401(k) fee litigation

Last month, nearly identical lawsuits alleging breach of fiduciary duties under ERISA were filed against seven large companies and certain of their officers, directors and employees in connection with fees paid from the assets of the companies’ 401(k) plans. The lawsuits, all filed by a St. Louis law firm seeking class action certification, allege breaches of ERISA’s fiduciary duties of loyalty and care, including the failure to follow the terms of plan documents, based on the use of 401(k) plan assets to pay administrative fees claimed to be "excessive."

Section 403(c)(1) of ERISA requires that plan assets be held for the exclusive purposes of providing benefits to participants and defraying reasonable expenses of administering the plan. Further, Section 404(a)(1)(A) provides, in part, that a fiduciary must discharge plan duties for the exclusive purposes of providing benefits to participants and defraying reasonable plan administrative expenses. Given these statutory requirements, plan documents often expressly state that, in addition to paying benefits, plan assets may only be used to pay reasonable administrative expenses.

Based on our review of two of the complaints filed and our understanding that the other five complaints are substantially similar in nature, the primary allegation in each case is that 401(k) plan assets were improperly used to pay excessive (i.e., unreasonable) fees to the 401(k) plans’ service providers and that, due to inadequate disclosure, the 401(k) plan participants were unaware of the extent of the fees charged against their accounts. The fees at issue involved both direct payments to service providers (known as "hard dollar" fees) and revenue sharing payments. Revenue sharing payments are amounts derived from asset-based fees paid by a mutual fund (in which a 401(k) plan’s participants invest) to other entities providing services to the 401(k) plan, such as a third party administrator. The complaints allege that the circuitous nature of the revenue sharing payments plus the use of a master trust1 frustrated the participants’ ability to discern and understand the amount of fees charged against their accounts and the ultimate use of revenue sharing dollars.

Such inability to determine fees paid and uses made of revenue sharing amounts allegedly resulted in excessive administrative fees and also served as the basis in the complaints for the fiduciaries’ liability to participants for investment losses in spite of the fact that the plans were intended to be ERISA Section 404(c) plans.2 To qualify as an ERISA Section 404(c) plan, participants must have an opportunity to obtain sufficient information to make informed decisions with regard to the investment alternatives available under the plan. Because the participants in the 401(k) plans allegedly did not have sufficient information about the fees charged in connection with the various investment alternatives, the complaints assert that the plans did not qualify as ERISA Section 404(c) plans such that the plan fiduciaries should not be protected from fiduciary liability.

Since these lawsuits were only recently filed, it is unclear whether the allegations will be found to have any legal merit or whether the cases will be class certified. However, the mere filing of these lawsuits and the possible proliferation of this type of litigation should serve as a reminder to plan fiduciaries that it is their fiduciary responsibility to prudently select and monitor plan service providers and their fees. The following steps should be considered:

  • Periodically review fee arrangements with service providers, particularly as plan assets increase, and ask for additional information and clarification if fees being paid are not clear. Consider periodically seeking competitive bids from a number of service providers.
  • Document the process by which service arrangements, including associated fees, are negotiated.
  • Review plan and trust documents to be sure that fee arrangements are consistent with their provisions.

Proposed DOL regulations on default investments

As directed by the Pension Protection Act of 2006 (PPA), the Department of Labor (DOL) issued proposed regulations on default investments on September 27, 2006. The PPA added a new subsection to ERISA Section 404(c), which generally provides relief from fiduciary liability for investment losses if a plan is designed so that plan participants exercise control over the investment of their accounts by providing investment direction. In recognition of the fact that assets may be contributed to a participant’s account prior to receipt of the participant’s investment direction (for instance, in connection with an automatic enrollment arrangement or where a former spouse was awarded part of an employee’s account upon marital dissolution but failed to provide investment direction), Section 404(c)(5) of ERISA was enacted as part of the PPA to provide fiduciary protection for investment of such a participant’s account in a default investment, provided that the default investment complies with relevant DOL regulations. Accordingly, the DOL issued the proposed regulations as guidance on approved types of default investments and the conditions that must be met in order for fiduciaries to be relieved from responsibility for selecting and utilizing default investments.

The required conditions are as follows:

  • assets must be invested in a "qualified default investment alternative" (a "QDIA")
  • participants must have been given an opportunity to provide investment direction but failed to do so,
  • a notice3 must be provided to participants 30 days in advance of the first investment in the QDIA and at least 30 days in advance of each subsequent plan year,
  • the terms of the plan must provide that any material provided to the plan relating to a participant’s investment in a QDIA (such as account statements, prospectuses, and proxy voting material) be provided to the participant,
  • participants must have the opportunity to direct investments to any other investment alternative available under the plan no less frequently than once within any three month period and without any financial penalty, and
  • the plan must offer participants the opportunity to invest in a "broad range of investment alternatives" within the meaning of 29 CFR 2550.404c-1(b)(3).4

For a default investment to constitute a QDIA, it must satisfy the following requirements:

  • it may not impose financial penalties or otherwise restrict the ability of a participant to transfer, in whole or in part, his or her investment from the QDIA to any other investment alternative available under the plan,
  • it must either be managed by an investment manager (as defined in ERISA Section 3(38)) or by an investment company registered under the Investment Company Act of 1940,5
  • it must be diversified so as to minimize the risk of large losses,
  • it may not invest participant contributions directly in employer securities, and
  • it must be either a (1) life-cycle or targeted-retirement-date fund, (2) a balanced fund (i.e., a mix of equity and fixed income investments designed to provide long-term appreciation and capital preservation), or (3) a professionally managed account.6

In its preamble to the proposed regulations, the DOL indicated that plan fiduciaries are not relieved of responsibility for the prudent selection and monitoring of a plan’s QDIA. The DOL proceeded to note, however, that fiduciary relief achieved through compliance with the proposed regulations is not limited to situations where the underlying plan is an ERISA Section 404(c) plan. In other words, the proper use of a QDIA under any qualified, participant-directed retirement plan will relieve a plan fiduciary of liability for investing a participant’s account in a default investment pending such participant’s actual investment direction.

The DOL has invited comments on the proposed regulations, which will be taken into consideration as the DOL acts to finalize the regulations. Final regulations are expected to be released in early 2007, becoming effective 60 days after publication in the Federal Register. Until then, the value of the proposed regulations is the long-awaited insight they provide into the DOL’s position on the proper selection and use of a default investment under a qualified retirement plan. In light of this insight, qualified retirement plan sponsors should act to identify whether there is a default investment fund under their plan. If so, it should be determined whether that fund is a QDIA under the proposed regulations. Since the final regulations may modify the definition of a QDIA, it is not recommended that assets be moved out of a default investment fund that does not qualify as a QDIA under the proposed regulations. However, plan sponsors should begin to examine investments in any fund that has been used as a default investment to determine whether participants are invested in that fund on a default basis or whether they actually selected that investment. This will give the plan sponsor some sense of the dollar amount of investments that may need to be shifted to a QDIA, as that term will be defined in the final regulations.

Footnotes

1 A "master trust" is a trust established by an employer to hold the assets of several qualified retirement plans sponsored by an employer (and perhaps by other members of the employer’s controlled group). Use of a master trust permits aggregation of plan assets for investment purposes and common utilization of service providers (often at a reduced fee due to the greater amount of assets involved).

2 An ERISA Section 404(c) plan is a plan designed to comply with ERISA Section 404(c), which provides relief to plan fiduciaries from liability for investment decisions made by plan participants who exercise control over the investment of their plan accounts.

3 The notice must be written in a manner calculated to be understood by the average plan participant and must contain the following information: (1) a description of the circumstances under which assets in the participant’s account may be invested on behalf of the participant in a QDIA, (2) a description of the QDIA, including a description of the investment objectives, risk and return characteristics (if applicable) and related fees and expenses, (3) a description of the right of the participants and beneficiaries on whose behalf assets are invested in a QDIA to direct the investment of those assets to any other investment alternative under the plan, without financial penalty, and (4) an explanation of where the participants can obtain investment information concerning the other investment alternatives available under the plan.

4 29 CFR 2550.404c-1(b)(3) generally provides that a "broad range of investment alternatives" means a sufficient range of investment alternatives to achieve in the aggregate a diversified portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant.

5 Some commentators on the proposed regulations have urged that asset allocation models that make use of underlying plan offerings (e.g., mutual funds) should also be permitted, even though the model itself is not managed by an investment manager and the combination of mutual funds is not itself a mutual fund.

6 The DOL notes in its overview of the proposed regulations that, although fiduciary relief is conditioned on the use of one of these three investment alternatives, the proposed regulations "should not be construed to indicate that the use of investment alternatives not identified in the proposed regulation as qualified default investment alternatives would be imprudent." The DOL notes that investments in money market funds and stable value products may, for example, be prudent for some participants.

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.