Most weeks, a plan sponsor (and frequently, several plan sponsors) is sued for breach of fiduciary duty in connection with the investment choices offered under its 401(k) or 403(b) plans.
Often, the complaint alleges that plan fiduciaries breached their fiduciary duties by:
(1) Making an investment option available under the plan when an alternate lower-cost investment option might have been available, or
(2) Retaining a higher-cost actively managed investment option as part of the plan's investment lineup when that option has produced (over some period of time and, with the benefit of hindsight) lower returns as compared to other actively or passively managed funds that the plan fiduciaries might have selected.
A few of these cases get dismissed early in the proceedings. A few go to trial. Most cases settle. And, unless dismissed, these claims, whether tried or settled, often involve million-dollar recoveries.
Deciding whether to litigate or settle can be a difficult decision for the plan sponsor and fiduciaries. A lawsuit filed and certified as a class action on behalf of all plan participants forces the sponsor to decide whether to "fight" its own employees and former employees. Further, the issues raised might involve fact-intensive inquiries that translate into time, effort, negative publicity and expense if the matter proceeds to trial.
However, what can or should a plan sponsor do today to establish the best record possible if the sponsor and its fiduciaries, when faced with a challenge, decide that they want to defend themselves?
The appropriate and oft-repeated answer is that an ERISA inquiry into a fiduciary's conduct looks primarily at the decision-making process followed by the fiduciary, and less so at the substantive results of the decision. But what does that mean as a practical matter? How might that translate into actionable steps today? How should a fiduciary document its process and conclusions?
There is no single answer to these questions, but consider this: most 401(k) lawsuits define the issue in very simple terms, e.g., the selection or retention of a particular option was imprudent because it had higher costs than other funds or generated returns that deviated from an established index. The fees and investment history associated with an investment option are obviously relevant, but the fiduciary process that underlies the decision to select, retain or replace a particular investment option normally is much more involved.
The specifics might vary case-by-case, but for purposes of illustration, assume that a 401(k) plan offers both (1) passively managed (and low-cost) index funds, and (2) actively managed (and higher-cost) funds. Is an actively managed fund that underperforms one of the index funds (such as a fund that tracks the performance of the S&P 500 index) inherently imprudent because the fund charged higher fees and produced a lower return over a period of time?
Of course, the question of whether plan fiduciaries satisfied their duties with respect to the initial selection and retention of the actively managed fund in this illustration might depend upon a variety of facts not addressed here, including how long the fund underperformed, whether the plan fiduciaries reviewed the fund's performance after its initial selection, and so on. However, there might be multiple reasons that the plan fiduciaries in this illustration concluded that the actively managed fund was and continues to be a prudent investment option, notwithstanding higher fees or certain performance variances. For example:
(1) The 10 largest companies in the S&P 500 comprise almost 30% of the index. The plan fiduciaries might have selected a fund that deviated from the index because they specifically wanted a complementary (actively managed) investment option that did not involve the significant level of concentration by those top 10 companies.
(2) The actively managed fund might have a conservative tilt that is likely to trail the index during periods when the markets are strong and risk is being rewarded, but outperform during more challenging market environments where holding higher-quality securities presumably offers more downside protection. The plan fiduciaries might have felt that the fund offered an excellent risk-return profile across full market cycles and that the investment management fee was reasonable in light of the value that the manager was expected to provide.
These are just a couple of possibilities; there are many others. The point, of course, is that plan fiduciaries might have good and legitimate reasons for selecting a particular investment option even though that option might involve higher costs than other available options or there might be periods of time during which the fund's performance does not match the performance of a particular benchmark or index.
Those reasons should be documented. Without documentation supporting the choices a plan fiduciary made, challengers can frame the debate in simple, relative terms that compare fees and returns to averages or benchmarks. As noted, fees and returns are never unimportant, but plan fiduciaries should never accept such simple characterizations because the actual process of selecting (and periodically reviewing) an investment lineup involves so much more. Don't be shy! Make sure your notes and plan fiduciary committee minutes explicitly say so.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.