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401(k) Fee and Disclosure Litigation Gets a Boost


     By Fulcrum Inquiry Damages, Appraisal, Accounting & Economics Expert Witnesses

PhoneCall David Nolte at (213) 787-4100


Expert Witness: Fulcrum Inquiry
This month, a settlement occurred which (i) demonstrates that these cases have meaningful value and (ii) will likely provide a model for others. We review the settlement, and the primary employer-friendly case that encourages employers not to settle at all.
Since late 2006, over two dozen federal lawsuits have been filed against some of the country’s largest employers. Many of these cases were filed by Schlichter, Bogard & Denton in St. Louis. The suits are based on the broad fiduciary duties specified in the Employee Retirement Income Security Act of 1974 (ERISA) – specifically sections 502(a)(2) and 502(a)(3). Generally, the cases focused on common practices of (i) “revenue sharing” as a source of compensation for plan service providers, (ii) undisclosed participant fees, and (ii) using high-cost investments when lower-cost alternatives were available.

Caterpillar Case will Likely be a Settlement Model

This month, a settlement occurred which demonstrates that these cases have meaningful value. Caterpillar, the heavy equipment manufacturer, paid $16.5 million to settle its case. After payment of plaintiff legal fees, the net proceeds will be paid into the participants’ 401(k) accounts.

More importantly, Caterpillar agreed to make changes to its 401(k) plan that will save employees many millions of dollars. The settlement is likely to provide a precedent negotiating position for other companies to follow in their settlements. Specifically, Caterpillar will:

1. Limit fees charged to participants, with such fees calculated on a flat fee or per participant basis
2. Not allow investment consultants to also serve as investment managers
3. Not allow investment consultants to receive compensation from plan investments
4. Increase its communications with employees about investment options and fees
5. Have an independent trust company monitor the plans
6. Not include retail mutual funds as investment options
7. Undertake competitive billing for all services as contracts come up for renewal

Caterpillar Unwilling to Rely on Recent Employer-Favorable Precedents

Caterpillar had the benefit of favorable case precedents had they been willing to continue to fight and take the attendant risks of litigation. Recent 401(k) cases against certain other employers have been thrown out entirely. Generally, appeals of these other decisions are pending. The most notable decision involves Deere, the farm equipment manufacturer. In the Deere case, Fidelity Investments was engaged to provide bundled 401(k) services, primarily using Fidelity retail mutual funds. In February of this year, the Seventh Circuit ruled in favor of Deer and Fidelity, and dismissed the case against both defendants. The district court ruled that:

1. "Nothing in the statute or regulation directly requires such a disclosure" contained in the plaintiffs’ complaint, noting that the mutual fund prospectuses "accurately reflect the expenses paid to the fund manager."

2. Surprisingly, defendants were not held liable because ERISA section 404(c) operates to shield fiduciaries from liability where the alleged loss or breach results from a participant's exercise of control over his or her plan account. In the words of the district court:

"The only possible conclusion is that, to the extent participants incurred excessive expenses, those losses were the result of the participants' exercising control over their investments within the meaning of [ERISA Section 404(c)] safe harbor provision."

3. As an alternative ground for dismissal of codefendant Fidelity, the district court ruled that Deere had responsibility for choosing plan investment options, so Fidelity was not a fiduciary with respect to the disclosure and fund-selection issues.

The Seventh Circuit affirmed the dismissal by holding that:

1. Revenue sharing information is not material and need not be disclosed.

2. Deere’s plan offered a sufficient mix of investments so that inclusion of allegedly expensive funds did not constitute a fiduciary breach.

3. Even if there was a breach with respect to fund selection, ERISA section 404(c) precluded liability.

Similarly, in Braden v. Wal-Mart Stores, the district court dismissed the complaint by ruling, without examining the defendant’s actual motivation, that the defendant could have chosen funds with revenue sharing:

"for any number of reasons, including potential for higher return, lower financial risk, more services offered, or greater management flexibility."

The Court ruled that plaintiffs failed to allege "facts showing Wal-Mart . . . failed to conduct research, consult appropriate parties, conduct meetings, or consider other relevant information" when making its decisions. The district court's dismissal has been appealed to the Eighth Circuit. The Department of Labor filed an amicus brief arguing the district court misapplied the notice pleading requirement.

ERISA Section 404(c) is NOT Really a Safe Harbor

Section 404(c) shields fiduciaries from investment losses caused by employee decisions if certain requirements are met, but the protection is not absolute. Before the Deere case (and maybe even after the Deere decision in other circuits), it was widely agreed that Section 404(c) does nothing to reduce exposure for:

1. The original selection of investment alternatives

2. A failure to reduce costs paid by participants

3. The duty to keep participants’ best interests in the forefront of every decision

Because of these Section 404(c) limitations, plan sponsors are not protected against claims of lost opportunity relating to costs.

What are the Common Problems?

401(k) plans are rapidly replacing traditional pension plans. In a traditional pension plan (aka defined benefit plan), employers pay a fixed amount based on a formula contained in the plan. Employers with pension plans have an incentive to manage costs. But in a 401(k) plan, employees receive only the value in their personal account. In this situation, employers do not have the same incentive to watch the costs that are paid by the employees.

Plan fiduciaries need to follow a prudent process in selecting investment alternatives and disclosing what the costs are. The Deere result was a surprise, and realistically may not be followed by other circuits. Absent completely relying on the Deere case, smart employers should proactively address the following common problems:

1. Revenue sharing deals are usually not disclosed. In a revenue sharing arrangement, the mutual fund company kicks back a portion of its fees to the salesperson who advises the plan on what investments to select. The conflict of interest is obvious.

2. In disclosures given to plan participants, some mutual funds claim that their portfolios are actively managed. For this active management, the mutual fund charges fees that are several times higher than would occur with passive investment management using an index fund. Yet, using statistical analysis, it can be shown that numerous mutual funds actually are closet index funds, in that their returns are consistently not any different than are achieved using cheaper index funds. If the investment results are consistently not any different from a cheaper index fund, the higher cost fund should be eliminated from the investment selection.

3. For larger employers that have multiple plans run through master trusts, the costs that are paid by the central trusts should also be disclosed.

The damages from 401(k) lawsuits can be staggering. Amounts invested in 401(k) plans in the U.S. currently total over $3 trillion. There are numerous illustrations by various financial service firms regarding the impact of additional investment costs fees over one’s career, with each employee’s losses generally exceeding a quarter million (obviously depending upon the illustration’s inputs for the typical employee). Even if the loss per employee were substantially less, a claim of $100,000 per employee would be devastating to practically any employer. For example a loss of $100,000 times 100 employees equals $10 million – hardly a small amount for a 100-employee firm.

Although the current cases are aimed at large employers, similar cases are likely against smaller employers, who are less likely to spend the time to negotiate reasonable fees. Consequently, fees paid by smaller plans, especially those holding insurance-based products, have proportionally higher fees.

Lawyers for plan sponsors should advise their clients to investigate the costs their plans are charged, and to make sound judgments regarding whether value is received for what plan participants are paying. Employers of all sizes should see these lawsuits as a wake-up call to negotiate different arrangements, and/or make changes in the investments offered participants if the fees are not warranted by what is being received. The entire process should be documented.

ABOUT THE AUTHOR: David Nolte
Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

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While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.
For specific technical or legal advice on the information provided and related topics, please contact the author.

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