2020 was a banner year for 401(k) lawsuits, seeing five times as many lawsuits as 2019. This fact brings up an important set of questions: what are the most common 401(k) lawsuits, and why do they happen?
ERISA
Before we get into specifics, let's quickly talk about ERISA, or the Employee Retirement Income Security Act of 1974. ERISA is a federal law that sets standards for retirement and health plans in private industry. 401(k) plans fall under the purview of ERISA.
ERISA regulation is designed to protect individuals in these plans. Virtually all 401(k) lawsuits---including the examples today---arise due to failure to meet ERISA standards.
Inappropriate Investment Choices
ERISA regulations stipulate that fiduciaries must show "the care, skill, prudence, and diligence" that a careful person would show when choosing investments. The law then gives the reason "so as to minimize the risk of large losses."
In other words, ERISA does not specifically stipulate which investments are appropriate for a 401(k) plan. Nor does it stipulate how to choose those investments.
But what is vital is the process by which investments are chosen.
Imagine a fiduciary who achieved a 100% investment gain for her clients. Sounds great! But if she did so by gambling her clients' money at the casino, that would be an obvious issue. The rationale behind an investment choice must be examined separately from the outcome of that investment choice.
A similar logic applies to determining responsibility in an "inappropriate investment choices" lawsuit. The outcomes of investments do not matter as much as the reasons why those specific investments were chosen.
What to do if you are a fiduciary who is tasking with choosing investment options for a 401(k) plan?
1. Select investments carefully. Do your due diligence.
2. Ask yourself, "What kind of complaints could arise?"
a. Example - are you selecting a fund that has been clearly outperformed by others in
its asset class?
b. Example - are you including the company's own stock in its 401(k) plan. Could that
be a conflict of interest?
c. Example - does the chosen fund have a sufficiently long history to prove past
performance?
d. Note - all three of the examples above come from recent 401(k) lawsuits.
3. Record your rationale. You must prove to yourself, your plan participants, and---
potentially---a court of law that you made choices in the best interest of the plan's
participants.
Self-Dealing
The term "self-dealing" in ERISA lingo refers to when a plan fiduciary acts in their own best interest rather than in the best interest of the plan's participants.
An easy example is a plan provider choosing to offer their own brokerage’s investments, even when their fees are higher, and their performance is worse than other brokerages’ investments. Higher fees and lower performance clearly are not what the plan's participants would like.
And yet many self-dealing lawsuits have arisen because major plan fiduciaries---e.g. Morgan Stanley, Charles Schwab, JP Morgan---have been accused of selling their own investment products to plan participants, even when better options existed.
How to avoid self-dealing?
As a fiduciary, ensure that you offer your own investment products only when they are clearly the best products for the plan's participants. Better yet, go a step further and document why your products are the best.
Excessive Fees
The first two lawsuit causes we have discussed---inappropriate investment choices and self-dealing---are common enough. But the most common lawsuits in recent years revolved around excessive fees.
While ERISA does not require that plans offer the absolute lowest fees, ERISA does stipulate that fiduciaries:
4. Follow a specific, careful process to ensure that fees are relatively low
5. Regularly review the plan's fees, and make changes to investment choices if particularly high
fees cannot be justified
This applies to both expense ratios and to administrative fees. Both have caused excessive fee lawsuits in the past, and both ought to be reviewed by a plan's fiduciary on a regular basis.
Summary
Inappropriate investment options, self-dealing, and excessive fees are the most common reasons for 401(k) lawsuits. But an attentive fiduciary has both the tools and good judgment to ensure that their plans avoid such lawsuits.
As always, the key factor is to ensure that the plan's decisions are in the best interest of the individual participants. If their best interest is always placed first, any 401(k) lawsuit will be hard to justify.