“Tipping Off” Potential ERISA Fiduciary Violations – Part 2

The recent actions filed by Jerome Schlichter against seven private colleges and universities raised a number of new issues that I have encountered in the course of performing forensic analyses of 401(k), 403(b), and 457(b) plans. In many cases, I believe that the plans actually tipped-off their violations as a result of certain decisions and/or policies they adopted. I also believe that many plans will continue to tip-off plaintiffs’ attorneys and regulators by engaging in the same sort of practices that Mr. Schlichter’s actions have cited.

Yesterday I addressed a number of product related issues, most notably the decision to offer a large number of similar investments options within a plan. Schlichter’s actions also raise the issue of excessive fees, the most common issue upon these cases have cited. While the arguments in the new actions are essentially the same as in all of the previous 401(k) based actions, I would suggest that the arguments in the new complaints suggest that plans and plan sponsors often make decisions and adopt policies that may actually serve to tip-off plaintiffs’ attorney and regulators as to potential ERISA-based fiduciary violations.

The SEC is currently involved in a sweeps operation focused on the use of various classes of  mutual fund shares by registered investment advisers (RIAs). It has been suggested that  RIAs often base their choice of a fund’s share class on whether the class offers a financial incentives such as 12b-1 fees or revenue sharing to the RIA. From the ERISA standpoint, the issue would be twofold. First, whether the plan sponsor simply blindly accepted their service provider’s recommendations without performing the independent and thorough investigation required by ERISA. Second, whether the plan sponsor chose the investment options for the plan based on the fact that the fund offered a revenue sharing plan to help plans cover all or a percentage of a plan’s administrative costs.

12b-1 fees and similar revenue sharing programs present a number of potential ERISA fiduciary liability issues. Service providers and plans are quick to point out that such fees are not illegal per se, and they are absolutely correct to a point.

Fred Reish, one of the nation’s top ERISA attorneys, has pointed out that 12b-1 fees may raise potential fiduciary liability issues, specifically the fiduciary duty of loyalty. The potential problem arises due to the fact that if only some of the plan participants select the funds that offer 12b-1 fees, and those 12b-1 fees are used by a plan to reduce administrative costs, then those choosing those funds are effectively subsidizing the costs for those who do not select such funds.

This is clearly inequitable. By knowingly allowing such a condition to exist and continue, a valid argument can be made that a plan sponsor has violated their fiduciary duty of loyalty,  their duty to put all of the plan’s participants interests first and to treat all plan participants equally and fairly.

Service providers and plan sponsors often attempt to justify 12b-1 fees and other revenue sharing programs on  the grounds that it prevents plan participants from having to personally pay for the plan’s administrative costs. However, if one does some basic calculations, the validity of that argument becomes highly suspect.

A plan has 100 participants. The offers several investment options that assess a 12b-1 fee of 0.25 basis points. Plan participants have invested $5 million dollars in Fund A. In this case, the 12b-1 fee would produce $12,500, some of which would presumably be returned as part of a revenue sharing agreement between the fund and the plan. That figure alone would probably be deemed excessive based on current industry standards. Multiply that by the number of plan options charging 12b-1 fees and it is easy to understand the rationale behind the excessive fee case, as plan participants would surely agree to pay a much lower and more reasonable per participant fee if given that option.

In the recent settlement of the Mass Mutual excessive fees case, the parties agreed to terms which I believe will quickly become the blueprint for future settlements off such cases. In addressing record-keeping, the parties agreed that record-keeping fees based on the plan’s assets under management (AUM) would be totally prohibited, and that the fee would not exceed $35 per participant. While there may be some variance in the fee per participant based on factors such as the size of the plan, the concept of a total prohibition against fees based on AUM and a cap on per participant fees definitely produces a more equitable situation for plan participants In our example, assuming the same $35 per participant cap on administrative cap, the total revenue from just the one fund charging a 12b-1 fee far exceeds the $3,500 that would be assessed under the per participant standard. For more information about the Mass Mutual settlement, click here.

Another fee-related issue that can tip-off plaintiffs’ attorneys and regulators as to potential ERISA fiduciary violations involves the choice among available share classes of investment options chosen for a plan. In most of the excessive fee cases to date, the issue has involved the use of retail shares instead of much less expensive institutional shares. However, I believe that cases focusing on the different fees of so-called retirement class shares will soon be filed. I believe that the SEC’s current sweep focusing on the use of share classes will simply speed up such strategies.

In addition to institutional shares, most fund families now offer some sort of retirement class shares. For instance, Fidelity offers K shares, American Funds offers various levels of R shares, and TIAA-CREF offers Retirement and Premier shares to plans. In the case of of American Funds and TIAA-CREF, the difference in the types of their retirement funds is predominantly the 12b-1 fee charged by the shares. For instance, American Funds’ offers six different types of R shares, with 12b-1 fees ranging from 100 basis points (R-1) to no 12b-1 fee at all (R-5 and R-6). So if an attorney or regulator checks a plan’s Form 5500 and sees that a plan sponsor has chosen R shares in an American Fund that assesses a 12b-1 fee, obvious questions about possible breaches of the plan sponsor’s fiduciary duties of loyalty and prudence are raised.

The final point with regard to tipping-off potential fee-related ERISA fiduciary violations involves the decision by a plan sponsor to include proprietary investment products in their pension plans. Again, investment companies and plan sponsors are quick to point out that the inclusion of such products in their plans is not illegal. True, but as we have seen in a number of recent actions and settlements, the decision to do so will probably not end well if that decision is legally challenged.

The basic problems with the inclusion of proprietary products in a 401(k) or other pension plan are their high fees and/or poor performance record relative to less expensive options. After the Citigroup decision validating Vanguard’s funds as legitimate investment options to be considered in choosing a plan’s investment options, the inclusion of overpriced and underperforming proprietary products has become even more difficult to justify.

Excessive fees will continue to be a primary focus of these actions against 401(k), 403(b) and 457(b) plans. The reason is that they are simple to prove, as most plans are loaded with overpriced and underperforming investment options. That fact, combined with the fact that most plan sponsors either do not perform the legally required independent investigation at all, or do so improperly, make cases against plans the proverbial “low hanging fruit” for attorneys and regulators.

Several years ago I created a simple cost/benefit metric, the Active Management Value Ratio™ 2.0 (AMVR) that allows plan sponsors, attorneys, regulators and investors to quickly assess the cost-efficiency of a mutual fund. Interestingly, the legal community has openly embraced the AMVR and I have given presentations to various legal groups on how to use the AMVR effectively. Some investment advisers have also embraced the AMVR as well, as it can be used as a risk management tool for both their clients and their practice. For more information about the  AMVR, click here.

The actions against 401(k), 403(b) and 457(b) is not going to end anytime soon. In most cases, the violations are blatant and, therefore, easy to prove. The easy availability of a plan’s information from its annual Form 5500 makes the task that much easier.

II tell all my fiduciary consulting clients that there are two legal decisions that they need to remember and/or print out and frame in their offices. The first decision is Meinhard v. Salmon, in which Judge Cardozo made his historic statement that

A [fiduciary] is held to something stricter that the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”1

The second decision is Donovan v. Cunningham in which the court admonished all fiduciaries that subjective good faith and/or ignorance are not relevant in cases involving breach of fiduciary duty claims, as

a pure heart and an empty head are not enough.2

Under the fiduciary duty of prudence, fiduciaries like plan sponsors are held to the “prudent man” standard. More specifically, the courts assess a fiduciary’s prudence based on an “objectively prudent” standard, with no consideration of any alleged subjective considerations. In defining “objective prudence,” the courts have held that

A decision is ‘objectively prudent’ if ‘a hypothetical prudent fiduciary would have made the same decision anyway…Put another way, the fiduciary would have made the same decision if a proper investigation had been made.3

The court then went on to dismiss the fiduciary’s argument that the applicable standard was whether a fiduciary “could have” made the same decision, not the “would have” made the same decision standard. The court pointed out that the difference in the two terms was more than semantics, as “would have” is more demanding, meaning probable, while “could have” simply means possible, which falls far short of the duties required of fiduciaries.

Mr. Schlichter’s newly filed actions against private colleges and universities sends a clear message and warning to all investment fiduciaries. Take the time to truly understand your duties as a fiduciary and take the time to perform them properly. Retain the services of an expert that is knowledgeable and experienced in ERISA and fiduciary to help both the plan and you personally. While it is too late now for plans and plans sponsors against a breach of fiduciary action for past decisions, plans and plans sponsors can create a win-win situation for the plan, plan sponsor and plan participants by being proactive and making the changes necessary to bring a plan into compliance with applicable rules and regulations.


1. 249 N.Y. 458, 164 N.E. 545 (1928)
2. 716 F.2d 1455, 1467 (5th Cir. 1983)
3. Tatum v. RJR Pension Investment Committee, 761 F.3d 346 (4th Cir. 2014)

© Copyright 2016 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or 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.


About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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