Supreme Court Rules that Employers Must Review Retirement Plans
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The Employment Retirement Income Security Act (ERISA) gives employers a fiduciary responsibility over any retirement plans that they choose to offer to their employees. Fiduciary duties are fairly straightforward for financial advisers, but what are the boundaries of that fiduciary duty for employers and their 401(k) administrators, who are not necessarily financial professionals? On May 18th, the Supreme Court issued a ruling that seems to simultaneously clarify and muddy the question.
The issue in Tibble v. Edison International (NYSE: EIX) regarded the types of shares offered within a 401(k) plan. A class action suit was filed in 2007 covering 20,000 Edison employees who were offered six types of retail mutual funds in their investment packages even though Edison qualified for institutional shares of the same mutual funds with lower fees. Failing to offer the lower-fee options was considered a breach of fiduciary responsibility.
The U.S. 9th Circuit Court agreed in three cases, but threw out three others based on a six-year statute of limitations that had passed in those cases. The Supreme Court unanimously overturned the statute of limitations on the remaining cases and remanded the case back to the 9th Circuit Court for clarification on what the boundaries of the fiduciary duties of employers.
In essence, the Supreme Court ruled that an employer's fiduciary duty continues without a statute of limitations, but the ruling doesn't spell out exactly what that duty is. A company must review its 401(k) plan offerings, but how often must they review it and to what extent are they required to alter investment options?
A Fiduciary Pandora's Box?
For retirement funds, the difference in fees is not trivial. USA Today cites a Vanguard study showing that a $100,000 initial investment would return $523,899 in 30 years with a 0.25% annual cost but only $438,976 at a 0.9% annual cost—a reasonable comparison of rates on higher-fee accounts with lower-cost index funds.
In this case, the comparison was fairly obvious and cited directly on fees for identical holdings — return was not a consideration. Other class action suits may follow with respect to overly high fees, but will returns be factored in? Passively managed low-fee index funds generally outperform actively managed funds but not all of them do, nor do all index funds produce superior results.
There's agreement among many legal experts that the Supreme Court ruling makes it easier now for employees to sue employers, but that it doesn't ensure victory in such litigation unless the difference is similarly clear-cut and independent of the returns generated and other funds offered. However, the eventual opinion of the 9th Circuit Court may open the "fiduciary Pandora's Box" that makes it easier to sue and win under different circumstances as they define fiduciary responsibilities for plan administrators.
In an interesting sidebar, the Department of Labor recently released a proposed rule that bans conflicts of interest with retirement planning — effectively eliminating the "reasonable" standard and replacing it with the fiduciary standard. Advisers would be required to disclose conflicts of interest. Do those conflicts of interest issues at the adviser/broker level now pass through to an employer's 401(k) administrator? If so, how are plan administrators required to deal with that conflict? Does the return on the fund matter in that case?
A Win for Many Employees, But Not Necessarily All
At first glance, the ruling seems like an obvious win for employees. In many cases it will be, as plan administrators are forced to review their options and revise their offerings. However, not all employees may benefit, and funds can make changes rendering the ruling less useful.
Chuck Jaffe suggests in Market Watch that funds are likely to skirt this issue by offering nearly identical fund packages. Instead of a single fund offering a share class for retail and another for institutional investors, a second fund will be created and labeled as a separate retirement fund with just enough differences to undercut the court's argument. Then it becomes a discussion of whether a difference in fees is justified by a better return, or the higher-fee fund can reasonably be expected to bring a better return based on those small changes.
Chris Carosa at www.benefitspro.com suggests that since index funds contain identical portfolios by definition, it will be hard to justify any higher fees on an index fund. Logically, this will drive the fee structure down and squeeze the market until only the largest survive. That could, in turn, either drop fees to the point where index funds are unprofitable and disappear — or the survivors may raise rates when enough of the competition has disappeared.
Both Jaffe and Carosa conclude that the Supreme Court ruling could backfire on employees of smaller companies, who may decide the risk of being sued is not worth offering the only options that they can afford to provide to employees. Without clear guidance, smaller employers may avoid any fund options that could be considered a potential headache — or they may just drop their 401(k) plans altogether. Either way, employees of smaller companies would end up with poorer options.
The Supreme Court decision by itself isn't much of a game changer, except that by removing the statute of limitations they have given lawyers more leeway and incentive to dig up past cases of likely retirement fund negligence. However, the eventual ruling of the 9th Circuit Court could produce a series of unintended consequences, depending on how far they intend to go in establishing the fiduciary rules for retirement plan administrators.
401(k) plan administrators will have to be more transparent in justifying the choice of funds with higher fees through their investment policy statements, which is clearly a positive development. On the whole, the costs of 401(k) programs should increase and returns should improve. Unfortunately, some employees may suffer as their employers modify options or abandon plans altogether.
This case is a good opportunity to pause and look at the fee structure and costs of your investments, whether employment-related or not, and ask the question: Are you getting what you're paying for?
Let's not forget that while employers are obligated to give us reasonable 401(k) choices based on what they can afford, as employees we still have the responsibility to make sound choices within the fund. If we cannot be bothered to do research on our choices, we can’t complain about their quality.
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