete defense to its actions, nor could the Committee defend merely on the basis that both the retail and institutional versions of the same fund were offered. Rather, the Committee must at least take the following steps to demonstrate its prudence in creating and maintaining the menu of options available:
- The Committee must monitor the performance of any fund offered to determine if it is an appropriate option. If it determines one to be inappropriate, then the Committee must remove it within a reasonable time. That holds true (for Northwestern) for each of the 400 funds offered. One lesson from this – the plan sponsor should make available to participants only that number of funds it is willing to review and analyze on a regular basis. But the plan sponsor must also satisfy the diversification requirements under ERISA so that participants are given a broad array of funds sufficient to allow them to choose funds that are within the participants’ own risk tolerance.
- The Committee must analyze the possible menu choices in the context of the Committee’s duties to provide prudent investments and to minimize expenses to the participants (since in every case, a plan’s expenses will at least in part be covered by plan assets). That may mean that retail (as opposed to institutional) funds may be more prudent if, after factoring in the net total expenses of the Plan’s administration considering potential revenue sharing arrangements that may be available, the participants are more likely to attain a higher rate of return (all other factors being equal) using the retail funds offered.
But it also requires the Committee to determine whether the expenses being charged the plan by outside third parties are reasonable. Factoring in the participants’ account balances as a source of payment for those expenses would most likely be considered inappropriate.
There is one more point to mention. The Court’s final words should give some comfort to plan fiduciaries when it noted that “difficult tradeoffs” may confront fiduciaries in making these decisions, even cautioning courts to consider the “range of reasonable judgments” a fiduciary may make considering the fiduciary’s “experience and expertise”. At first blush, a fiduciary may take from this that the less experienced or knowledgeable one is, the prudence standard as applied to the fiduciary is not as high as for more knowledgeable fiduciaries. A better reading is that fiduciary must understand his or her own weaknesses and retain qualified consultants to the extent necessary to satisfy the fiduciary’s duty to monitor plan investment options and the plan’s expenses.
