As an employee benefits lawyer who counsels employers, I have become increasingly concerned about the implications of “pension leakage” for fiduciary liability, at least in the absence of currently available loan protection or a statutory safe harbor. Pension leakage is a term describing what happens when plan assets intended to support the employee during retirement drain out of tax-favored 401(k) accounts prematurely.
Recent studies have found that tens of billions in retirement savings are lost annually through involuntary plan loan defaults triggered by death, disability, layoffs and other involuntary terminations of employment.
This problem has become far more widespread, partly because plan borrowing has drastically outgrown its original purpose. Traditionally, employers allowed plan loans because the mere availability of borrowing was sufficiently reassuring to the participants to achieve the desired effect of increasing plan participation and contribution amounts to the point necessary to ensure non-discrimination compliance. Today, employers allow plan loans because employees regard borrowing from their 401(k) or other defined contribution accounts as an essential convenience and online application processes have made this type of borrowing quick and easy.
Since the plan loan process has become more perfunctory, it has become correspondingly easier for everyone involved to overlook the unique risk these loans pose for the borrower. By law, the unpaid defaulted loan balance is treated as a distribution to the employee and cannot be put back into the plan to continue tax-deferred growth. Moreover, in the event of a default in today's economic climate, it is unlikely that employees and their families will ever be able to get back to their pre-loan account balances.
The dramatic increase in pension leakage is a very bad omen for employers and fiduciaries. It signals that a broader cross section of American families has been adversely affected. This fact — plus the increasing availability of optional death, disability and unemployment protection as a plan loan feature — make fiduciary claims disproportionately more likely as time goes on. In fact, as a candidate for the next breach-of-fiduciary-duty cause du jour, pension leakage has a lot going for it. If this seems far-fetched, consider the following.
Employers and plans are at greater risk of being sued when economic factors lead to consolidation, downsizing and other strategies that entail layoffs. Companies that announce job cuts to groups of employees with a large number of recent plan loans are especially vulnerable, because employees in those groups are more likely to experience high-dollar involuntary loan defaults and are more likely to feel betrayed because they were permitted to take plan loans on the verge of a reduction in workforce, especially if they feel they were not given adequate disclosure. Once they are no longer in service as an employee, they are more likely to be willing to step forward as plaintiffs in a lawsuit.
Employees who plan to retire during this decade are culturally more predisposed to sue if they suffer an injury as a result of something provided to them. Moreover, today's employees who experience pension leakage are more likely than earlier generations to understand the gravity of their lost retirement assets. Plan providers also have a widespread appreciation — as reflected in the Department of Labor's regulations for qualified default investment alternatives, for example — that equity-based investments are necessary if a plan is to provide an adequate level of retirement income. So, leakage only adds impetus to the growing sentiment that a participant whose retirement plan actually is inadequate for retirement might be a source of liability for employers.
Most importantly, long-established principles of basic trust law provide a theory of recovery against ERISA fiduciaries that is tailor-made for a pension leakage case.
A fiduciary has a duty “to communicate to the beneficiary material facts affecting the interests of the beneficiary which he knows the beneficiary does not know and which the beneficiary needs to know for his protection,” according to the most recent understanding of trust law in the American Law Institute's “Restatements” of the law, which reflect the consensus views of judges, practicing lawyers and scholars from almost every state.
U.S. courts of appeals have invoked the principle to hold that retirement plan fiduciaries have an affirmative duty to provide information beyond the basic disclosures required by regulations. As the 3rd U.S. Circuit Court of Appeals put it, a fiduciary under the Employee Retirement Income Security Act has “an affirmative duty to inform when the (fiduciary) knows that silence might be harmful.”
Another incentive for the plaintiff's bar is ERISA's definition of “fiduciary.” That definition reaches not only named fiduciaries, but also any person, including any individual corporate officer or board member, who exercises any discretionary authority over the plan's operations. To a plaintiff's attorney, the opportunity to name highly placed corporate officials as individual defendants, to tie them up with discovery responses and depositions, and to question their activities means a greater chance of a favorable settlement.
I wish I could say that current written disclosure about the unique risks inherent in plan loans would be sufficient to ward off fiduciary claims based on the affirmative duty to disclose. Unfortunately, I've seen plaintiffs in retiree medical cutback cases testify with evident sincerity that they did not understand clearly worded reservation of rights clauses. We can hardly expect similarly situated employees to acknowledge they understood the intricate tax rules surrounding involuntary defaults on 401(k) plan loans.
It is wishful thinking to imagine that better disclosure can make this risk go away. It is far more likely the affirmative fiduciary duty to inform will evolve to play the same role in retirement litigation as the role played in products liability cases by the duty to warn. That field of the law became an arms race, where ever-clearer warning labels were developed in response to past cases, only to be met with increasingly clever expert opinion demonstrating that people still did not understand the new warnings. As with product liability trials, no matter how clear the disclosure, we should expect that victims of pension leakage will testify that if the disclosures had been even clearer, they would have accessed loan protection or they would not have taken the loan at all in order to preserve their pre-loan account balances.
These are the types of legal battles that can rage on for decades, and have the potential to cost the business community billions of dollars, until the risk of loss is adequately protected by insurance or a safe harbor is accessible, thus immunizing the defendants from future exposure. The sooner plan fiduciaries and legislators realize that we are on the verge of the same predicament and develop a legislative safe harbor, the better. n
Tom Christina is a member of the employee benefits and executive compensation practice group of Ogletree, Deakins, Nash, Smoak & Stewart PC, Greenville, S.C. His work includes counseling employers on the design and administration of retirement plans and defending plan administrators and others against claims alleging breaches of ERISA's fiduciary duty rules.