The Fear Driving Plan Sponsors’ Decisions

Worries over litigation increase the number of passive investment options in 401(k) plans and squelch innovation, a new survey concludes.

Portrait of four well-dressed lawyer with arms crossed in the co

Portrait of four well-dressed lawyer with arms crossed in the court room

Plan sponsors must consider many factors when choosing what investments to offer. But the fear of being sued by plan participants is one that is influencing more and more of these decisions, a new report funds.

“The defined contribution market saw an unprecedented number of lawsuits brought against plan sponsors and their providers in 2016,” write researchers from Cerulli Associates, a research and consulting firm, in a report titled U.S. Retirement Markets 2016: Preparing for a New World Post–Conflict of Interest Rule, released this month. Calling the fear a “barrier to innovation,” Cerulli researchers found that fully half of all plan sponsors share these concerns.

Class action lawsuits filed against defined-contribution-plan sponsors, while an expensive annoyance to U.S. corporations, have served plan participants in the past by encouraging companies to improve their plan offerings. The most common corrections that resulted from litigation included lowering plan fees, providing greater fee transparency, and limiting the amount of company stock allowed in a plan menu. The first such lawsuit was filed in 1998; the number has since ballooned to more than 800. This year the lawsuits expanded to the nonprofit, 403(b) world of university retirement plans; Cornell and Columbia universities, among other prominent schools, were sued for excessive retirement plan fees.

The Cerulli survey, which logged responses from more than 800 401(k) plan sponsors, sought to clarify how the continued threat of 401(k) lawsuits has affected plan sponsors’ decision making. Cerulli asked plan sponsors what changes they made to their defined contribution plans in 2016; when respondents said selecting a passive investment option or increasing passive investments, they were then asked for the primary reason for this move.

The answers surprised Jessica Sclafani, an analyst and associate director at Cerulli. Whereas the move to passive investing has been a large and growing theme in the asset management industry, she says, she expected respondents to say they made such decisions because they feel active management does not outperform passive. Among the smallest plan sponsors, those with under $5 million in assets, 25 percent did offer that response. But for the largest sponsors, those with more than $500 million in plan assets, none said they chose passive options in the belief that active managers do not outperform passive indexes.

Instead, such decisions were “driven by costs and the fear of being sued,” says Sclafani. Among the largest funds, those with more than $1 billion in assets, only 12 percent said they believe active managers cannot outperform passive investments. Instead, 24 percent expressed fiduciary concerns, including the threat of lawsuits, while 13 percent said that passive investments are easier for a fiduciary to monitor. A full 40 percent checked the box on cost as the primary factor driving them to increase passive investments. That’s not surprising, given that cost has been a primary feature of past lawsuits, says Sclafani.

One quarter of all plan sponsors surveyed selected passive options because they are easier for a fiduciary to monitor. Cerulli cautions active managers to seek ways to make the monitoring process as easy as possible for plan sponsors, such as implementing a system of quarterly or monthly reporting “that reflects the particular data points the plan sponsor wants to regularly monitor,” states the report.

Sclafani also thinks the fear of litigation is going to curb plan sponsors — and their defined-contribution-investment consultants — from trying to innovate their current plans.

Cerulli emphasizes that plan sponsors have a fiduciary duty to do what is in the best interest of plan participants, versus plan administrators.

“If they are choosing a passive investment option simply because it is less work for them, this is not in line with the spirit of ERISA,” warn the Cerulli researchers.