W. Scott Simon
Under America’s legal system, anyone can be sued for anything (whether liability attaches eventually– with or without a remedy–is a different kettle of fish). This, of course, includes sponsors of retirement plans such as 401(k)s. In just the last month, no less than a dozen institutions of higher learning that sponsor 403(b) plans governed by the Employee Retirement Income Security Act of 1974 (ERISA) (as well as those sponsoring 401(k) plans) have been on the wrong end of such lawsuits. These institutions include USC, Northwestern, Cornell, NYU, MIT, Emory, Yale, Penn, Vanderbilt, Johns Hopkins, Duke, and Columbia. At present, the plaintiffs’ bar seems to be running wild, so it’s possible that this list will be incomplete by the time this column gets published.
It’s no accident that all these schools are private because governmental (i.e., non-private) 403(b) plans such as those made available by, say, K-12 public school districts or public institutions of higher learning don’t fall under the aegis of ERISA.
It seems likely that the new conflict-of-interest rules promulgated by the U.S. Department of Labor (DOL)–effective since June but not enforced until April 2017 (and completely so by Jan. 1, 2018)–will survive challenges in the courts. Since the DOL itself cannot enforce these rules by law or through regulation, the rules provide a way for the plaintiffs’ bar to enforce them through class action lawsuits. So it could be that the new crop of lawsuits we’ve seen filed over the last month is just the tip of the iceberg (for other crops as well). Plan sponsors–as they have always been required to be under ERISA–must be vigilant, more so than ever in this new age.
One allegation often made in these and other such lawsuits is that the plan investment options had lousy returns. Returns (whether good or bad) make up a track record. And any track record, by definition, is from the past. No body of fiduciary investment law–whether found in ERISA or in the Restatement (Third) of Trusts (and its progeny, the Uniform Prudent Investor Act (UPIA) as well as associated model acts promulgated since the 1990s) requires fiduciaries to peer into a crystal ball and accurately predict which investments will turn out to be winners and which ones will turn out to be losers.
Once it’s known how the performances of such investments have “turned out” (as winners or losers), the performances become consigned to the past and, as noted, become, by definition, track records. But just as modern prudent fiduciary investing doesn’t require fiduciaries to make predictions about the future, it also doesn’t allow fact-finders (i.e., courts of law) to look at past performance and second-guess fiduciaries.
Indeed, section 8 of the UPIA mandates: “Compliance with the [standard of prudence] is determined in light of the facts and circumstances existing at the time of a [fiduciary’s] decision or action and not by hindsight.” Commentary to section 8 explains that “[h]indsight is not the relevant standard … [i]n the language of law and economics, the standard is ex ante [i.e., only what we have the ability to know now before we can see, say, lousy returns show up in a track record later], not ex post [i.e., what we now know but only because those lousy returns have now actually shown up in a track record]…” The opinion in Tussey v. ABB condemns 20/20 hindsight judgments about investment performance within the realm of ERISA plans.
And yet, it does seem as if some fact-finders do look at past performance and second-guess fiduciaries. In reality, though, they are not in violation of this tenet of modern prudent fiduciary investing. For example, it seems rather easy for a fact-finder to seemingly engage in 20/20 hindsight and find that plan fiduciaries breached their fiduciary duties for using a non-institutional class investment option instead of an identical–except for cost and therefore performance–institutional class investment option. (I’m assuming here that the institutional class investment option is lower cost than the non-institutional class investment option. But this may not always be the case. Labels on investment options can sometimes be quite misleading.)
In such a case, however, the fact-finder is not engaged in a 20/20 hindsight judgment of performance which, as noted, is forbidden. Rather, it can quite properly apply the standard of prudence which requires a plan fiduciary to chart a prudent course of action but one which is based only on the facts and circumstances existing at the time of the fiduciary’s decision or action.
This ex ante standard–only what the fiduciary has the ability to know now–in my simple example would include knowing, before the fact of selecting a plan investment menu, that the only difference between two otherwise identical investment options–one institutional class and the other non-institutional class– is the cost and necessarily the difference in resulting performance. Failure to have such basic understanding should result in a finding of breach of fiduciary conduct. That finding should not hinge on the basis of 20/20 hindsight but because a prudent plan fiduciary should have known–at the time before investing–the difference between the two options.
Such simple but crucial mistakes made by plan fiduciaries have been revealed by some of the lawsuits against retirement plans over the last decade. What’s shocking is that many of these lawsuits have involved giant 401(k) plans holding billions of dollars of assets in trust for plan participants and their beneficiaries. The sponsors of such plans have untold resources to run them prudently and yet the plans seem as if they’re run like mom-and-pop operations. Even in the cases where there are phalanxes of investment committees at the plan sponsors charged with helping ensure that the plans are operated prudently, many of them appear no more useful (and a lot less funny) than the Keystone Kops.
Added to such situations are the ones where non-fiduciary “advisors” and “consultants,” in effect, control retirement plans because plan sponsors have essentially defaulted their powers to them. Hopefully, the DOL’s new conflict-of-interest rules will help change this paradigm, which pervades so much of the retirement plan business.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.