Report: Fear of Litigation Potentially Stifling 401(k) Plan Innovation

By Ted Godbout • May 14, 2018 • 0 Comments
A potential negative consequence of litigation involving defined contribution plans is engendering fear among plan fiduciaries to offer innovative plan options, a new report suggests.

With lawsuits being brought against 401(k) fiduciaries for a variety of reasons, an open question is whether this fear is preventing the use of “creative options” that may improve participant outcomes, the Center for Retirement Research poses in its paper, “401(k) Lawsuits: What Are the Causes and Consequences?

While lawsuits filed in the midst of the Great Recession largely focused on allegations concerning inappropriate investments and employer stock in 401(k) plans, these lawsuits have become less common. Instead, more recent lawsuits have tended to focus on excessive fees, as well as self-dealing, the report notes.

Citing Bloomberg BNA data, the report shows that 107 complaints related to 401(k) plans were filed during 2016-2017 — the highest two-year total since 2008-2009. In addition, the report notes that 401(k) plans sponsored by more than 40 financial firms — including most of the largest in this sector — have been connected with lawsuits alleging self-dealing.

Authors George Mellman and Geoffrey Sanzenbacher explain that a potential result of this focus on excessive fee allegations is the rise in the use of low-cost index funds and a downward trend in investment and administrative fees. They suggest that, although higher fees associated with actively managed funds are not necessarily imprudent, fiduciaries may believe it is beneficial to avoid the risk altogether.

As an example of the trend, they cite Investment Company Institute data showing that the percentage of equity mutual fund assets in index funds shifting over the last 15 years, from 9.9% in 2011 to 24.9% in 2016.

They note that it remains to be seen whether this trend is good or bad for plan participants. While index funds generally have performed well on after-fee returns, given the recent strength of the market and its lower volatility, some industry participants and observers “view the resulting bias against active management options in 401(k)s as a negative trend that rewards ‘safe’ funds over those that could add greater value,” the authors emphasize.
Litigation concerns may also reduce fiduciaries’ enthusiasm to add narrowly focused investments as menu options. The report explains that, before increases in litigation, some fiduciaries offered more asset class choice by including specialty assets, such as industry-specific equity funds, commodities-based funds and narrow-niche fixed income funds.

While these options could enhance expected returns in well-managed portfolios, Mellman and Sanzenbacher note that some plans offering these products were criticized on the grounds that their participants were “insufficiently aware of the potential for higher fees, investment risks and misuse.” “Given the lack of knowledge that most participants have about investing, the gains from not offering such funds in terms of lower fees would likely offset the losses from restricting these options,” they further note.

The report also warns that, according to some industry observers, it is possible litigation related to specialty assets will become more common.

Lack of Innovation

Meanwhile, concerns about litigation could dissuade 401(k) sponsors from offering potentially useful innovations, such as lifetime income options, the authors contend. So far, investment vehicles designed to provide a lifetime income stream when participants retire have not caught on, and it is unclear what role litigation has played, Mellman and Sanzenbacher observe.

They note that offering an annuity option would involve more complexity than passive investments and would require the plan to choose a provider, which would involve some risk, but such options would likely improve retirement security. “To the extent the fear of litigation does play a role, retirees may benefit from more government clarification on how plans can offer drawdown products in ways that protect them from any legal consequences,” the authors state.

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