401(K) InvestSense 101: The DOL Addresses 401(k) Litigation

by James W. Watkins, III, J.D., CFP Board Emeritus™ member, AWMA®  

Recent developments in the 401(k) and 403(b) litigation arena suggest that a major change is coming to said landscapes, none more so than the amicus brief that the Department of Labor’s (DOL) recently filed with the 11th Circuit in connection with Pizarro v. Home Depot, Inc. (Home Depot).

But first, a little background. First, in Hughes v. Northwestern University1, SCOTUS upheld the provisions of ERISA Section 404(a) by ruling that each individual investment option within a plan must be legally prudent. Then, in Forman v. TriHealth, Inc.2, the Sixth Circuit suggested that dismissal of 401(k) actions based on the alleged cost of discovery to plans is premature and inequitable, Chief Judge Sutton stating that

“This wait-and-see approach also makes sense given that discovery holds the promise of sharpening this process-based inquiry. Maybe TriHealth “investigated its alternatives and made a considered decision to offer retail shares rather than institutional shares” because “the excess cost of the retail shares paid for the recordkeeping fees under [TriHealth’s] revenue-sharing model….” Or maybe these considerations never entered the decision-making process. In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case on this ground. Nor is this an area in which the runaway costs of discovery necessarily cloud the picture. An attentive district court judge ought to be able to keep discovery within reasonable bounds given that the inquiry is narrow and ought to be readily answerable.”3

“The fact that other courts have not suggested the use of “controlled” discovery has always interested me, it that is seems perfect for 401(k)/403(b) litigation. In controlled discovery, the plaintiffs would submit all discovery requests to the court for approval. As Judge Sutton suggested, since the only discovery that would be needed at this preliminary stage would be regarding whether the plan complied with the legal independent and objective investigation and evaluation requirement, the discovery request could be as simple as “any and all materials relied upon by the plan sponsor in determining that each investment option with the plan was legally prudent, including, but limited to reports, analyses, third-party research and analyses, notes, advertisements, articles, books, magazines and other publications.”4

The DOL Amicus Brief
On February 10, 2023, the DOL filed an amicus brief (DOL brief) with the 11th Circuit in connection with the Home Depot case. I believe that the DOL’s amicus brief may be instrumental in finally creating a universal and equitable application of the ERISA in the legal system.

As a fiduciary risk management counsel, I am actually more interested in the macro aspects of the amicus brief since it would have a much broader national application. For that reason, I am not going to get into the specifics of the Home Depot case. The amicus brief gave a brief analysis of the issues involved in the case. The brief identified the question before the 11th Circuit:

“Whether, in an action for fiduciary breach under 29 U.S.C. § 1109(a), once the plaintiff establishes a breach and a related plan loss, the burden shifts to the fiduciary to prove the loss is not attributable to the fiduciary’s breach.”

The brief then addressed the issues with the district court’s ruling and the issues that the 11th Circuit should consider.

“The district court did not grapple with whether to import trust law’s burden shifting rule because it erroneously that this Court in Willett had already decided that plaintiffs exclusively bear the loss-causation burden in ERISA cases. But Willett did not even consider burden shifting, let alone reject it. If anything, Eleventh Circuit precedent—including Willett itself—supports applying trust law’s burden shifting rule to ERISA fiduciary breach cases.”5

“While Willett did not explicitly address burden shifting, other Eleventh Circuit cases have endorsed the rationale behind it. This Court has long acknowledged that ERISA “embod[ies] a tailored law of trusts” and has cautioned that courts should engage in a thorough analysis before determining that a “prominent feature of trust law” does not apply where ERISA is silent. Useden, 947 F.2d at 1580, 1581 (recognizing the “incorporation of procedural trust law principles” in ERISA). To determine whether a rule should be incorporated into ERISA’s common law, the Eleventh Circuit instructs that “courts must examine whether the rule, if adopted, would further ERISA’s scheme and goals.” 6

“Moreover, by adopting burden shifting, this Court would promote uniformity in the governance of ERISA plans by aligning with its sister circuits that already apply a burden-shifting framework for proving loss causation in ERISA fiduciary breach cases.”7

As I said, I believe that the DOL’s amicus has a far greater implications for 401(k)/403(b) litigation. The DOL’s amicus brief essentially adopted the earlier argument of both the 1st Circuit Court of Appeals in their Brotherston decision, and the Solicitor General in its amicus brief to SCOTUS. All three noted that trust law supports the idea that in cases involving a fiduciary relationship, the general rule that a plaintiff must prove all part of its cases, is replaced by shifting the burden of proof as to causation to the fiduciary/plan sponsor.

“As the Supreme Court and this Court have recognized, where ERISA is silent, principles of trust law—from which ERISA is derived—should guide the development of federal common law under ERISA. Trust law provides that once a beneficiary establishes a fiduciary breach and a related loss, the burden on causation shifts to the fiduciary to show that the loss was not caused by the breach. That is why five circuits have held that once an ERISA plaintiff proves a fiduciary breach and a related loss to the plan, the burden shifts to the fiduciary to prove the loss would have occurred even if it had acted prudently.”8

“When a statute is silent on how to assign the burden of proof, the “default rule” in civil litigation is that “plaintiffs bear the burden of persuasion regarding the essential aspects of their claims.” But “[t]he ordinary default rule, of course, admits of exceptions.” Id. One such exception is found in the common law of trusts, from which ERISA’s fiduciary standards derive. Tibble v. Edison Int’l, 575 U.S. 523, 528 (2015). Trust law provides that “when a beneficiary has succeeded in proving that the trustee has committed a breach of trust and that a related loss has occurred, the burden shifts to the trustee to prove that the loss would have occurred in the absence of the breach.”9 (citing Restatement (Third) of Trusts § 100 cmt. f}.

“As Judge Friendly explained, ‘Courts do not take kindly to arguments by fiduciaries who have breached their obligations that, if they had not done this, everything would have been the same.’”10

“This burden-shifting framework reflects the trust law principle that “as between innocent beneficiaries and a defaulting fiduciary, the latter should bear the risk of uncertainty as to the consequences of its breach of duty.” Trust law requires breaching fiduciaries to bear the risk of proving loss causation because fiduciaries often possess superior knowledge to plan participants and beneficiaries as to how their plans are run.”11 (citing Restatement (Third) of Trusts § 100 cmt. f.) 

Citing Brotherston, the amicus brief notes that

“Given that an ‘ERISA fiduciary often . . . has available many options from which to build a portfolio of investments available to beneficiaries,’ the First Circuit reasoned that ‘it makes little sense to have the plaintiff hazard a guess as to what the fiduciary would have done had it not breached its duty in selecting investment vehicles, only to be told ‘guess again.”” The court thus held that “once an ERISA plaintiff has shown a breach of fiduciary duty and loss to the plan, the burden shifts to the fiduciary to prove that such loss was not caused by its breach.'”12   

“[T]rust law’s burden-shifting rule ‘comports with the structure and purpose of ERISA,’ which is “to protect ‘the interests of participants in employee benefit plans and their beneficiaries.’ To require that the plaintiff—who has already proven a breach and a related loss—also prove that the loss would not have occurred absent the breach ‘would provide an unfair advantage to a defendant who has already been shown to have engaged in wrongful conduct, minimizing the fiduciary provisions’ deterrent effect.’”13

The amicus brief went on to address the general position of federal circuit court jurisdictions with regard to shifting the burden of proof on causation in ERISA actions.

“The First, Second, Fourth, Fifth, and Eighth Circuits unequivocally hold that, once a plaintiff has proven a breach of fiduciary duty and a related loss to the plan, the burden shifts to the fiduciary to prove that the loss was not caused by the breach.14

Going Forward
As I said earlier, I believe the DOL’s amicus brief has the potential to have a significant impact in 401(k) and 403(b) litigation, especially when combined with the Northwestern and TriHealth factors. While I see numerous issues that plan sponsors will need to consider, I believe that three key issues that will need to be considered are selection of and reliance on third-party consultants, reconsideration of fiduciary disclaimer clauses, and inclusion of annuities in pension plans, in any form.

While the district court cited the 6th, 9th and 10th circuits in support of not shifting the burden of proof as to causation, the DOL pointed out that in the cases cited by the district court, “the Sixth and Ninth Circuit cases did not directly address loss causation at all.”15 As for the 10th Circuit’s refusal to adopt shifting the burden of proof on causation, the DOL pointed out that the 10th Circuit’s position was purportedly based on the 11th Circuit’s misinterpretation of of its own decision in Willett.16

1. Selection and Reliance on Third-Party Consultants
It continues to amaze me that plan sponsors blindly rely on the advice of mutual funds and insurance agents rather than experienced ERISA attorneys. Despite the warnings of the courts that such practices are in clear violation of ERISA, the courts have warned plan sponsors that such practices are impractical.

“A determination whether a fiduciary’s reliance on an expert advisor is justified is informed by many factors, including the expert’s reputation and experience, the extensiveness and thoroughness of the expert’s investigation, whether the expert’s opinion is supported by relevant material, and whether the expert’s methods and assumptions are appropriate to the decision at hand. One extremely important factor is whether the expert advisor truly offers independent and impartial advice.”17

“[The plan sponsor] relied on FPA, however, and FPA served as a broker, not an impartial analyst. As a broker, FPA and its employees have an incentive to close deals, not to investigate which of several policies might serve the union best. A business in FPA’s position must consider both what plan it can convince the union to accept and the size of the potential commission associated with each alternative. FPA is not an objective analyst any more than the same real estate broker can simultaneously protect the interests of “can simultaneously protect the interests of both buyer and seller or the same attorney can represent both husband and wife in a divorce.”18

Whether voluntarily or as a result of a decision by SCOTUS, I believe that there is little doubt that the Restatement’s position on the shifting of the burden of proof as to causation will become the universal rule in ERISA actions.

2. Reconsideration of Fiduciary Disclaimer Clauses
They have never made sense from a fiduciary liability standpoint. They make even less sense now with the consensus position of the DOL, the 1st Circuit Court of Appeals, and the Solicitor General on the shifting of the burden of proof as to causation.

As I have explained to plan sponsors, trustees and my other fiduciary risk management clients, this is basic argument an ERISA should make in claiming that granting a plan adviser a fiduciary disclaimer clause is in itself a breach of one’s fiduciary duties.

So, you hired a plan adviser because you did not feel confident in your ability to properly evaluate the prudence of investment options for the plan; yet you agreed to provide the plan adviser with a fiduciary disclaimer clause, arguably releasing the plan provider from any liability for providing poor investment advice and harming the plan participants, resulting in the selection and evaluation being right back in your hands, and in so doing, essentially acknowledged your negligence and a breach of your fiduciary duties.

As I tell my clients, if a plan adviser feels the need to request a fiduciary disclaimer clause, in essence telling you they have no confidence in the quality of their advice, should that not raise a huge red flag for plan sponsors? Don’t go there!

3. Inclusion of Annuities in Pension Plans
“Guaranteed income for life” But as my late friend, insurance adviser Peter Katt, used to say, “at what cost?”

Annuity advocates refuse to acknowledge the inherent fiduciary liability issues with annuities. With SECURE and SECURE 2.0, visions of sugarplums danced in the heads of every annuity advocate.

Annuity advocates like to try to ignore the potential fiduciary liability issues by discussing all the various “bells and whistles” that annuities offer. And I used to engage in such nonsense, forgetting the sound advice to “never argue with someone who believes their own lies.”

Even before the DOL’s amicus brief, I warned my clients that annuities were a fiduciary trap. Smart plan sponsors do not voluntarily assume unnecessary fiduciary liability exposure.

I tell my clients that whenever considering potential investment options for a pension plan or a trust, use this simple two question test:

1. Does ERISA or any other law expressly require you to include the specific investment in the plan/trust?
2. Would/Could the inclusion of the investment potentially expose you and the plan/trust to unnecessary fiduciary liability exposure?

I have been receiving calls and emails telling me that some annuity agents have been telling plan sponsors that SECURE and/or SECURE 2.0 require them to include annuities in their plans. Simply not true. I have told my clients to actually recite the two question test to any annuity agent. FYI – with regard to annuities, the answers are “no” to question number one, and “yes” to question number two.

Plan participants that want to invest in an annuity are obviously free to do so – outside the plan where there would be no potential fiduciary liability issues for a plan sponsor.

Many plan sponsors unnecessarily expose themselves to fiduciary liability exposure because they do not truly understand their fiduciary duties under ERISA. ERISA does not require a plan sponsor to offer a specific investment simply because a plan participant would like to invest in the product. Again, they are free to open a personal account outside the plan and invest in any product they are interested in.

I predict significant changes in ERISA litigation over the next two years, as SCOTUS is called on to resolve the two remaining primary issues blocking a unified standard for determining 401(k)/403(b) litigation-the ‘apples and oranges” argument and the shifting the burden of proof on causation. The 1st Circuit, the Solicitor General and the DOL have already properly decided the issues. Now all that is left is for SCOTUS to officially endorse their arguments in order to guarantee plan participants the rights and protections promised them by ERISA.

1. Hughes v. Northwestern University, 42 S. Ct. 737 (2022)
2. Forman v. TriHealth, Inc., 40 F.4th 443 (2022). (TriHealth)
3. TriHealth, 453.
4. DOL Amicus Brief (DOL Brief), 2.
5. DOL Brief, 19.
6. DOL Brief, 21.
7. DOL Brief, 22.
8. DOL Brief, 10-11.
9. DOL Brief, 12-13.
10. DOL Brief, 13.
11. DOL Brief , 12-14.
12. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 38 (2018) (Brotherston)
13. Brotherston, 39.
14. DOL Brief, 15.
15. DOL Brief, 18.
16. DOL Brief, 18
17. Gregg v. Transportation Workers of America Int’l, 343 F.3d 833, 841-42 (2003). (Gregg)
17. Gregg, 841-42 (2003).

Copyright InvestSense, LLC 2023. 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.

Brokerage Windows Exposed by Crypto

By Chris Tobe, CFA, CAIA  June 14, 2022

Crypto, trying to bribe its way into 401ks via Congress and with providers like Fidelity, has exposed a non-transparent dark area of 401(k) that has been on the back burner – brokerage windows.   A typical plan has 12 to 16 main options, but a brokerage window could add hundreds of additional choices that so far have escaped any oversight.  Fidelity stated they would put crypto as a main option and prompted this response from the DOL

“The plan fiduciaries responsible for overseeing [cryptocurrency] investment options or allowing such investments through brokerage windows should expect to be questioned about how they can square their actions with their duties of prudence and loyalty.”[i

The DOL advisory council put together a report on brokerage windows that basically said they are so immaterial, that the DOL needs to give little or no oversight to them since those in the brokerage window are aware of the additional risks.[v]

A report cites PSCSA that

23.2 percent of all retirement plans offer a brokerage window, and nearly 40 percent of those with more than 5,000 participants do. Even though brokerage windows are being offered in many plans, participants do not use them widely only 1.5 percent of plan assets are invested through brokerage windows. DOL states that custodians saw a usage ranged from .03 percent to 3 percent. [vi]

Because of their size, less attention has been paid to brokerage windows both by the DOL and the plaintiff’s bar.  But with the declaration by Fidelity to offer crypto as a main option within plans and the DOL doing its job by sounding concerns, people realized that there could be crypto investing already going on in brokerage windows, with most plans not having a clue.

Fidelity, who is the largest runner of brokerage windows and who cut the deal with bitcoin to put them on their platform, are most likely receiving millions of undisclosed dollars from the crypto crowd.

Crypto is pouring millions into DC lobbying, and seems shocked that DOL did their job and did not roll over like they did with private equity investments under Trump.

Bloomberg writes that

Under that guidance, which the DOL issued last month, employers could be responsible for risky crypto trades their workers make in workplace 401(k)s. The DOL’s employee benefits enforcement agency will launch what it’s calling “an investigative program” that requires plan officials to “square their actions with their duties of prudence and loyalty” if they allow crypto investments in self-directed accounts, according to the guidance.[vii]

“This is a very damning statement about brokerage windows,” said Lisa Tavares, a partner at Venable LLP and a former IRS attorney.”

Since almost all brokerage windows have excessive fees and many have excessive risks that do not pass fiduciary scrutiny, this opens up almost any plan with a brokerage window to potential litigation. 

Leading plaintiffs firm Keller Rohrback LLP is investigating whether employees and retirees have paid unnecessary fees in connection with their use of brokerage windows such as excessive fees, selecting funds based on the amount of fees shared with the brokerage firm, and selecting more expensive share classes despite the availability of less expensive classes of the same fund.   They have targeted particular large firms like Continental Airlines, Kimberly-Clarke, Lilly, and Caterpillar looking for plaintiffs.[viii]

In the article, “401(k)s with Bitcoin Should Expect Lawsuits: Lawyers,” trade publication “Ignites” quotes Jerry Schlichter as saying that

Any employer who would follow the Fidelity lead by offering cryptocurrency and 401(k) plan is exposing itself to very serious risk of a fiduciary breach…. As an unproven, highly volatile investment, Bitcoin would test the prudence standard under the Employee Retirement Income Security Act….The account will carry a fee of up to 90 basis points, plus undisclosed commission fees, which would be 20 times as much as a simple index fund.[ix]

The defense bar is trying to talk up a structure the digital accounts to qualify for 404(c) protections. Schlichter, however, suggested that 404(c) protections would not provide a safe harbor anyway. He pointed to a Supreme Court decision handed down in January that found that plan sponsors could not escape their responsibility for allowing imprudent investments in their plans even if they feature them alongside prudent ones. Schlichter represents the plaintiffs in that case, the plan participants in Northwestern University’s 403(b) plan. Quoting Schlichter,

“[The Supreme Court] said, ‘No, the employer plan sponsor has the duty to furnish only prudent options,’ and the same applies here.'”

Any 401(k) plans with a brokerage window will be subject to severe fiduciary liability unless they can prove they have provided 100% prudent options.  This will most likely lead to much more litigation and many more settlements, as the cost of proving 100% prudent options will be extremely expensive. 

[i] DOL Guidance Could Put a Crimp in 401(k) Brokerage Windows SHRM   https://www.shrm.org/resourcesandtools/hr-topics/benefits/pages/dol-guidance-could-crimp-401k-brokerage-windows.aspx.  

[ii] https://www.morningbrew.com/daily/stories/2022/05/27/crypto-money-is-shaking-up-us-politics.

[iii] https://news.bloomberglaw.com/crypto/yellen-says-crypto-is-very-risky-option-for-retirement-savers?context=search&index=4

[iv] https://news.bloomberglaw.com/daily-labor-report/401-crypto-investment-restrictions-eyed-by-labor-regulators?context=search&index=0

[v] DOL Advisory Council on Pension Benefit Plans Understanding Brokerage Windows in
Self-Directed Retirement Plans December 2021 (“Brokerage Windows”).

[vi] Brokerage Windows, supra.

[vii] https://news.bloomberglaw.com/daily-labor-report/new-crypto-guidance-rewrites-rules-on-401k-brokerage-windows.

[viii] https://krcomplexlit.com/the-newsroom/keller-rohrback-l-l-p-investigates-excessive-fees-401k-brokerage-window

[ix] https://www.ignites.com/lead/c/3622614/465124?referrer_module=t.cohttps://uselaws.com/media-turns-to-jerry-schlichter-for-guidance-following-fidelity-bitcoin-announcement/

Problems With Target Date Funds

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]

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. 

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. 

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.

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]

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/

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

Private Equity in 401(k) Plans: A Ticking Time Bomb

Private Equity along with other illiquid contract investments like hedge funds, private debt, real estate are a potential Fiduciary Time Bomb for plans and their participants

Center for Economic and Policy Research’s Eileen Appelbaum recently said “Much as private equity firms may wish it were different, they have been mostly unable to worm their way into workers’ 401(k)s and abscond with their retirement savings,[i] from a series of articles on how the new Trump DOL rules were connected to massive political donations by the Private Equity industry.[ii]  

A report by University of Oxford professor Ludovic Phalippou shows that in the last 15 years, private equity firms generally have not provided better returns to investors than low-fee stock index funds. Prof. Phalippou has shown excess mostly hidden fees and expenses to exceed 6% killing net returns. [iii]    

Noted founder of investment consulting firm Richard Ennis in quoting Beath & Flynn 2020 study says that private equity (as a class of investment) in fact ceased to be a source of value-added more than a decade ago. [iv] 

Jeff Hooke of Johns Hopkins book the “Myth of Private Equity” goes into great detail on an asset class and its numerous fiduciary flaws.  He documents that many performance claims are made up by the managers with no independent verification and are greatly exaggerated. [v]

The plan as I see it is to bury Private Equity into Target Date Funds where they can hide these Fiduciary Time bombs collect the massive fees and hope that they do not blow up.   Their main claim for inclusion is excessive performance which is dubious at best.

A Private Equity like structure technically private debt has cost JP Morgan over $400 million in damages in 401(k) litigation.  This private debt was put in a JP Morgan CIT, which was put in JPM broad bond CIT, with was put in a JPM stable value CIT.[vi] [vii] This type of layering is what I expect to see in Target Date CIT’s.

Former SEC Attorney Ted Siedle goes over the Fiduciary Breaches common in most Private Equity funds in his Forbes Column that should make any fiduciary nervous.  [viii]

1.   Private equity offering documents generally prominently state (in capital, bold letters) that an investment in a private equity fund is speculative, involves a high degree of risk, and is suitable only for persons who are willing and able to assume the risk of losing their entire investment.  

2. Largely “unconstrained” and may change investment strategies at any time.  Can engage in borrowing, or leverage, on a moderate or unlimited basis.  No assurance of diversification since funds generally reserve the right to invest 100 percent of their assets in one investment.  Heightened offshore legal, regulatory, operational and custody risk.

3. Myriad conflicts of interest, self-dealing practices. The investment manager determines the value of the securities held by the fund. Such valuation affects both reported fund performance as well as the calculation of the management fee and any performance fee payable to the manager. [ix] Naked Capitalism writes “The toothless and captured Institutional Limited Partners Association has proposed a fee disclosure template which has gone nowhere.”[x]  It is widely known there is a massive underreporting of fees.

4. Business practices that may violate ERISA. Private equity fund offering documents often disclose that investors agree to permit managers to withhold complete and timely disclosure of material information regarding assets in their funds. Further, the fund may have agreed to permit the investment manager to retain absolute discretion to provide certain mystery investors with greater information and the managers are not required to disclose such arrangements. As a result, the fund you invest in is at risk that other unknown investors are profiting at its expense—stealing from you. Finally, the offering documents often warn that the nondisclosure policies may violate applicable laws. That is, certain practices in which the fund’s managers engage may be acceptable to high-net-worth individuals (or unknown to them) but violate laws applicable to ERISA plans. [xi]

5.  Lack of disclosure has led to numerous violations some pointed out by the SEC, others pertaining to IRS like monitoring fees tax law violations and management fee waivers tax law violations.

These 5 points are a very abbreviated list of Former SEC Attorney Ted Siedle’s column on the Fiduciary Breaches in Private Equity funds in his 8/23/20 Forbes Column.  [xii]

Even a small allocation to a Target Date Fund, with the excessive risk, lack of outperformance and excessive fees seem to make it a Fiduciary Risk.

If you have underlying Private Equity or are seriously considering it, get an independent legal opinion (from a firm that does not represent PE firms) that the actual underlying Private Equity contract passes ERIA fiduciary muster.   Make sure your fiduciary liability insurance covers Private Equity many do not.

While the Trump DOL “get out of jail free card” letter may protect a plan from Department of Labor action on Private Equity, you are making a dangerous bet in litigation, that the judge will block transparency and discovery of these contracts. 

With no proven performance advantage, grossly excessive fees, and numerous fiduciary issues there seems to be nothing but harm in adding Private Equity into your 401(k) plan.

Chris Tobe, CFA, CAIA is an expert on Private Equity Corruption writing the book Kentucky Fried Pensions, and dozens of articles..  http://www.christobe.com/alternatives/

[i] https://www.dailyposter.com/biden-reversal-gives-wall-street-a-big-win/

[ii] https://www.dailyposter.com/news-trump-just-fulfilled-his-billionaire/

[iii] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3623820  an Inconvenient Fact Private Equity Returns U.of Oxford  Ludovic Phalippou

[iv] https://richardmennis.com/blog/how-to-improve-institutional-fund-performance

[v] https://cup.columbia.edu/book/the-myth-of-private-equity/9780231198820

[vi] https://www.nytimes.com/2012/03/23/business/jpmorgan-discloses-it-lost-in-arbitration-to-american-century.html

[vii] https://casetext.com/brief/whitley-v-jp-morgan-chase-co-et-al_memorandum-of-law-in-opposition-re-49-motion-to-dismiss-first-amended

[viii] https://www.forbes.com/sites/edwardsiedle/2020/08/23/trump-dolsec-fail-to-warn-401ks-about-massive-private-equity-dangers/?sh=62e7fb7eb808

[ix] https://www.forbes.com/sites/edwardsiedle/2020/08/23/trump-dolsec-fail-to-warn-401ks-about-massive-private-equity-dangers/?sh=62e7fb7eb808

[x] https://www.nakedcapitalism.com/2022/02/sec-set-to-lower-massive-boom-on-private-equity-industry.html?

[xi] https://www.forbes.com/sites/edwardsiedle/2020/08/23/trump-dolsec-fail-to-warn-401ks-about-massive-private-equity-dangers/?sh=62e7fb7eb808

[xii] https://www.forbes.com/sites/edwardsiedle/2020/08/23/trump-dolsec-fail-to-warn-401ks-about-massive-private-equity-dangers/?sh=62e7fb7eb808