What You Should Know About Recent Trends in 401(k) Fee Litigation


litigation-6-25-18.pngParticipation in 401(k) plans has grown astronomically since they came into existence almost 30 years ago. Today, tens of millions of employees participate in 401(k) plans, and total assets under management exceed $7 trillion. It is little wonder that 401(k) plans have increasingly become targets for litigation over the last decade. In 2017 alone, dozens of new cases were filed against 401(k) plans, with settlements collectively exceeding $145 million. Litigation has also extended to substantively similar 403(b) plans. It is therefore important for plan sponsors and administrators to be aware of recent litigation trends and take appropriate steps to minimize litigation risks.

Basis of 401(k) Fee Litigation
401(k) plans are “employee welfare benefit plans” governed by the Employer Retirement Income Security Act (“ERISA”) and, as such, must be managed exclusively for the benefit of plan participants. Plan sponsors and administrators (collectively “plan fiduciaries”) are accordingly subject to a fiduciary duty—which courts refer to as “the highest duty known to law”—requiring them to act prudently (i.e. with the “care, skill, and prudence” of a prudent person) and loyally (i.e. only for the benefit of plan participants) towards plan participants. Practically, this means that plan fiduciaries must carefully consider the expenses of the plan; and the type and cost of investment options.

Common Allegations in 401(k) Fee Suits
Flowing from the fiduciary duties owed, fee suits commonly allege that plan fiduciaries:

  • Should have offered substantively identical but less expensive investment options;
  • Did not obtain the best possible price from plan service providers; and
  • Failed to adequately monitor the cost of investments and administrative expenses over time.
  • Poor investment performance (though many courts have found that poor performance alone does not indicate that the fiduciary’s decision-making process was flawed); and
  • Prohibited transactions claims, as ERISA prohibits fiduciaries from making payments to “parties in interest” from plan assets (though often, courts have found that exemptions clearly applied to permit payments).

Recent Trends in 401(k) Fee Litigation
Recent trends indicate the plaintiffs’ bar has broadened their sights: increasingly targeting other defendants apart from larger 401(k) plans, and alleging new bases of breach.

Plaintiffs’ Bar Increasing Targets of Litigation
Historically, plaintiffs have targeted larger 401(k) plans. Recent settlement successes against 401(k) plans have buoyed the plaintiffs’ bar, and smaller plans are increasingly targeted. Large universities, which offer 403(b) plans, are also increasingly targeted. In August 2016, a dozen suits were filed against universities. In 2017 and 2018, new suits have continued to be filed with regularity against universities.

Recent Bases of Fiduciary Breach
There has been an uptick of claims targeting investment options. Plaintiffs are challenging proprietary funds (wherein fiduciaries include their own proprietary funds in the 401(k) plan), alleging that those investments benefit the fiduciary at the expense of plan participants. Plaintiffs are also targeting money market funds, claiming that the plans should have offered stable value funds instead; as the latter serves the same purpose but yields highest interest rates.

What Can I Do to Minimize Litigation Risk?
Unfortunately, there is no magic bullet. Plaintiffs’ firms are savvy, and whether plan fiduciaries have discharged their fiduciary duties is often a fact-sensitive inquiry; meaning that early resolution of litigation (i.e. at the motion to dismiss stage), is not always possible.

However, ERISA does not impose a duty on fiduciaries to achieve perfect outcomes. As long as fiduciaries consistently strive to make decisions in the best interests of plan participants, they have a good chance of demonstrating that they have discharged their fiduciary duties when challenged in court. In other words: process, process, process. Brotherston v. Putnam Investments, LLC, 2017 WL 1196648 (D. Mass. Mar. 30, 2017) illustrates this. There, plaintiffs claimed that Putnam’s proprietary products were too expensive and that Putnam lacked a fiduciary process. The court had the opportunity to review Putnam’s processes post-discovery, and found that there was no evidence to show that Putnam had breached its fiduciary duties by placing its interests ahead of participants, or that a reasonable fiduciary “in the shoes of” Putnam would have chosen a different investment lineup.

Thus, while obtaining early judgment may be difficult, establishing a robust process to consistently monitor the plan’s investment selection and plan expenses is key to demonstrating discharge of fiduciary duties and increasing the odds of success on a dispositive motion later in the litigation.

How Will New Fiduciary Rules Impact the Bank?


fiduciary-rules-4-13-16.pngThe new fiduciary rules from the Department of Labor stand to impact a huge number of banks, as more employees will fall under “fiduciary” standards that will change the way they do business. Boards should be asking questions now about how the revised rules will affect their banks, especially if they have wealth management or trust departments or subsidiaries, which are likely to see the greatest impact.

The Department of Labor, which has rule-making authority for ERISA, the Employee Retirement Income Security Act of 1974, last week expanded the definition of fiduciary to include a wider variety of people who give advice on retirement accounts. The rules don’t apply to non-retirement accounts. Although some employees may already be fiduciaries and familiar with the rules, others may be encountering them for the first time. There also could be an impact on certain fee-generating products such as the sale of proprietary funds and variable annuities, and boards should ask questions of the bank’s senior management to assess the effect on their bank. “Over the next several months, we will find out what the impact is,” says Andrew Strimaitis, a partner at the law firm Barack Ferrazzano in Chicago.

The rules go into effect a year from now, April 2017, with some requirements delayed until January, 2018.

Saying outdated rules didn’t protect Americans as their retirement savings increasingly move away from employer-provided pensions and into self-directed individual retirement accounts (IRAs) and 401(k)s, the labor department said Americans were too often exposed to conflicted advice that moves them into high-fee products that benefit advisors more than clients. The labor department estimated Americans would save $40 billion over 10 years under the new rules. “While many investment advisers acted in their customers’ best interest, not everyone was legally obligated to do so,’’ the labor department said. “Instead, the broken regulatory system had allowed misaligned incentives to steer customers into investments that have higher fees or lower returns—costing some middle-class families tens of thousands of dollars of their retirement savings.”

What’s Changed?
Any investment advisor who handles retirement accounts becomes a fiduciary and has to comply with ERISA standards, which means providing impartial advice and not accepting payments that represent a conflict of interest, according to the department of labor. The industry has been concerned that the new rules would eliminate the possibility of brokers making commissions on trades or fees for selling insurance, or prohibit certain products such as a bank’s proprietary funds, or even variable rate annuities. But none of those products were ruled out, and neither are commissions. Instead, there is a “best interest contract exemption” that allows brokers and other advisors to continue their compensation practices and to sell products such as proprietary funds as long as they promise to put their clients’ best interest first, pay “reasonable” compensation to advisors and disclose all conflicts and fees.

What’s the Impact?
There will be new compliance costs associated with the rule. Analysts at the investment bank Keefe, Bruyette & Woods estimated that Morgan Stanley, as an example, could face a two-year implementation cost of $2,500 per financial advisor, plus about $600 yearly per advisor after that for on-going compliance, based on calculations from the trade group SIFMA, the Securities Industry and Financial Markets Association. The costs could potentially push some banks with marginally profitable asset managers to sell or outsource their compliance, and many of them already do the latter. Some think the rule could have far-reaching effects in terms of changing the types of products advisors are willing to sell, because of the uncertain liability. “It is fundamentally changing the way a bank will interact with the typical IRA client,’’ says Richard Arenburg, a partner at the law firm Bryan Cave LLP in Atlanta. Customers can sue advisors who don’t represent their best interests. Recommending products that benefit the advisor when lower-cost or more appropriate products are available could be a bad idea. “To continue to recommend funds where it is questionable whether they are in the best interest of consumers, you will have a tougher road to hoe to avoid liability,’’ Arenburg says. Some banks may react by limiting the number of advisors who handle retirement accounts such as IRAs. “I think you’re going to see consolidation definitely,’’ says Strimaitis. “People are going to have larger operations to make the compliance costs worth it.”

Boards should review the impact on the bank periodically, says Nancy Reich, an executive director with accounting and advisory firm Ernst & Young LLP. What’s the impact on the business model? What changes to its policies and procedures is the firm considering to address the impact?

Is Your Compensation Plan Generous Enough?


6-24-13_Equias.pngWhile banks continue to have challenges with low interest rates and slow loan growth, two issues are always critical: (1) the need to attract, retain and reward executive talent and (2) the need to consistently optimize earnings.

Many bankers put compensation and retirement discussions on the back burner for the past four or five years, but are showing a renewed interest in these programs as the crisis has eased. While salary, annual performance bonuses and equity plans are important elements to consider in a compensation plan, many banks have been offering nonqualified plans to help balance the total compensation plan for key executives.

If a bank upgrades its executive compensation and benefits to compete for outstanding talent, won’t the additional cost reduce earnings? Not really. When you are able to attract and retain key officers, the bank can expect to be rewarded with superior performance and increased earnings. Additionally, banks can generally offset these unfunded benefit liabilities with the tax-advantaged earnings from bank-owned life insurance (BOLI).

There are several types of nonqualified benefit plans and unlimited benefit and contribution formulas as well as performance-based strategies that can be incorporated to meet board approval. Where do you begin?

Begin by Understanding Your Shortfall
By design, qualified plans regulated by ERISA (the Employee Retirement Income Security Act) do not provide top executives with sufficient retirement benefits and do not reflect the shareholder value they create. Salary caps, the virtual elimination of defined benefit pension plans and the relatively low level of 401(k) matching contributions typically limit executives’ retirement benefits to 30 to 50 percent of final pay. Knowing the extent of your shortfall (amount needed at retirement compared to estimated amount available) is vital to the design of an effective nonqualified plan.

Regulatory guidance says that the overall compensation package must be reasonable; therefore, SERPs and other nonqualified plans should take into consideration other compensation being provided.

Prevalence of Nonqualified Plans
Such plans are common in the banking industry. According to the American Bankers Association’s 2012 Compensation and Benefits Survey, 68 percent offer some kind of a nonqualified deferred compensation plan for top management (CEO,C-Level, EVP), and 43 percent of respondents offer a SERP.

Nonqualified Plan Basics

  • Supplemental executive retirement plans (SERPs) can be designed to address an executive’s shortfall. Generally, under the terms of a SERP, an institution will promise to pay a future retirement benefit to an executive, separate from any company-sponsored qualified retirement plan.
  • Deferred compensation plans (DCPs) minimize taxation on base salary and bonuses by allowing executives to make elective deferrals into a tax-deferred asset. The bank can also make contributions to the executive’s account using a matching or performance- based methodology.
  • Performance-driven benefit plans tie the bank’s overall objectives to an executive’s measurable performance. As these plans are based on reasonable performance benchmarks critical to the bank’s success, they address corporate governance concerns by increasing compensation only when objectives are met. Part or all of the distributions are made on a deferred basis for a variety of reasons.
  • Split-dollar plans allow the bank and the insured officer to share the benefits of a specific BOLI policy or policies upon the death of the insured. The agreement may state that the benefit terminates at separation from service or it may allow the officer to retain the life insurance benefit after retirement if certain vesting requirements are met.
  • Survivor-income plans/death benefit-only plans specify that the bank will pay a benefit to the officer’s survivor (beneficiary) upon his or her death. Typically, the bank will purchase BOLI to provide death proceeds to the bank as a hedge against the obligation the bank has to the beneficiaries. The benefits are paid directly from the general assets of the bank.

How Banks Use BOLI to Offset the Benefit Expense
The cost of each of the above plans varies by type and design. BOLI is a tax-advantaged asset whereby every $1 of premium equates to $1 of cash value on the bank’s balance sheet. Basically, BOLI is an investment asset that generates a return currently in the range of 3.00 percent to 3.50 percent after all expenses are deducted, which translates into a tax equivalent yield of 4.84 percent to 5.65 percent (assuming a 38 percent tax bracket). From an income statement standpoint, the cash surrender value (CSV) is expected to grow every month. Increases in the CSV are booked as non-interest income on a tax preferred basis. From a cash flow perspective, BOLI is a long-term accrual asset that will return cash flow to the bank upon the death of the respective insured(s).

As an example, let’s assume a 50-year-old executive will be provided a $100,000 per year nonqualified benefit payment for 15 years at age 65. The annual pre-retirement after-tax cost averages $47,000 per year. The bank could invest $2 million into BOLI to fully offset the annual after tax benefit cost.

Summary
While bank challenges still remain, providing a balanced and affordable compensation plan that includes nonqualified benefit plans can help make a difference for growing shareholder value.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.