Note: I am not a lawyer or a law firm and I do not provide legal advice. The information contained in this post is general information and should not be construed as legal advice to be applied to any specific factual situation. Although I have gone to great lengths to make sure our information is accurate and useful, I recommend you consult a lawyer if you want professional assurance that this information, and your interpretation of it, is appropriate to your particular situation.
On May 18, 2015, the United States Supreme Court issued a unanimous ruling on behalf of the plaintiffs in Tibble v. Edison International, a high profile 401(k) case. The ruling appears to reinforce two themes discussed below:
1. The Fiduciary Duty to Monitor - Plan fiduciaries have both an initial duty to prudently select plan investment options but also to monitor those investments on an ongoing basis.
2. A Focus on Mutual Fund Fees and Share Classes - A continued focus on 401(k) fees and the prudence of higher cost “retail” share classes of investments versus lower cost institutional share classes, especially in larger 401(k) plans.
The case was originally filed in 2007 when participants of the Edison 401(k) Savings Plan sued Edison International and the plan fiduciaries for alleged breaches of fiduciary duties. At the time of the original lawsuit the Plan had more than $3 billion in assets and 40 different investment options. At issue were six funds in the plan (three added in 1999 and three added in 2002) which were higher cost “retail” share classes when lower cost “institutional” share classes of the same funds were available. The participants argued that Edison and the plan fiduciaries had acted imprudently and violated their duties by offering these six higher cost funds. Specifically, the plaintiffs argued that a large institutional investor like the Plan (with billions of dollars in assets) could essentially utilize its scale to provide access to lower cost investments not readily available to retail investors.
In 2010, the U.S. District Court for the Central District of California granted the plaintiffs a judgment of $370,732, stemming from damages related to high fees in the three retail share class funds added to the plan in 2002. However, the Court denied the plaintiffs claim regarding the three funds added in 1999. This is because the Employee Retirement Income Security Act of 1974 (“ERISA”) requires a breach of fiduciary duty complaint to be filed no more than six years after “the date of the last action which constitutes a part of the breach or violation” or “in the case of an omission the latest date on which the fiduciary could have cured the breach or violation” (see 29 U. S. C. §1113). The District Court held that the complaint as to the three funds added in 1999 was untimely because they were included in the Plan more than six years before the complaint was filed, and nothing had materially changed [emphasis added] in that six year period to obligate plan fiduciary to review the retail share class funds and move them to lower priced institutional share classes.
The plaintiffs appealed the ruling on the 1999 funds and the case moved to the Ninth U.S. Circuit Court of Appeals which affirmed the decision of the lower court. The case eventually made its way to the Supreme Court which agreed to hear the case in October 2014, in part, based on the recommendation of the Office of the Solicitor General, which filed an amicus brief on behalf of the participants in the case.
The key question at hand with this case was fairly narrow and straightforward - whether the District Court and Ninth Circuit correctly applied ERISA’s six-year limitations period barring imprudent investment claims where the initial investment decision was more than six years prior to the suit being filed.
In the ruling, the Supreme Court affirmed that the Ninth Circuit correctly asked whether the “last action which constituted a part of the breach or violation” of respondents’ duty of prudence occurred within the relevant six-year period.” However, the Court pointed out that the lower court focused on the initial selection of the designated investments as the start of the six-year period. The Court then stated that it believed the lower courts failed to consider the duty to monitor as specified in trust law. Specifically, the Court stated that:
“We believe the Ninth Circuit erred by applying a statutory bar to a claim of a ‘breach or violation’ of a fiduciary duty without considering the nature of the fiduciary duty. The Ninth Circuit did not recognize that under trust law a fiduciary is required to conduct a regular review of its investment with the nature and timing of the review contingent on the circumstances. Of course, after the Ninth Circuit considers trust-law principles, it is possible that it will conclude that respondents did indeed conduct the sort of review that a prudent fiduciary would have conducted absent a significant change in circumstances.”
In further support of the need to consider trust law, the Court said:
“We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts.’ Central States, Southeast & Southwest Areas Pension Fund v. Central Transport, Inc., 472 U. S. 559, 570 (1985). In determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts. We are aware of no reason why the Ninth Circuit should not do so here. Under trust law, a trustee has a continuing duty to monitor trust investments and remove imprudent ones. This continuing duty exists separate and apart from the trustee’s duty to exercise prudence in selecting investments at the outset. The Bogert treatise states that ‘[t]he trustee cannot assume that if investments are legal and proper for retention at the beginning of the trust, or when purchased, they will remain so indefinitely.’ A. Hess, G. Bogert, & G. Bogert, Law of Trusts and Trustees §684, pp.145–146 (3d ed. 2009) (Bogert 3d). Rather, the trustee must ‘systematic[ally] conside[r] all the investments of the trust at regular intervals’ to ensure that they are appropriate.”
The Court also referenced the Restatement (Third) of Trusts which states:
“’[A] trustee’s duties apply not only in making investments but also in monitoring and reviewing investments, which is to be done in a manner that is reasonable and appropriate to the particular investments, courses of action, and strategies involved.’ §90, Comment b, p. 295 (2007).”
Finally, the Court cited the Uniform Prudent Investor Act which “confirms that ‘[m]anaging embraces monitoring’ and that a trustee has ‘continuing responsibility for oversight of the suitability of the investments already made.’”
As you can see, the Court made it clear that to fulfill ERISA’s mandate that a fiduciary must discharge his or her responsibilities “with the care, skill, prudence, and diligence” that a prudent person “acting in a like capacity and familiar with such matters” would use applies not just to the initial selection of plan investments but on an ongoing basis as well. In essence, the fiduciary duty to monitor is perpetual.
Of note, the Court highlighted the fact that both parties (even Edison International) “now agreed that the duty of prudence involves a continuing duty to monitor investments and remove imprudent ones under trust law.”
However, the Court then specifically stated that it expressed “no view on the scope of respondents’ fiduciary duty in this case. We remand for the Ninth Circuit to consider petitioners’ claims that respondents breached their duties within the relevant 6-year period under §1113, recognizing the importance of analogous trust law.”
This last point is extremely important because the Court did not rule on whether the plan fiduciaries breached their duties but simply that the lower courts misapplied the six-year statute of limitations and vacated the Ninth Circuit’s judgement, sending the case back to the Ninth Circuit for further review.
We believe that the Court got this ruling right and pointing back to trust law is both reasonable and correct. Intuitively, the fiduciary duty to monitor makes sense if you take the idea that the duty of prudence only applies with the initial selection of investments to its logical end. For instance, if that was the case, plan fiduciaries would be wise to simply select investments to start the six-year clock, hold their breath and cross their fingers until the period ended and then never make an investment change again (regardless of performance) so as not to “restart the clock.”
We also think it is important to recognize that the Court ruled very narrowly on this case and focused specifically on whether the Ninth Circuit correctly applied ERISA’s six-year period. The Court passed no judgement on whether plaintiff’s claims regarding the 1999 funds was valid – this will now be up to the Ninth Circuit to decide using the additional context of trust law. That said, the District Court originally ruled that the plan fiduciaries breached their duties with regard to the 2002 funds (which did fall within the six-year period) and had “not offered any credible explanation” for offering higher priced retail share classes and had failed to exercise “the care, skill, prudence and diligence under the circumstances” that ERISA requires. Thus, it is certainly within the realm of possibility (or even likely) that the 1999 funds will be considered imprudent as well.
In light of this ruling, we think there are a number of lessons to be learned and it makes sense to provide some additional fiduciary considerations which we believe to be relevant and worthy of discussion. We have identified five key issues to consider:
1. Don’t “Set It and Forget It” – When it comes to monitoring investments the die has been cast – fulfilling ERISA’s prudence requirements includes not just making good initial investment decisions but monitoring those selected investments on an ongoing basis. A good selection and monitoring process begins with a well-constructed Investment Policy Statement (IPS) and a closely aligned reporting mechanism to ensure the criteria set forth in the IPS are being followed. We also believe that the IPS should be viewed as a framework for making decisions and not as a mandate. It should include both quantitative and qualitative elements while remaining broad and flexible so that plan fiduciaries are not “boxed in” when it comes to making decisions. The reporting aspect is also critical. In our experience, far too many plan fiduciaries and committees simply utilize a “boilerplate” IPS (often provided by a broker, consultant or recordkeeper) which then gets shoved in the file without regard to whether the document can actually be fulfilled. Plan fiduciaries should not view the IPS as a “check the box” best practice but as the central tool to facilitate the investment process. If the IPS cannot be followed it shouldn’t be used.
2. Consider restructuring plan fees and even eliminating revenue sharing altogether– Revenue sharing is clearly falling out of favor. Although we believe there is nothing inherently wrong with revenue sharing as long as it is properly accounted for, captured and utilized to offset eligible plan expenses, it is clear to us that the popularity of this compensation mechanism is waning. In addition, we continue to see a number of potential challenges with using revenue sharing that make it inefficient and inflexible. First, revenue sharing is indirect in nature and lacks transparency which often leads to confusion and misunderstanding. It can also be difficult to account for. Second, revenue sharing in most cases is asset-based meaning the fees generated to offset plan costs such as recordkeeping and administration are based on a percentage of assets in the plan. However, we believe that services like recordkeeping and administration really have nothing to do with assets and the scope of these services is more appropriately tied to the number of plan participants. While some recordkeepers still focus (or prefer) to charge for their services on a percentage basis (which provides a nice built-in increase in compensation as plan assets grow), an increasing number of plan sponsors and advisors are negotiating fixed, per participant fee arrangements with vendors. We believe this is beneficial because it ties the compensation method more closely to the scope of work, helps control costs which can quickly spiral to an unreasonable level depending on the growth of plan assets and can provide participants with economies of scale and lower costs (on a percentage basis) as account balances grow. Lastly, moving away from a revenue sharing arrangement can create significant flexibility when selecting investments (see below). While a move to fixed fees may not always be possible or a fit for every situation (depending on a number of factors), we believe plan fiduciaries and committees would be wise to at least begin considering this option and discussing the potential merits of this approach.
3. Move to lowest cost share classes – By “decoupling” the investment, recordkeeping/admin and advisory expenses by moving to a transparent approach that is not dependent on indirect compensation, plan sponsors are free to select from the full universe of investments and share classes (depending on availability on recordkeeping platforms). Historically, recordkeepers (and advisors) who were dependent on getting paid through revenue sharing would limit access to non-revenue sharing funds (which in most cases included the lowest cost share classes). This was done so that these service providers could continue to get paid because a non-revenue sharing fund meant reduced compensation. However, once service providers begin to get compensation directly from the plan (via participant accounts) or as a direct billable to the plan sponsor and are no longer dependent on indirect compensation to get paid it does four things. First, it gives plan fiduciaries the freedom to select any investment or share class available. In essence, the investment selection process can be fully focused on the needs of participants and not whether investment changes impact the economic structure of the plan. Second, it eliminates the conflict of interest that certain service providers may have to limit the selection of funds to only those that provide revenue sharing. Third, it essentially mitigates the legal argument that “retail” share classes are imprudent (though not the fiduciary duty to ensure fees are reasonable). Fourth, it creates transparency and simplicity for both plan fiduciaries and participants.
4. Consider how fees are allocated – One of the challenges of revenue sharing arrangements occurs when the payments are not level or only paid by some funds within a plan. This leads to the issue where certain participants can avoid contributing to the administrative cost of the plan by selecting (often lower cost) funds that do not include revenue sharing. In our opinion, this can give rise to the issue of fairness or equitability. For instance, assume a 401(k) plan has two participants (Participant 1 and Participant 2) and two investments (Fund A and Fund B). Fund A is an actively managed fund that costs 1% and provides revenue sharing of .50% to the recordkeeper to offset the entire cost of recordkeeping the plan. Let us also assume that the .50% revenue sharing equates to $100 per year which is the amount the recordkeeper requires to handle the plan. Fund B is a low-cost index fund that costs .20% and provides no revenue sharing payments. Also, assume that a lower cost share class of Fund A is available that only costs .50% and provides no revenue sharing. If Participant 1 invests his entire balance in Fund A and Participant B invests her entire balance in Fund B, Participant 1 is paying for the full administrative cost of the plan. Since revenue sharing payments are not required to be disclosed to participants as part of the annual 404(a)(5) fee disclosure it is unlikely that either participant is aware of these arrangements and, therefore, not in a position to make a fully informed decision. A better approach would be to eliminate any revenue sharing by using the lower cost share class of Fund A and allocating $50 in fees to both Participant 1 and Participant 2 to equally cover the administrative cost of the plan. This is known as the “per capita” (or per participant) method of allocating fees. Alternatively, the plan could still negotiate the $100 annual fee with the recordkeeper but elect to apply the fee on a “pro rata” basis (such as .50%) to the account balances of both Participant 1 and Participant 2. In this case, the dollar amount each participant pays would be different (assuming their account balances are different) but the percentage would be equal and both participants would contribute to the administrative cost of the plan.
5. Stay ahead of the “(k)urve” – The retirement industry is evolving quickly from a research, trends and best practices standpoint. We believe the burden on plan fiduciaries has never been higher and it is critically important for them to stay at the forefront to successfully navigate the rapidly changing fiduciary landscape. For instance, this case highlights how the perception and conventional wisdom of a common industry practice like revenue sharing has changed over time. Ten to fifteen years ago 401(k) fund lineups consisted heavily of actively managed funds and the overwhelming way to underwrite the cost of a 401(k) plan was through higher cost share classes and indirect compensation methods such as revenue sharing. Fast forward to today and it is clear that this approach is quickly falling out of favor and the trend is towards, transparency, fixed fees and passively managed investments. The most progressive plan fiduciaries recognize this increasing burden and the need for specialized advice that allows them to stay up-to-date on the latest trends and take a more dynamic approach towards fiduciary oversight. Plan fiduciaries who become complacent or embrace the status quo may quickly find themselves out of step with the latest ideas and best practices that can reduce corporate risk and improve outcomes for participants.