ERISA litigation

The Conversation Every 401(k) and 403(b) Plan Needs to Have: The Plan Sponsor Liability Circle™

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James W. Watkins, III, J.D., CFP®, AWMA®

Whenever plan sponsors and plan advisers talk about 401(k) litigation, they always point the finger at those bad ‘ol ERISA plaintiff attorneys. Since I am one of those bad folks, I respectfully disagree with such sentiments. I respectfully suggest that plan sponsors should look in the mirror to see the real party for such litigation. As the famous comic strip, “Pogo,” once said, “we have met the enemy and he is us.”

Whenever I talk with a CEO and or a 401(k) investment committee, this is the first graphic I show them. Most plan advisers insist on plan sponsors agree to an advisory contract that contains a fiduciary disclaimer clause. Many plan sponsors are not aware that they have agreed to such a provision since they are usually set out in legalese. But they are usually there.

When a plan sponsor agrees to such a clause, it waives important protections for both itself and the plan participants. With a fiduciary disclaimer clause, securities licensed advisers can claim to be subject to Regulation “Best Interest” (Reg BI) rather than the more demanding duties of loyalty and prudence required under a true fiduciary standard.

Reg BI claims that it requires brokers to always put a customer’s best interests first, including considering the costs associated with any and all recommendations. The Reg BI turns around and allows brokers to only consider “readily available alternatives,” which the SEC considers to be the cost-inefficient and consistently underperforming actively managed mutual funds and various annuity products. In whose best interests?

Unless a plan sponsor properly performs the investigation and evaluation required under ERISA, this usually results in 401(k) litigation and the plan sponsor settling for a significant amount. As we discussed in a previous post, when you consider that all of this can be easily avoided by a plan sponsor by performing a cost-efficiency analysis using our free Active Management Value Ratio, you have to wonder why plan sponsors do not better protect themselves by simplifying their plans and ensuring that they are ERISA-compliant.

My experience has been that most plan sponsors create unnecessary liability exposure for themselves due to a mistaken understanding of their true fiduciary duties. “The CommonSense 401(k) Plan”™ provides a simple solution that reduces both administration costs and potential liability exposure, resulting in a win-win situation for both plan participants and plan sponsors.

So, for plan sponsors and plan advisers, the next time you point a finger at ERISA plaintiff’s attorney and blame us for the number of 401(k) litigation cases, remember the words of my good friend, Charles Nichols, when you point at us, three of your remaining fingers point back at you. Then contact InvestSense for a free “The CommonSense 401(k) Plan” consultation at “CommonSense InvestSense.” (investsense.com)

Copyright InvestSense, LLC 2022. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Annuities Are a Fiduciary Breach

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By Chris Tobe, CFA, CAIA

Annuities issued by a single insurance company are a Fiduciary Breach.  They can be called guaranteed income, they can be called GIC’s or fixed accounts, or index annuities.   I am focused on the institutional annuity products mostly used in 401(k)s.   There are many more fiduciary breaches in retail and variable annuities, as noted by attorney James Watkins in his recent article.

There are breaches in institutional annuities for 4 basic reasons

  1. Single Entity Credit Risk
  2. Single Entity Liquidity Risk
  3. Hidden fees spread and expenses
  4. Structure -weak cherry-picked state regulated contracts not securities and useless reserves

A 1992 Federal Reserve paper notes that the so-called insurance safety net is much weaker than most realize. [i] 

Annuities are in the news as insurance companies are pouring millions of dollars into lobbying and PR and advertising trying to trick people into buying them.

The insurance industry spends millions of dollars trying to abolish and weaken fiduciary standards because they do not come close to meeting them.

Insurance companies are especially frustrated with 401(k) plans because they have not only the strongest fiduciary standards, but an enforcement mechanism in 401(k) litigation.   While they have lobbied the US Department of Labor to ignore most of their enforcement duties on excessive fees on 401(k), they have not been able to block court action, and the latest Supreme Court ruling has reinforced this.

Annuities in 401(k) plans have traditionally been in 401(k) plans though a stable value of fixed annuity option. [ii]  In recent years they are trying to expand into hiding annuities in target date funds,[iii] mostly under the guise of Lifetime Income.[iv]

The Insurance industry’s huge push into 401(k) has even had some plan fiduciary consultants sounding words of caution.  A commentary in Benefits Pro by Mitch Shames is titled “Annuities: The Straw That Breaks the Back of Retirement Plan Fiduciaries.”[v]

Annuity contracts, however, are not investment securities. Instead, they are individually negotiated contracts entered into between an insurance company and the annuity-holder. …… the fiduciary will also need to be a prudent expert in the selection of the annuity. That is a pretty tall order. Retirement plan fiduciaries are on notice.   Annuity contracts may be the straw that breaks the back of the fragile fiduciary infrastructure employed by plan sponsors under ERISA.[vi]

Single Entity Credit Risk
Single Entity Credit Risk – Diversification is one of the most basic Fiduciary duty and annuities totally ignore this.  Like a single stock or a single bond is a clear fiduciary breach so is an investment 100% reliant on one entities credit like an insurance contract.

For over 20 years fiduciaries in the know, like large 401(k) plans, fled fixed annuity products backed by the general account of a single insurance company.  This was due to concerns about single entity credit and liquidity risk. Many attribute this to the 1992 and 1993 defaults by Executive and Confederation Life, as documented by the Federal Reserve Bank 1992 article. [vii]

In 2005 AIG was AAA rated and some in the trade press said that AIG was as safe as the Government by 2008 it was in default. In 2008 Federal Reserve Chairman Ben Bernanke said that “workers whose 401(k) plans had purchased $40 billion of insurance from AIG against the risk that their stable-value funds would decline in value would have seen that insurance disappear.” [viii]  Many investment professionals believe that a plan sponsor is taking a severe fiduciary risk by having a single contract with any one entity, such as AIG. It can be argued that a plan is taking less risk by assuming that the single insurance company backing the stable value option is too big to fail and has an implied government guarantee.

The Federal reserve for several decades bought fixed annuities in their stable value option in there 401(k) option for their employees. They limited credit exposure to 5% per insurance company.  In the late 2000’s there were not the 20 issuers needed for diversification so they shut the fund down.    Even the few diversified annuity structures still have 25% or 33% single entity exposure which is considered high by fiduciary diversification norms.

Taking 100 perentsingle entity credit risk is a clear breach of fiduciary duty. 

Single Entity Liquidity Risk
Single Entity Liquidity Risk – A fiduciary managing a bond portfolio sells a bond when it is downgraded to a level allowed in the investment policy.  Most Annuities are not allowed to be sold when they are downgraded.  They have no liquidity if the firm is downgraded multiplying the credit risk as a participant has to ride it down to default.  

Noted Morningstar analyst John Reckenthalrer said in April 2022 that in selecting 401(k) investment options, “inappropriate are investments that don’t price daily.” [ix]

Annuities do not price or mark to market daily. There is a secondary market for retail annuities provided by firms like JG Wentworth and Peachtree, which many times only pay 80 percent on the dollar.  So, if you bought an annuity and wanted to sell it the next day on the secondary market, you would take a 20 percent loss. There are annuity products that provide some limited liquidity, what they call benefit responsive, but is always a major fiduciary risk. 

Hidden fees spread and expenses
Prudential in a 2013 conference documented by Bloomberg bragged that they had secret hidden spread fees of over 200 basis Points.[x]

This loophole allows insurance companies to hide as much 2% or 200 basis points (bps) in yearly spread profits.   I was quoted in the Wall Street Journal’s Marketwatch, stating that

“These excessive profits, even if called spread, act like fees and are used like fees,” [xi]     

In addition they continue to pay commissions out of the hidden spread which drive even more sales.

The National Association of Government Defined Contribution Administrators, Inc. (NAGDCA) in September 2010 created a brochure with this characterization of insurance company general account stable value that got beyond the high risks and right to fee disclosure.  

Due to the fact that the plan sponsor does not own the underlying investments, the portfolio holdings, performance, risk, and management fees are generally not disclosed. This limits the ability of plan sponsors to compare returns with other SVFs [stable-value funds]. It also makes it nearly impossible for plan sponsors to know the fees (which can be increased without disclosure) paid by participants in these funds—a critical component of a fiduciary’s responsibility.[xii] 

It is hard to comprehend why the DOL lets these products escape disclosure.  However, there is already ERISA litigation in which spread fees have been important in settlement negotiations.

Structure -Weak Cherry-Picked State Regulated Contracts and Useless Reserves
When you purchase an annuity, you do not get to own any securities, you just get a piece of paper.  

Whereas securities (and the firms issuing, offering or underwriting the instruments) are governed by the federal securities laws and regulated by the Securities and Exchange Commission, insurance companies and the contracts they enter into are governed by the States – 50 different regulators and bodies of law. Once again, the variety can be staggering. This is the world that retirement plan fiduciaries are being forced into. [xiii]

A 1992 Federal Reserve paper notes that the so-called insurance safety net is made of 50 different state regulators with a wide variety of regulations and is much weaker than most realize.  This allows companies to shop for insurance regulation among the 50 states to find the ones that have the softest regulations. [xiv]  In 2017, The European Union showed concern with the weakness of state regulators of insurance companies. [xv]

Investors are mostly unaware of this risk based on flimsy state guarantees which the Federal Reserve has said have little worth. [xvi] These guarantee fund balances are typically a joke with $0 as they pass the hat to other insurers if one goes under. 

Required Fiduciary Questions
What should a fiduciary document and become comfortable with before investing in an annuity.

1.Which state issues the annuity, what is their record, do they have conflicts of interest with the insurance company?

2.What is their minimum capital requirement in basis points for this annuity product in the state your contract is issues in? 

3.What is the current solvency of that states guarantee pool.

4. Get full fee disclosure all internal spreads (200+) before expenses and then with expenses and profits broken down?

5. Does the Annuity contract have a downgrade provision to get out if the company is downgraded?

All annuities flunk at least one of these fiduciary tests, most flunk all. By and large the Fortune 500 largest US Corporations have avoided these insurance company products in their 401(k) plans since 1992. This is not because of fear of regulators, but because of fear of lawsuits filed by employees under the Employee Retirement Income Security Act of 1974 (ERISA). Thus, many of these non-transparent insurance products are in smaller company plans which are not cost effective for plaintiff bars to litigate individually.  However, as litigation goes downstream there are over 9 thousand plans from $100mm to $3 billion out of the top 500 many of which have annuity assets.  It is these mid to large plans who need to resist the annuity marketing push into guaranteed income mostly hidden in target date funds.

[i] Pg. 6   Federal Reserve Bank of Minneapolis Summer 1992  Todd, Wallace  SPDA’s and GIC’s

[ii] https://commonsense401kproject.com/2022/02/28/stable-value-the-goood-the-bad-and-the-ugly-avoiding-litigation/ 

[iii] https://commonsense401kproject.com/2022/04/30/problems-with-target-date-funds/

[iv] https://commonsense401kproject.com/2022/02/10/401k-lifetime-income-a-fiduciary-minefield/

[v] https://www.benefitspro.com/2022/05/03/annuities-the-straw-that-breaks-the-back-of-retirement-plan-fiduciaries/

[vi] https://www.benefitspro.com/2022/05/03/annuities-the-straw-that-breaks-the-back-of-retirement-plan-fiduciaries/

[vii]  Federal Reserve Bank of Minneapolis Summer 1992  Todd, Wallace  SPDA’s and GIC’s http://www.minneapolisfed.org/research/QR/QR1631.pdf

[viii] http://www.federalreserve.gov/newsevents/testimony/bernanke20090324a.htm

[ix] https://www.morningstar.com/articles/1090732/what-belongs-in-401k-plans

[x] http://www.bloomberg.com/news/2013-03-06/prudential-says-annuity-fees-would-make-bankers-dance.html

[xi] _http://www.marketwatch.com/story/these-funds-give-retirement-savers-stabili
ty-2012-10-16_

[xii] http://www.nagdca.org/documents/StableValueFunds.pdf_

[xiii] https://www.benefitspro.com/2022/05/03/annuities-the-straw-that-breaks-the-back-of-retirement-plan-fiduciaries/

[xiv] Pg. 6   Federal Reserve Bank of Minneapolis Summer 1992  Todd, Wallace  SPDA’s and GIC’s

[xv] https://www.nytimes.com/2017/03/31/business/dealbook/will-overseas-regulators-trust-the-states-to-watch-insurers.html

[xvi]  Federal Reserve Bank of Minneapolis Summer 1992  Todd, Wallace  SPDA’s and GIC’s http://www.minneapolisfed.org/research/QR/QR1631.pdf

Problems With Target Date Funds

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by Chris Tobe, CFA, CAIA

Target Date Funds now are above 50% of all 401(k) assets.[i]   They are the most non-transparent plan investment option and the easiest to hide fees and play performance games.   They are also the dominant default option or QDIA (Qualified Default Investment Alternatives) resulting in the highest level of fiduciary responsibility.    Despite the high level of fiduciary risk, they are specifically designed to avoid accountability and thus need the most scrutiny. 

A 2021 study shows that in general Target Date funds cause participants to “lose 21%” over career to primarily excessive fees from proprietary funds.[ii]  A 2020 study finds that asset managers exploit reduced investor attention (i.e. lack of transparency) to deliver lower performance.[iii]

HISTORY
The history of the Target Date Fund, I believe, is mainly a story about Fidelity.   I think around 2002 they saw Vanguard and indexing as their biggest threat.  Fidelity needed a new vehicle to hide the fees for active mutual funds and created the Target Date Fund. 

With heavy lobbying by Fidelity, in 2006 the Pension Protection Act was passed. This act allowed for auto-enrollment of target-date funds into defined contribution plans and set the stage for QDIAs (Qualified Default Investment Alternatives), which strongly supported the growth of these funds.[iv] 

Fidelity had Target Date Funds ready to go before the legislation was passed and dominated in market share immediately, and still keep the highest levels today.  This gave them basically a 10-year ride from 2006-16 in which they could load-up their higher fee active funds in target date funds with little or no pushback.   Starting around 6 years ago there has been a shifting inside Fidelity’s target date funds toward greater indexing. 

USING THE RECORDKEEPER
After choosing a record keeper or administrator, most plans automatically default to the Target Date Funds of that company.   A prudent process would be to have a competitive bid, but most 401(k) committees make selections based on informal processes and relationships. 

Many times, the target date and administrative fees are commingled in the Target Date funds using revenue sharing to create a total lack of transparency.[v]

This record keeping default fuels the 2021 study showing that Target Date funds cause participants to “lose 21%” of their end-returns over their career due primarily to excessive fees from proprietary funds [vi]

A 2020 study found that the average higher-cost actively managed target date funds failed to perform as well as the cheaper indexed competition in the 2015-2019 period.[vii] Some of the actively managed funds did very well in relative terms, but most did not. We found that past performance is only weakly predictive of future performance. The implication is that even an active fund with a superior record has an expected future return below the passive alternative TDFs.

However, even within a record keeper’s Target Date Fund selections, there can be a wide variety of fee levels (especially with market leader Fidelity) in which 401(k) committees can make better fiduciary decisions. The burden is on the plan fiduciary to show why they are not selecting an index fund for the Target Date Fund the QDIA. 

HIDING HIGH RISKS & FEES IN TARGET DATE FUNDS
The least transparent Target Date Funds are those that are not SEC registered mutual funds.  Many are in poorly state regulated annuities either in whole or in part.   Many are in poorly state regulated Collective Investment Trusts (CIT)s. [viii]  There are a few good CITs like the Fidelity, Vanguard, T. Rowe Price that are clones of their SEC mutual funds at a lower cost.   Many CIT’s can hide private equity or annuities and their many hidden fees and risks. [ix]

Many, if not most, CIT based Target Date Funds and all the annuity TDF’s are a fiduciary breach based on the higher risks alone, not to mention the excessive fees.

GAMING THE BENCHMARK
Many plans rely on consultants to guide them in the selection of Target Date Funds.  However, some consultants have conflicts in which they are compensated more for high fee non-index funds in backdoor payments.  Plans blaming consultants on poor Target Date Fund choices does not absolve them from fiduciary liability, but in some cases they have been able to get conflicted consultants to pay a portion of the settlement. [x]

High fee Target Date Funds typically justify their existence by some manipulation of a benchmarks.   They may hold investments which are not in the benchmark, which create different performance and risk characteristics.   They may use different allocations, mostly to higher equity positions, to create the appearance of higher returns. 

A 2020 study shows Target Date Funds ‘Create a Lack of Accountability”[xi] For example a 2040 T. Rowe or American Fund can appear to outperform a 2040 Vanguard fund because it has a 90/10 equity allocation compared to 80/20 with Vanguard.   “Target Date Fund managers engage in fee-skimming by charging higher fees on the less observable, more opaque underlying funds” [xii]  Opaque funds can be illiquid high-risk alternatives like private equity and hedge funds & annuities.

In some cases, the courts have given active managers the benefit of the doubt on their claim that it is conceivable they could outperform index plans, especially in down markets. The validity of this market-based argument has become harder. The recent Supreme Court decision letting the appeal in Brotherston vs Putnam Investments, LLC stand upholds the use of index funds for benchmarking purposes in calculating damages – regardless of performance.[xiii]

PLAN ACTIONS
Plans should always document in their 401(k) plan minutes the following regarding Target Date Funds:

  • The plan’s investment policy statement should include provisions on selecting and monitoring Target Date Funds.  Does it address each asset class involved in the plan including inside the Target Date Funds?
  • Each asset class in each Target Date Fund should be fully evaluated in terms of risk, fees, and performance as if they were a standalone option. 
  • Assets that are not SEC registered mutual funds or registered securities such as private equity, annuities need additional scrutiny and documentation.
  • Additional documentation, including a Request For Proposals (RFP), should be required if the plan is using a recordkeeper vendor’s proprietary Target Date Funds.
  • Select an appropriate benchmark to evaluate each asset class in the funds.  Compare and justify the attributes of your fund if it has differences with the benchmark
  • Understand the different fees and compare fund family fees, bearing in mind that Target Date Funds have multiple layers of fees.
  • Do a RFP for Target Date Funds at least every 5 years.
  • Carefully document the reasons that the fund was selected.
  • Regularly monitor the funds.
  • Document any and all reasons for not removing retained funds if performance has lagged peer funds.

Target Date Funds are now above 50% of all 401(k) assets.[xiv] They deserve a 50% level of fiduciary oversight or even more because of their lack of transparency. 

[i]  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3729750

[ii] https://www.kiplinger.com/investing/mutual-funds/602705/the-disturbing-conflicts-of-interest-in-target-date-funds

[iii] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3729750

[iv] https://mutualfunds.com/retirement-channel/history-target-date-funds/

[v] https://commonsense401kproject.com/2022/04/02/revenue-sharing-in-401k-plans/

[vi] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3729750

[vii] AN ANALYSIS OF THE PERFORMANCE OF TARGET DATE FUNDS John B. Shoven and Daniel B. Walton, https://www.nber.org/system/files/working_papers/w27971/w27971.pdf   Oct.2020

[viii] https://commonsense401kproject.com/2022/02/22/cits-collective-investment-trusts-in-401k-the-good-and-the-bad/

[ix] https://commonsense401kproject.com/2022/02/15/private-equity-in-401k-plans-a-ticking-time-bomb/

[x] https://commonsense401kproject.com/2022/03/09/conflicted-401k-consultants-should-plan-sponsors-fire-them-sue-them-or-both/

[xi] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3729750

[xii] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3729750

[xiii] https://www.plansponsor.com/supreme-court-will-not-weigh-burden-proof-index-fund-comparison/
https://401kspecialistmag.com/brotherston-v-putnams-far-reaching-401k-fallout/

[xiv] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3729750

Healthcare 401(k)/403(b) Plans: A Growing Target of Litigation

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by Chris Tobe, CFA, CAIA

Floodgates are opening after US Supreme Court Northwestern 403(b)Case. [i] Most Hospitals not affiliated with public universities are subject to ERISA laws.  Hospitals tend to have a higher percentage of high fee funds and a much higher risk of litigation.

Why are hospitals at such high risk?  My take is that the 403(b) culture with its mix of ERISA and non-ERISA plans tends to have higher fee providers especially those associated with insurance companies.   My other theory is that Hospitals face so much litigation on health care issues that this litigation is not seen as material by senior management.  GAO recently did a report confirming that 403(b) s are not as sensitive to fees. [ii]

Here is the list of the 21 ERISA class actions I have found against hospital and health care 403(b)s and 401(k)s.  Columbus GA Regional Hospital, Aurora Health WI Iowa Healthcare, Henry Ford 401k , Henry Ford 403b, Spectrum Health, Mercy Hospital Health IL Kalenda NY Barnabas Health. Rush University Medical Center, MedStar Health  MD, Boston Children’s Hospital Corporation, Froedherdt WI,  B.Braun Medical Inc.PA, Allina Health plan, Emory Healthcare, Bon Secours.   Settlements I have found include Norton Ky ($5mm),  Southcoast MA Hospitals Group ($2mm), Bronson Healthcare ($3mm),  Novant Health ($32mm).

Many hospitals do not have independent consultants and one Lockton actually paid $2.5mm of the $5mm Norton Hospital settlement. [iii]  Many hospitals still use revenue sharing which is a magnet for litigation. [iv]  Hospitals are also high users of annuities. [v]

For most hospitals who have not paid attention and lowered fees already substantially it is only a matter of time before they face litigation.  Even larger physician groups will soon be subject to litigation as well.  Plans doing half fixes will not avoid litigation and some who have already settled may be sued a 2nd time.

[i] https://commonsense401kproject.com/2022/03/04/brave-new-world-how-hughes-v-northwestern-the-fiduciary-responsibility-trinity-and-the-active-management-value-ratio-are-changing-the-401k-landscape/

[ii] https://www.financial-planning.com/list/gao-study-examines-403b-plans

[iii] https://commonsense401kproject.com/2022/03/09/conflicted-401k-consultants-should-plan-sponsors-fire-them-sue-them-or-both/

[iv]  https://commonsense401kproject.com/2022/04/02/revenue-sharing-in-401k-plans/

[v] https://commonsense401kproject.com/2022/02/28/stable-value-the-goood-the-bad-and-the-ugly-avoiding-litigation/