Heat is rising on financial firms' use of own strategies in their 401(k) plans

Financial services firms that want to use their own products and services for their defined contribution plans are facing a growing body of case law that so far is not going their way.

Financial institutions may invest their own 401(k) plan assets in mutual funds, insurance contracts and other investment vehicles they or an affiliated company might manage, and they might also provide services like record keeping. The Department of Labor has granted a number of class exemptions for these proprietary activities, but compliance with these exemptions and fiduciary standards is getting increased attention from regulators and lawyers representing plan participants in class-action lawsuits.

Among the practices being questioned by regulators and attorneys recently are investments in mutual funds advised by corporate affiliates of the plan sponsors, purchase of group annuities from the firm or affiliates, pooled separate accounts and bank collective trusts or deposit vehicles. Other red flags are reimbursement to the sponsor for plan expenses or revenue sharing, inclusion in the 401(k) plan of higher-cost or lower-performing proprietary products, and having the plan “seed” or launch a new product before it is available on the open market.

Officials at the Department of Labor's Employee Benefits Security Administration “are willing to commit the necessary resources” to scrutinize the practices, while plaintiff lawsuits “are gaining more traction,” said Ivan Strasfeld, senior adviser at Fiduciary Counselors Inc., an independent fiduciary firm in Washington, who until 2012 directed EBSA's office of exemption determinations. Said Laura Rosenberg, vice president for finance at Fiduciary Counselors: “We are seeing increasing litigation surrounding the use of proprietary services and products by in-house plans of financial institutions.”

Although financial firm plan sponsors might be making what they consider good choices, regulators can exact penalties and excise taxes for decisions they question.

Even more expensive are the lawsuits. In June 2013, attorney Jerome Schlichter won a $35 million settlement against Prudential Retirement Insurance Annuity Co., a unit of Prudential Financial Inc., and Cigna Corp. in a class-action lawsuit for Cigna 401(k) participants alleging a breach of fiduciary duty in plan management. The settlement does not allow for any investment options advised by Cigna or a Cigna subsidiary and called for independent monitoring of plan decisions, including hiring of record keepers.

Mr. Schlichter, managing partner for Schlichter, Bogard & Denton LLP in St. Louis, has six similar lawsuits pending against 401(k) plan sponsors, including ones sponsored by Massachusetts Mutual Life Insurance Co., and Ameriprise Financial Inc. Mass Mutual spokesman David Potter said his company is seeking to have the case dismissed. “The complaint fails to state a single reason why MassMutual should not make available its award-winning investment products and services to its employees and sales force,” he said.

Mr. Schlichter believes there should be more transparency in these decisions. Financial firm plan sponsors “need to take their duty very seriously to avoid self-dealing and avoid the temptation of just putting their products in. If they do (use their products or services), they should be prepared to show that they have a process that does not favor them. It's something that should have strong justification ... with the same kind of analysis that they have for other products,” he said.

Gregory Porter, a partner with the Washington law firm Bailey & Glasser LLP, won a $17.5 million settlement for participants in Wells Fargo & Co."s 401(k) plan who had claimed the plan's services and investment products generated significant revenue for Wells Fargo while providing higher fees and weaker returns than comparable products. Mr. Porter is now pursuing several class actions against large financial institutions, challenging their use of in-house mutual funds or employer stock in those companies' 401(k) plans and the fees paid.

“A clue to us that the fiduciaries haven't done their due diligence is if all the investment offerings are from the plan sponsor. No fund family is good at every asset class and investment product,” said Mr. Porter. He cautions that while “there has already been a sea change in the way fiduciaries approach their obligations about fees,” it takes constant vigilance.

“Just because the company is doing it right now doesn't mean it won't lapse in the future. I will be keeping an eye on this for some time,” said Mr. Porter, who advises outsourcing to an independent fiduciary with full discretion.

Ms. Rosenberg of Fiduciary Counselors has seen an uptick in financial firm plan sponsors' use of independent fiduciaries and consultants, as well as an increase in documentation of due-diligence procedures for selecting investment products or services “to demonstrate that ERISA's fiduciary standards were met,” she said.

“The standard of care for plan fiduciaries is always evolving. What may have been appropriate 10 years ago may not be sufficient today,” said Michael Prame, an ERISA attorney with Groom Law Group in Washington. He said the firm is seeing increased demand from financial institutions for advice on improving policies and procedures, and reducing litigation risk.

While the Department of Labor allows the practice, it “is looking closely in its investigations at the service arrangements for, and expenses charged to, in-house plans,” said Mr. Prame. “Using affiliated products and services for an in-house plan involves special challenges that need to be carefully addressed.” n