September 10, 2012

Crystal Ball Part 2: Help sponsors manage 401(k) plan risk

In last month’s column, I discussed two major waves of 401(k) litigation—company stock cases and allocation of revenue sharing. This month, I cover two more potential areas for litigation—“excessive” payments to service providers and expense ratios of mutual funds.

Excessive payments to service providers. Disclosures under 408(b)(2) will alert plan sponsors—and, ultimately, under 404(a)(5), participants—to the amounts of revenue sharing and other indirect payments made to service providers. It is inevitable that, in some cases, those amounts will be excessive (or, in the words of the law, “unreasonable”). For attentive plan sponsors, those excessive payments will be identified during the process of evaluating the 408(b)(2) disclosures, for example, by benchmarking the disclosed amounts against appropriate data. However, I am concerned that plan committees will fail to evaluate and benchmark those payments. If my fears prove to be well-founded, it will almost inevitably lead to litigation.

Expense ratios of mutual funds. While the courts are split over how much responsibility plan sponsors have to evaluate the expenses of mutual funds, it is possible that one of those cases could reach the Supreme Court in the near future. And if one does, it is very likely the court could rule that plan fiduciaries do, indeed, have a heightened responsibility to review the available funds and to select those appropriate for the “purchasing power” of the plan. For example, a billion-dollar plan should, as a practical matter, be able to obtain institutionally priced mutual funds and collective trusts, while a smaller plan may need to pay higher prices for retail funds—but, even then, with a waiver of front-end commissions. In that case, the practices of plan sponsors, particularly of larger ones, will almost immediately come under scrutiny. As a word of advice, plan sponsors should focus on this possibility, to make sure the expenses of their mutual funds are appropriate for the size of their plan. Even in this context, the good news is that the use of revenue sharing to pay for the cost of operating a plan is not prohibited, and, of course, the cost of revenue sharing is embedded in the expenses of mutual funds. The issue is not whether revenue sharing may be used, because it may, but whether the amounts are excessive, as measured both by the payments to service providers and the costs imposed in the plans (i.e., the expense ratios).

As a final thought, there is one commonly mentioned theory for potential litigation that I disagree with. From time to time, speakers and writers suggest that litigation might occur because 401(k) plans are producing inadequate retirement benefits. That is, there is a growing concern that 401(k) plan-holders are not accumulating enough money to allow them to retire with a reasonable standard of living, and some critics imply that plan sponsors may be held accountable for this shortfall. I have found nothing in the law indicating that plan sponsors or fiduciaries are obliged to operate their plans to produce “adequate” benefits, other than the general requirement that fiduciaries act prudently in fulfilling their duties. Nonetheless, the fiduciary standard is evolutionary, not static. In the years ahead, a greater burden may fall on fiduciaries, such as plan committee members, to help participants accumulate benefits that are adequate for retirement. That could include, for example, projections of retirement income and gap analysis. For the moment, though, these remain in the realm of best practices.

Only time will tell if some, or even all, of my predictions are off-target. It’s not easy to forecast future litigation, but anticipating the key issues will help manage the risk in your 401(k) plan.

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