An upcoming case before the U.S. Supreme Court could launch a new push among 401(k) sponsors away from retail funds and toward options with lower fees. This shift has been taking place slowly and steadily for years, but a decision in favor of the petitioners might bring a new level of urgency to making a low-fee choice.
In February chief justice John Roberts and his Supreme Court benchmates will hear Tibble v. Edison International, a suit being brought against a California public utility holding company by participants in its 401(k) plan. The question isn’t whether Edison’s plan sponsors breached their fiduciary duty by choosing expensive retail-share-class mutual funds over identical but cheaper institutional options — the Ninth Circuit panel that heard the case ruled as much last year. Instead, the justices will determine whether Edison can be held liable for those choices more than six years after it made them.
The plan participants and the Department of Labor (DoL), which waded into the case with an amicus brief, argue that ERISA should cover damage done by bad investment choices throughout the lifetime of those plans. It’s the continued investment and payment of higher fees that the participants are suffering from, not simply the initial plan choice, the argument goes. The lower court — the U.S. District Court for the Central District of California — and the Ninth Circuit investigated six funds and found that all of them were chosen in a breach of fiduciary duty by Edison. Damages were awarded for three funds while the remaining three were found to be immune from fiduciary claims under ERISA because they had been in the plan for more than six years.
“That is not the law,” says Jerry Schlichter, senior partner at St. Louis–based law firm Schlichter Bogard & Denton, which is representing the plaintiffs in the case. “That would violate the ongoing duty to monitor funds that every fiduciary has and grant permanent immunity to a known imprudent fund.”
Schlichter, who is currently litigating several similar cases against major companies, including Northrop Grumman Corp. and Lockheed Martin, hopes that if the Supreme Court agrees, the shift away from including retail funds in 401(k) plans will gain momentum. There’s no justification for including them when an identical institutional fund with lower fees exists, he says, but some companies are beginning to shy away from retail altogether, just in case.
According to data from Morningstar, 2014 is likely to be the worst year for retail mutual funds since the Chicago-based research firm started measuring them in 1993. Redemptions from retail funds that charge sales and distribution fees reached $122 billion by the end of October, more than the record full-year outflows for 2011, which totaled $88 billion. On the other end of the spectrum, institutional funds are thriving, accepting $230 billion in deposits this year through October.
Fear of lawsuits like Tibble v. Edison is part of the reason for this change, but another major driver is transparency. The 2012 implementation of mandatory fee disclosure by the DoL has made plan participants more aware of the fees they have been paying. Previously, fee information was often buried in plan documents.
An increase in coverage of 401(k) fee issues by the media has made an impact as well, says Mike Alfred, co-founder and CEO of BrightScope, a San Diego–based retirement plan analysis and information company. “There’s just a lot more data in the marketplace now than there was five to ten years ago,” he adds.
Knowledge is power, but in this case it may be leading to a detrimental overcorrection, says Jeremy Stempien, director of investments for Morningstar Investment Management. “The one area the average worker can very easily understand is, Do the funds in my plan cost a lot or not?” Stempien says, but a lot more goes into choosing a fund than the cost of its fees. There’s a concern that as scrutiny and litigation increase, sponsors will pull out all the stops to create the cheapest plans despite the potential negative impact on investment quality.
A recent Towers Watson survey of 457 companies found that the pressure is getting to sponsors. Eighty-four percent of the large and midsize companies polled said they had evaluated their fees in the past three years, and a little more than half had re-examined their plans and fees within the past 12 months. If the Supreme Court decides that the duty to choose the lower-fee option when faced with identical funds extends throughout the life of that investment, experts say the incentive to avoid a similar suit will result in more reshuffling. It’s one thing when participants lobby for change; it’s another when the DoL and Supreme Court justices throw their hat into the ring.