Fee disclosure rules are a win-win for everyone

Participants more likely to gain once regulations are established

The willingness of an experienced plaintiffs' ERISA counsel to settle for “pocket change” in the Braden vs. Wal-Mart Stores Inc. case and the 7th U.S. Circuit Court of Appeals' upholding of a lower court's dismissal of the Loomis vs. Exelon Corp. case must have delighted 401(k) plan sponsors. If the Wal-Mart case had merit, surely an experienced plaintiffs' ERISA litigator could have negotiated a settlement that was much greater than a mere fraction of what the amended complaint described as the “tens of millions of participants' retirement savings squandered to pay for ... unreasonably expensive funds.”

Settling the Wal-Mart case made good business sense for both plaintiffs' counsel and defendants. Plaintiffs' counsel accepted a bird in the hand for two in the bush, and took home $4.25 million. After all, the plaintiffs' counsel were not assured of winning since much of their argument was based on fund performance viewed with hindsight. The Employee Retirement Income Security Act, to the contrary, focuses on process and recognizes that prudent processes can have bad outcomes.

The parties in the Wal-Mart case — like those in excessive-fee cases against Bechtel Group Inc. (2008), Caterpillar Inc. (2010) and General Dynamics Corp. (2010) — concluded it was better to rid themselves of the expense of incurring a dragged-out discovery that might have uncovered evidence damaging to their position.

Going forward, reaching much larger settlements — like the $36.9 million that was recently awarded to the plaintiffs in another excessive-fee case, Tussey vs. ABB Inc. — likely will become the norm thanks to the mandatory participant fee disclosures and the DOL's clarification of fiduciaries' duties under the 404(c) regulations. Perhaps the concern over larger awards explains why the Plan Sponsor Council of America found that 63.8% of the plans surveyed changed their investment lineup in 2011 vs. just 19.7% of those surveyed in 2009.

Even though the reasoning behind the 7th Circuit's decision favoring the defendant in Loomis vs. Exelon is likely passť because of the DOL's clarification, it is still worth reviewing for two reasons.

First, it illustrates that when ERISA and its regulations are ambiguous, and they often are, different courts will come to different conclusions over the same issues. As a result, sponsors and fiduciaries should not assume they can follow their own preferences rather than doing what's in the participants' best interests. Such conduct guarantees that the fiduciaries will be unable to document, as they must if they land in court, that they diligently implemented their duties of loyalty and prudence.

When Loomis vs. Exelon was filed, the Labor Department's regulations were unclear as to whether fiduciaries of 401(k) plans that qualify under 404(c) rules were relieved of liability for participant losses suffered from the imprudent selection and monitoring of investment options.

Some circuits ruled that participant choice did not relieve fiduciaries from prudently selecting and monitoring the plan's investment lineup. Other circuits thought participant choice trumped these fiduciary duties, especially when participants can create their asset allocations from a wide selection of investment options with varying fees and investment styles.

In October 2010, the DOL resolved this dispute by amending the 404(c) regulations to state that participant choice “does not serve to relieve a fiduciary from its duty to prudently select and monitor” any service provider or investment option.

Second, the Loomis vs. Exelon case also demonstrates how judges' decisions are affected by their own intellectual leanings when counsel for either side omits incorporating relevant facts and circumstances into an argument that tells a convincing story.

Cognitive neuroscience has found that when we have to make a judgment, but don't have all the facts, our brain enables us to arrive at an acceptable solution. Nobel laureate Daniel Kahneman notes: “The amount of evidence and its quality do not count much, because poor evidence can make a very good story.”

The Exelon decision favoring the defendant in its use of retail funds is an example of Mr. Kahneman's observation. Exelon's plan had 32 investment options with a wide range of fees and a variety of asset classes and investment styles. The fact that 24 of these options were retail funds was, in the judges' opinion, advantageous because their fees are subjected to market competition.

The plaintiffs thought differently. A $1 billion plan should not be using overpriced retail funds. By not using, whenever possible, mutual funds with institutional shares and other “wholesale” investment vehicles, the fiduciaries violated their duties of loyalty and prudence, argued the plaintiffs.

The judges, referring to a “helpful amicus brief filed by the Investment Company Institute,” arrived at just the opposite conclusion and pointed out that:

“(T)he average expense ratio of institutional-share classes in equity funds in 2009 was 1.09%, which is higher than any of the retail funds offered to the participants in Exelon's plan. (The ICI calculates the average expense ratio of retail equity funds at 0.76%).” The judges also observed that it was in Exelon's best interest to use competitively priced funds since they would help portray the plan as a valuable benefit.

The ICI brief also noted that low-cost institutional vehicles are usually not valued daily, lack the liquidity needed for daily transfers, and do not provide the services 401(k) plan administrators and participants needed. To obtain these services, additional costs would have to be incurred.

The ICI's brief was filed in 2010. In April 2009, ICI released its 2009 Defined Contribution/401(k) Fee Study. This study contradicts ICI's own brief since it found that “total plan assets appeared to be the most significant driver of fees.” “The median "all-in' fee for the plans in the survey was 0.72% of assets,” the study said. However, the “all-in” fee for a plan of Exelon's size would be approximately 0.41% of assets. Thus, plan size drives down investment-related fees since they account for 74% of the “all-in” fee.

ICI's 2009 fee study, along with its 2011 update, provides a convincing argument that Exelon's participants were paying excessive fees for the services they received. The study also confirms that the Exelon panel of judges was partially correct: A competitive marketplace can drive fees down, but it is the institutional 401(k) market, not the retail one, that drives fees lower.

A case illustrating this very point, Tibble vs. Edison International, is pending in the 9th U.S. Circuit Court of Appeals. The issue is: What process, if any, led the fiduciaries to include the retail share class of a mutual fund when, to quote from the district court decision, “institutional share classes offered the exact same investment at a lower cost to the plan participants”? The court also pointed out that the fiduciaries of this $2 billion plan knew that the retail share classes provided no advantages that could justify the greater expense.

An Aon Hewitt survey, “2012 Hot Topics in Retirement,” found that “36% (of plan sponsors) have lowered costs by changing some or all of funds from mutual funds to institutional funds.” In the future, thanks to fee disclosure, participants will be able to go to their employers and ask: “Why do my friends' 401(k) plans have much lower costs?”

The current economy, 11 years of poor stock returns, likely reductions in entitlement programs and the constant press coverage of this nation's impending retirement crisis provide many opportunities for knowledgeable and creative plaintiffs' counsel. If they keep current with industry surveys and research relating to participant behavior, expert judgment and the inability of investment advisers to identify funds that will consistently outperform their benchmarks net of fees, aggressive litigators will have plenty of opportunity to make money.

If sponsors and fiduciaries do the same and incorporate this knowledge into their procedures for running their plans, they will create a win-win situation for themselves and their participants.

Richard D. Glass is president of Investment Horizons Inc., Pittsburgh.