401k excessive fee litigation has been an active area of ERISA litigation for over a decade with 401k participants arguing the plan administrator–along with various other plan fiduciaries–breached the duty to prudently manage the investment options of the plan.
Most of these cases argue the plan administrator failed to select investments with reasonable fees, particularly in light of the buying power of the 401k plan to obtain lower fee share classes or to obtain access to lower fee funds in the market. Although this issue has been litigated for over a decade we still do not have a clear rule of law. A class action recently filed against health insurance provider Anthem takes on interesting arguments in 401k fee litigation.
This case–Bell v. Anthem Inc.–is interesting because the funds are Vanguard index funds, known for being low fee funds. Vanguard’s basis for offering low fee funds is the position that high fee funds are a drain on retirement savings. So the irony of 401k fee litigation targeting these funds cannot be overlooked. Today’s post will explore some of the issues presented in this case and why it may turn out to be a significant case in 401k fee litigation.
Vanguard’s Business Model for 401k plans
To understand the issues in this case it is first important to understand the business model for The Vanguard Group. Vanguard created and leads the retail market in index funds. It is second in the market for exchange traded funds (ETFs). Vanguard’s founder, John C. Boyle, identified that most actively managed mutual funds fail to deliver more return than benchmark indexes. Boyle instead developed index funds for sale to individual investors that tracked benchmark indices like the S&P 500 that carried low fees because the fund management did not need to employ market analysts or pay a fund manager a premium for picking stocks. Boyle’s index funds have become popular and have at least in part reduced mutual fund fees across the market.
Vanguard’s position on mutual fund fees is openly hostile to the active management mutual funds. Boyle once stated, “Over time, even seemingly small differences in fees and performance can result in vast differences in the amount of savings available at retirement … a 1% difference in fees and expenses over 35 years reduces participants’ account balance at retirement by 28%.”
Issue #1: Did the 401k plan get the best share class it could for participants?
The plaintiffs allege the buying power of the plan could have allowed the plan to negotiate for fund share classes with lower fees. Mutual funds charge management fees and other fees to all shares of the fund to cover operational costs. Not all shares pay the same expense ratio. Mutual fund shares sold in the retail market carry the highest expense ratio. These are retail share classes.
Most mutual funds also offer institutional share classes for institutional buyers. These are investors who buy huge blocks of fund shares. They pay lower fees like getting a bulk rate on the mutual fund. To obtain access to institutional share classes one must typically have a large amount of buying power. There are often multiple levels of institutional share classes depending upon the buying power. Some funds even have multiple retail share classes.
401k plans tend to have institutional buying power because they have so much money under management. However, many plans do not negotiate for institutional shares although they could.
One reason why this often happens is revenue sharing. Under revenue sharing agreements a mutual fund company provides the 401k plan plan services and a menu of mutual funds. The fund company agrees to give the 401k plan a portion of the fund fees as a discount for services. The greater the fees collected from the 401k plan the less the employer pays for the 401k. So the employer benefits by leaving retail shares in the plan to cover its own costs.
Here Anthem had access to institutional share classes but left participants in retail share classes. It’s worth noting that the plan’s investment options were all on the low end of fees for the retail mutual fund market–but the difference between the retail and share classes is a 50% reduction.
This case raises an interesting question here because the funds available through the plan were index funds of lower fees than the actively managed funds available in many other 401k plans. Recent Supreme Court opinion (Edison v. Tibble) indicates employers must offer institutional share classes through the plan when available and appropriate so Anthem probably loses on this issue even with the already low fees of the Vanguard index funds.
Issue #2: Did the 401k plan administrator have a duty to request separate accounts as investment options?
The most interesting issue in this lawsuit is the plaintiffs’ claim that institutional share classes are still unreasonably high fees for the buying power of the 401k plan. Plaintiffs allege the administrator had buying power to have separate accounts created for the plan that would offer lower fees. Separate accounts are portfolios that hold investments similar to mutual funds. They are not publicly available and offer even lower fees because they have no marketing expenses.
Separate accounts in 401k plans often appear identical to mutual funds aside from the lower fees. The plan administrator has greater power to negotiate fees and dictate the investment strategy of the portfolio management. Plaintiffs allege the plan administrator could have negotiated with Vanguard or another provider to create and manage separate accounts. This claim is the first of its kind and strikes right to the core of 401k fee litigation. How much does the plan administrator have to do to reduce fees to the participants?
The plaintiffs’ argument here is really simple to understand. A rational buyer with billions of dollars in purchasing power is going to seek out the lowest cost option. When GM buys bolts it’s going to find and negotiate the best deal. It has the buying power to dictate the market because it has so much purchasing power.
The value of the contract to the seller is worth selling low to make it up on volume. A rational buyer might not buy an inferior good or service to cut costs but would seek the best value. A rational buyer would not find the best deal if the buyer had a conflicting interest.
401k plan administrator’s views
From a plan administrator’s perspective this asks the administrator to have the knowledge about the financial industry and the ability to properly negotiate billion dollar investment deals. It would require understanding how to evaluate private portfolios and compare them against other public and private investment options available to the plan.
This might be unreasonable for small plans which would lack the buying power to get into that market but larger plans typically pay handsome sums to financial consultants to provide this information and evaluations. So there is very little reason to not ask plan administrators to make prudent investment elections. It’s what ERISA requires.
However, I am not optimistic about this argument. Requiring plans to seek out the lowest cost investment opportunities–with reasonable risk and return potential–means all that revenue sharing is drastically cut. That will create two substantial problems in the 401k market.
First, costs will have to be reallocated somewhere. If plan administrators want to continue outsourcing plan services then they will have to pay the bill out of pocket or find a way to reduce services or the costs of services. Service providers will want to cut costs to remain competitive which means somebody is going to get less service and it is likely to be the participants. Service providers will not want to cut into the tremendous profit opportunities of 401k plan services so they will undoubtedly roll out anything they can to ensure this does not happen.
Second, it will discourage low wage employees from deferring wages to the plan and create problems for the highly compensated employees. If the plan administrator must pay more out of pocket for plan services then there will be a strong motivation to charge periodic fees to participants as an offset. Low wage participants will then be less inclined to defer to the plan. This was a widespread chain of events following the 2008 market collapse when plan assets shrunk and revenue sharing no longer paid off the plan service bill.
This becomes a problem for the plan administrator because 401k plans undergo annual discrimination testing to ensure the plan is not designed to benefit highly compensated employees more than other employees. One of these tests compares the deferrals of highly compensated employees against the rest of the employer’s workforce.
If non-highly compensated employees are not deferring then the plan then the plan likely fails testing. The corrective measure often employed is to reduce the deferral opportunities to the highly compensated employees. Executives do not like losing opportunities to defer salary but they also do not want to increase plan administration costs. This puts plan administrators in a difficult position to ut costs or find different solutions to pay the bills.
Probable outcomes for the 401k industry
Following the logic of Tibble there is a good argument that the Supreme Court has taken the position that plan administrators must reach for the lowest cost option when available and appropriate; however, there is a difference between asking for a different share class and asking for an investment portfolio to be created for the plan. (Learn more about the Supreme Court decision in Tibble here.) Separate accounts already exist. Portfolio management firms already offer these investments. It’s not like the plaintiffs are asking for plan administrators to invest something new.
Nevertheless, I find it less likely that the federal courts will blow up the highly profitable 401k service industry. I expect to see at least one court point out trust law does not require the absolute lowest cost. It will be up to the plaintiffs to show how readily available separate accounts are to Anthem’s plan administrator. If you believe your employer violated ERISA then you should talk to employee benefits attorneys today.