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A Closer Look at the Braden v. Wal-Mart Case

A poster child for the way in which a 401(k) plan should not be run.

W. Scott Simon, 02/02/2012

I participated on a panel at an investment gathering a couple of weeks ago. Toward the end of my comments, I briefly discussed the settlement proposed by plaintiffs in the Braden v. Wal-Mart Stores, Inc. case. To my surprise, the audience was absolutely riveted by what I was saying. I'd like to chalk up that reaction to my stellar good looks and overall peachy disposition, but alas, neither would be true. Even more remarkable, this occurred late in the day when I was about the last remaining obstacle between the audience and Happy Hour. All that made me think that a column on the Wal-Mart case would be interesting to advisors.

The Wal-Mart case is the poster child for the way in which a 401(k) plan should not be run: plan investment options bearing excessive and entirely unnecessary costs, undisclosed conflicts of interest, lack of meaningful disclosure of costs to plan participants (which was actually part of the agreement between plan fiduciaries), and, I'd argue, an apparent absence of any serious fiduciary mindset on the part of the plan sponsor fiduciary and the trustee fiduciary.

A Bit of History
Jeremy Braden, a Wal-Mart employee from Ozark, Mo., filed a class action lawsuit in U.S. District Court in Springfield, Mo., against Wal-Mart in March 2008. He alleged that Wal-Mart breached its fiduciary duties under the Employee Retirement Income Security Act (ERISA). Braden had two basic contentions. First, the 10 mutual fund investment options offered by the Wal-Mart 401(k) plan--eight of which were actively managed--were not only priced at retail but highly priced at retail to boot, so they were imprudent per se given that the Wal-Mart plan held about $11 billion in assets. Second, Braden argued that the process by which these investment options were selected for the plan menu was essentially a corrupt one because every fund generated revenue-sharing payments to Merrill Lynch in its capacity as the (fiduciary directed) trustee and (non-fiduciary) record-keeper of the Wal-Mart 401(k) plan.

The district court judge tossed Braden's lawsuit in late 2008, but his decision was unanimously overturned in November 2009 by a three-judge panel of the U.S. Eighth Circuit Court of Appeals. The case was then returned to the district court for further action. The parties then eventually agreed to settle the case with the district court judge providing preliminary approval of the settlement last month and final approval set for March. Wal-Mart has agreed to pay $13.5 million with the net amount (after attorneys' fees, costs and administrative expenses) going to pay for plan expenses.

The Menu of Investment Options for the Wal-Mart 401(k) Plan
What follows is a table detailing the menu of 10 mutual fund investment options offered to participants by the Wal-Mart 401(k) plan in 2008, the year that Braden filed his class action lawsuit. (The plan apparently offered other investment options in addition to the mutual funds in the table. These included (1) a common/collective trust, (2) a stable value fund (comprised of a money market fund, a common/collective trust, and traditional and synthetic guaranteed investment contracts) and (3) Wal-Mart common stock).

While Braden's pleadings focused on the high retail-priced annual expense ratios of the mutual funds, there seems to have been no mention of the annual turnover rate or any commissions for the funds. Yet the harmful monetary impact of either or both of these factors--which are represented in the following table--on the wallets of plan participants can, in some cases, could be a multiple of the impact made by expense ratios alone.

The costs in the preceding table are expressed in basis points (bps). One basis point is equal to 1/100th of one percentage point (0.01%). 100 basis points therefore equal one percentage point (1.00%).

The expense ratio of a mutual fund is determined through an annual calculation in which a fund's operating expenses are divided by the average dollar value of its assets under management. Operating expenses are taken out of a fund's assets and reduce the return to plan participants invested in the fund. For example, the AIM International Growth Fund (Class A) had an annual expense ratio of 145 basis points (1.45%) which, every year, came out of the pocket of those plan participants invested in this fund. Some mutual funds have a marketing cost--referred to as a 12b-1 fee--which is included in the fund's operating expenses. Nine of the 10 funds in the Wal-Mart 401(k) plan bore a 12b-1 fee.

Note that a fund's trading activity--that is, the fund manager's purchase and sale of securities in the fund--is not included in the calculation of the annual expense ratio. Instead, the cost of this trading activity is measured by a fund's annual turnover rate. A fund's turnover is the rate at which a mutual fund manager buys or sells stocks or bonds for the fund during the course of a year. A fund's turnover rate equals the lower of these purchases or sales (i.e., trading costs) divided by the average net assets of the fund.

Although it's difficult to precisely calculate the amount of a mutual fund's annual trading costs, it's possible to make a rough estimate. In his book, Bogle on Mutual Funds, the legendary John Bogle suggests doing so by doubling a mutual fund's turnover rate, and then multiplying that number by 0.60%. For example, the AIM International Growth Fund (Class A) has a turnover rate of 38%. Doubling that number yields 76 and 0.60% of that number is 46 bps. So a participant in the Wal-Mart 401(k) plan invested in this fund would have paid an annual expense ratio of 145 basis points (1.45%) of its invested assets plus annual trading costs of approximately 46 basis points (0.46%) of those assets, for an estimated total of 191 basis points (1.91%) each year.

And there's more. The AIM International Growth Fund (Class A) also bore a (front-load) commission of 550 basis points (5.50%). This is the percentage that a participant in the Wal-Mart 401(k) plan who held that fund may have paid (to the fund company providing the fund) on the amount of new assets it invested each time in the fund. (Instead of being paid on a front-load basis, commissions can alternatively be paid on a spread-load or a back-load load basis.)

By the way, it's important to understand that commissions are sometimes confused with "brokerage commissions," but the two are completely different. Brokerage commissions are the costs racked up by a fund manager when buying and selling securities within a fund. Although commissions and brokerage commissions are paid by a plan participant to any fund companies that provide funds in which a participant is invested, they are accounted for (or not) in different ways. The cost of a brokerage commission is removed from the net asset value (NAV) of a mutual fund share, which reduces the performance of the share to that extent. So at least this cost factor is accounted for, however murky that may be. But the cost of a commission is not accounted for in any formal reporting formats at all. This cost factor is neither removed from the NAV of a fund share (thereby reducing performance) nor is it included in the annual expense ratio of a mutual fund (thereby increasing costs). That's why explanations of the negative effect of, say, front-load commissions "averaging out" and therefore "going away" over time are the complete opposite of simple arithmetic reality. In fact, the difference in accumulated wealth between a plan account bearing no (or low) commissions and one bearing low (or high) commissions grows absolutely over time--all other costs and performance being equal.

It's probable that a participant in the Wal-Mart 401(k) plan with a relatively larger plan account would pay a smaller commission because of break-points. And it's always possible that Wal-Mart negotiated with the fund companies to get all commissions in the plan waived--whether front-load, spread-load, or back-load. But given the other facts in this case, one can't have confidence that such negotiations took place. In fact, no participant should pay any commissions in any 401(k) plan, especially one with billions of dollars in invested assets.

But folks, that's not all. All these hits to the wallets of participants in the Wal-Mart 401(k) plan (or any unnecessarily high-priced plan) contribute to what I've called the "negative compounding effect of lost money." The costs just described for the AIM International Growth Fund (Class A) add up to about 2 percentage points annually--and more when commissions are included. They obviously reduce a plan participant's wealth immediately.

But there's an additional penalty on the accumulation of wealth: the negative compounding effect of the money that's used to pay for the foregoing costs. This money, which is "lost" in the sense that it won't ever be available for compounding into additional wealth, represents a phantom-like negative impact on the growth of total wealth.

Here's how Braden's recent pleading in support of his motion for a court order to preliminarily approve the Wal-Mart class action settlement put it: "…the nature of Braden's claims--that small dollar amounts of additional fees cause compounded losses in savings over time. While the present value of any given participant's claimed losses due to [Wal-Mart's] conduct… are relatively small in terms of dollars, their effect on future retirement savings is what Braden has undertaken to redress." (Emphasis in the original.)

Did Wal-Mart Waste Corporate Assets?
As the sponsor of a 401(k) plan, Wal-Mart owes a plethora of fiduciary duties to the participants in that plan. Distinct from such duties are the fiduciary duties owed by Wal-Mart to its stockholders. The Wal-Mart 401(k) plan had just over 1 million participants in 2008, purportedly comprising nearly 90% of its U.S. workforce. Although Wal-Mart has no obligation to match any contributions made by plan participants, it reportedly voluntarily contributed $932 million to the plan in 2007 alone.

The Wal-Mart 401(k) plan was a decidedly inferior one in all respects, especially considering that it was sponsored by such a large and sophisticated company as Wal-Mart. I don't see how anyone, especially Wal-Mart's ERISA counsel (in private, of course), could disagree with that. The case could be made, then, that Wal-Mart wasted corporate assets--nearly $1 billion in one year alone!--when it made matching contributions to the accounts of plan participants, contributions that came from corporate coffers. Making matching contributions out of hard-won profits to a qualified retirement plan that's decidedly superior in all respects is one thing, but any such contributions made to an inferior plan is quite another.

As the legendary Rex Sinquefield has said: "Poor performance is not cheap. You have to pay dearly for it." Making matching contributions with perfectly good corporate money to a 401(k) plan with a suboptimal menu of investment options is the very epitome of poor performance.

The Trust Agreement Between Merrill Lynch and Wal-Mart
There is a great "disconnect" in the ERISA statutory scheme: While a plan sponsor has always had the duty to defray only reasonable costs for a plan under ERISA section 404(a), the service providers to such plans never had the duty to actually disclose such costs to sponsors or plan participants. (This should change--at least some--this spring.) The Trust Agreement Between Merrill Lynch Trust Company, as the Trustee of the Wal-Mart 401(k) plan, and Wal-Mart Stores, Inc., as the Employer (August 1, 2003), is a good example of affirmatively withholding such costs (i.e., effectively hiding them) from plan participants.

Section 4.04 of the Trust Agreement reads, in part: "[Wal-Mart] agrees that it will not, nor will it permit any employee of [Wal-Mart], to disclose, in whole or in part, the Written Fee Report [describing the fee break-down of the plan's mutual fund investment options] or any information in the Written Fee Report, to any person…This obligation of [Wal-Mart] not to disclose the Written Fee Report or any information in the Written Fee Report shall survive the termination of this agreement. [Wal-Mart] and the Trustee [i.e., ERISA section 403(a) fiduciary Merrill Lynch] agree that in the event of a disclosure of the Written Fee Report or any information in the Written Fee Report by [Wal-Mart] and/or any of its employees, contrary to the terms of this Agreement, the Trustee may terminate this Agreement immediately."

Merrill Lynch, the fiduciary trustee and record-keeper of the Wal-Mart 401(k) plan, continues to serve the plan in both capacities to this day.

The Proposed Independent Advisor to Wal-Mart
In addition to paying $13.5 million, Wal-Mart has also agreed to provide nonmonetary relief including retention of an ERISA section 3(21)(A) "independent" advisor for a period of two years from the date of final approval of the settlement. This advisor will assist Wal-Mart in its continuing efforts to remove retail-priced mutual funds, or funds that pay 12b-1 fees or revenue-sharing, from the menu of investment options offered by the Wal-Mart 401(k) plan. Wal-Mart has also agreed to consider, when appropriate, adding low-cost, passively managed investment options to the plan menu (apparently there are now two index funds on the menu).

The advisor will additionally provide independent advice and recommendations concerning the selection and monitoring of plan investment options. The words "advice" and "recommendations" in this context signal that the advisor will be a 3(21)(A)(ii) fiduciary who renders investment advice for a fee. That means the advisor won't be an ERISA section 3(21)(A)(i) fiduciary who exercises discretionary authority or control in the management of the plan or disposition of the plan's assets. "Discretion" is the lynchpin here, imbuing a fiduciary that has it with actual independent authority. The pseudo-"independent" fiduciary to be retained by Wal-Mart will have no such discretion and therefore will have no authority to effect real change in the Wal-Mart 401(k) plan and in the fiduciary mindset of Wal-Mart in its duties as the plan sponsor.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding, is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visit Prudent Investor Advisors or you can e-mail him at wssimon@prudentllc.com. The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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