DEFINED CONTRIBUTIONS - Plaintiffs v. Fiduciaries

When the U.S. Supreme Court speaks, entire industries can quake. Last month the high court made a simple, clear and unanimous statement that threatens to unsettle the $4 trillion defined contributions industry.

Overturning a decision by the business-friendly U.S. Court of Appeals for the Fourth Circuit in Richmond, Virginia, the Supreme Court ruled that a 401(k) participant has the right to sue an employer for actions that erode the value of his or her plan. Defined-contribution-plan sponsors have been sued before, not least by tort attorneys wielding the blunt instrument of class-action lawsuits. But the Supreme Court’s decision could open the floodgates to “tons of lawsuits,” frets Peter Demmer, chairman and CEO of Sterling Resources, a Paramus, New Jersey–based consultant to defined-contribution-plan service providers. “About 50 million people have 401(k) accounts,” he says, “and all are doing badly in this market.”

The 401(k) business is already proving tempting to the class-action attorneys, known collectively as the plaintiffs’ bar. After extracting billions of dollars in fines and compensation from companies found liable for asbestos- and tobacco-related ills, for overcharging credit card customers and for misleading shareholders about profits, they are zeroing in on the defined contributions industry as their latest deep-pocketed corporate target. Since the fall of 2006, litigants have filed 50 lawsuits seeking damages from employers for the way they managed 401(k) programs — and, more precisely, for not getting the most economical deals from plan service providers.

Now companies face even greater risks. “I copied this decision and sent it out to everyone I know,” says Demmer, whose clients account for about $2 trillion in 401(k)s and other defined contribution plans. “Any Supreme Court ruling like this gets people worried.”

The ruling pertains to the narrow circumstances of James LaRue, who contended that his employer, Dallas-based management consulting firm DeWolff, Boberg & Associates, had cost his 401(k) $150,000 by not following his investment instructions. The decision means that a participant, in suing an employer, no longer has to prove that investors have been harmed as a group. An individual can sue for allegedly excessive fees, negligence in the choice of investment options or simply lax administration.

“There are substantial areas of ERISA that have not yet been exposed to the light of litigation,” says Jerome Schlichter, a onetime personal injury lawyer for railroad workers and other employee claimants who has taken up the cause of 401(k) investors. A partner at St. Louis firm Schlichter Bogard & Denton, Schlichter is lead attorney on 14 class-action suits on behalf of plan participants. His cases, like the recent one at the Supreme Court, shine a light on the rickety legal underpinnings of the 401(k), by far the most popular of the defined contribution plans that typically allow workers to choose where to put their money from among the selections offered by the corporate, government or nonprofit sponsor. Almost all fees are paid out of investors’ account assets, and in retirement the plan participants receive what remains.

Introduced in 1981, the 401(k) did not fit neatly into the prevailing regulatory framework of ERISA. That 1974 statute was designed for defined benefit pension plans, in which the employer chooses the investments, pays the fees and guarantees employees’ benefits. By contrast, 401(k) participants bear investment risks, and their employers’ fiduciary responsibilities on administrative matters are less well defined.

The Supreme Court, in the LaRue opinion written by Justice John Paul Stevens, acknowledged the legal gap between defined benefit and defined contribution and concluded that individual 401(k) accounts were protected from “the kind of harms” that ERISA’s provisions cover.

Schlichter’s suits have accused Fortune 100 companies — including Boeing Co., General Dynamics Corp. and Deere & Co. — of violating their fiduciary responsibilities by not finding out the true costs of transactions and other services that their 401(k) plans were incurring, and for allowing their employees to overpay. Though the main targets are plan sponsors, providers, including Fidelity Investments, ING Insurance and Nationwide Corp., are co-defendants in a few defined contribution complaints filed by Schlichter and others. Without specifying monetary damages, Schlichter’s suits seek refunds of improper or excessive charges, attorneys’ fees and any other relief that courts might find appropriate.

Earlier class actions in the defined contribution industry involved accusations that executives at such companies as Enron Corp., Global Crossing and WorldCom made rosy public pronouncements ahead of precipitous declines in their stock prices, causing employees who had company shares in their 401(k) accounts to lose heavily. Keller Rohrback, a Seattle-based law firm that represents employees in ERISA cases and currently has 28 lawsuits pending, says it has been awarded $750 million in damages — out of $1.5 billion in total settlements — from that wave of so-called stock-drop suits.

The plaintiffs’ bar now has its sights on plan fees and the nitty-gritty of what they are supposed to cover, which, the lawyers argue, is not clearly disclosed. Keller Rohrback partner Lynn Sarko, who represented 401(k) participants against Enron, says he is considering several suits in cases where, for example, participants are “paying too much” for the mutual fund choices they are offered.

One of Schlichter’s suits, against International Paper Co., challenges common management practices, such as pooling the accounts of several employers or related groups into a master trust to cut administrative expenses. The plaintiffs’ gripe is that the expenses taken out of the underlying investment vehicles — out of the net asset value of the overall fund — are not specified in International Paper’s plan documentation. The suit is awaiting a trial date in the U.S. District Court for the Southern District of Illinois in East St. Louis. Robert Hunkeler, International Paper’s vice president for investments, declines to comment on the pending litigation.

Twice recently, courts have favored plaintiffs in 401(k) suits. In December, Chief Judge G. Patrick Murphy of the Southern District of Illinois court ordered attorneys for General Dynamics to refile their brief for summary judgment against plaintiffs represented by Schlichter because, at 50 pages, it exceeded the 20-page limit. The judge, however, let his leanings be known, saying that General Dynamics “probably is not entitled” to a dismissal if it could not produce a concise argument on a “question of fact.”

In February, in another case filed by Schlichter, the U.S. Court of Appeals for the Eighth Circuit in St. Louis rejected an appeal by the U.S. subsidiary of Swedish-Swiss power equipment manufacturer ABB and its 401(k) provider, Fidelity Investments, of an earlier decision that had certified class-action status. Schlichter believes that the weight of one or more such legal rulings will ultimately bring reform. Whether or not the Department of Labor, the primary ERISA regulator, imposes hard-and-fast rules for fee disclosure and transparency, plan sponsors will likely see the writing on the wall. Consultant Demmer predicts that Fortune 100 targets will come around to settling their cases out of court, which in turn will encourage others to do the same before defeats and legal costs mount.

The controversy over plan costs and disclosure raises basic questions about ERISA: Does it need fine-tuning to reflect the maturation of defined contribution plans, which since 1997 have held more assets than have defined benefit plans? Or are there regulatory holes so gaping that the retirement industry structure needs an overhaul?

The issues center on the distinctions between the two types of plans. And the debate plays out amid a slowing economy, as an aging workforce increasingly worries about its retirement nest egg. “Defined contribution plans have simply not fulfilled their promise,” says 401(k)-cost critic Edward Siedle, a former Securities and Exchange Commission lawyer who now heads Ocean Ridge, Florida, money management consulting firm Benchmark Financial Services. “The first baby boomers to reach retirement age are coming up short in 401(k) accounts that have been depleted by high costs and poor performance.”

Gregory Barden, a partner in the Washington office of law firm Morgan, Lewis & Bockius who has defended plan sponsors in 401(k) cases, holds that plan investors have been fairly treated, thanks largely to the stiff competition in the retirement business. “Larger plans with sophisticated advisers do a good job of monitoring the fees in their plans,” Barden contends. He says that the class-action lawyers have shifted their focus to the retirement business for pragmatic rather than substantive reasons. “The numbers are large, with billions of dollars of assets and lots of people in these retirement plans,” Barden notes. Fortune 100 companies, he adds, are “fat targets.”

Schlichter has gotten very specific in his charges, drilling down into revenue-sharing arrangements, a practice that was formalized in 1997 to reflect the evolution of 401(k) plans that offered investment choices from more than one fund family. To promote choice, 401(k) recordkeepers and investment managers agreed to share fees. The practice is comparable to the purchase of shelf space in grocery stores, with the producers — investment managers — paying a fee to middlemen out of gross receipts from the consumer.

But a recordkeeper’s interest in maximizing its income may conflict with the interests of investors seeking funds that will minimize costs and maximize returns. As the class actions frame the argument, plan sponsors that are unaware of these excessive costs are vulnerable to charges of fiduciary irresponsibility.

Schlichter also objects to what he sees as misleading benchmark comparisons. His International Paper complaint, for example, faults the company for citing a Morningstar statistic to claim that its fees in 2004 were “30 to 70 percent lower than comparable retail mutual fund fees.” Schlichter argues that at $4.5 billion, the International Paper plan is big enough to command — and pass along to participants — lower institutional charges dictated by economies of scale. These can range from below 5 basis points of assets up to 75 basis points for illiquid instruments, whereas retail fund charges run from 80 to 120 basis points.

The Department of Labor is beginning to stir. On December 12 it proposed that the defined contribution industry be required to disclose certain fees to plan sponsors. But some experts say the proposal doesn’t fully resolve the issues of costs and the definition of fiduciary responsibilities.

“Labor regulators have suggested that bundled providers — firms like Fidelity, Vanguard Group and T. Rowe Price, among others — do not have to specify separately the charges for investment management and for administration,” notes Matthew Hutcheson, an independent fiduciary consultant in Portland, Oregon, who serves plans that collectively have about $3 billion in defined contribution assets. The bundled providers have resisted disclosure of what they consider proprietary information.

In a comment letter to the DoL, Fidelity senior vice president and deputy general counsel Douglas Kant contends that it would be a logistical headache, if not an impossibility, for his firm to track down all the mutual fund companies whose funds are offered to 401(k) investors through its system.

Vanguard Group CEO-designate F. William McNabb III, currently head of the fund company’s institutional and international businesses, told the DoL that the firm has no objection to providing fee information from other managers whose funds Vanguard offers to 401(k) investors. But McNabb doesn’t want Vanguard to be held responsible for the accuracy of that information or for other managers’ failure to provide the required disclosures. The DoL has not addressed either Kant’s or McNabb’s objection.

Some observers argue that participants’ interest in managing their own money ought to trump the need for corporate confidentiality. “Business models should not be permitted to prevent a fiduciary from fulfilling duties and obligations that are otherwise required by law and universally accepted principle,” Hutcheson notes. The recent Supreme Court decision said as much, holding that ERISA “does authorize recovery for fiduciary breaches that impair the value of plan assets in a participant’s individual [401(k)] account.” The plaintiffs’ bar’s next payday may be near.