The Supreme Court Sides With 401(k) Participants

Bad Apples

The central issue of Hughes vs. Northwestern University, decided last week by the Supreme Court, was straightforward. Northwestern University's defined-contribution system--which is formed under 403(b) regulations, but the court's ruling applies equally to 401(k) plans--featured a whopping 242 investment options. Unsurprisingly, some of those funds were good and others were not. The plaintiffs sued because some were not. The defendant responded that participants need not own the duds. They could instead choose the better funds.

Had the case involved retail investing, rather than within an employee-sponsored retirement plan, the defendant would have easily won. Nobody expects brokerage firms to have only excellent funds. They cannot sell plainly unsuitable investments, but aside from that modest legal requirement, brokers are free to operate as they wish. Should they carry more weak funds than strong--or indeed not any strong funds at all--clients will be their judge. The law will abstain.

That principle was upheld in the 2009 Supreme Court case of Jones vs. Harris Associates, where shareholders alleged that their mutual fund had overcharged them. In the oral argument, Chief Justice Roberts telegraphed the court's decision by stating that the plaintiffs should have shopped elsewhere. Said Roberts, "These days all you have to do is push a button and you find out exactly what the management fees are. I mean, you just look it up on Morningstar … as an investor you can make whatever determination you'd like, including to take your money out." In other words, half a barrel of bad apples doesn't spoil the whole bunch.

(Were I a marketer, I would plaster "You just look it up on Morningstar" underneath a photograph of Chief Justice Roberts in his robe. Fortunately for Morningstar's legal department, I have this job instead.)

A Different Game

So maintained the Seventh Circuit of the U.S. Court of Appeals, in finding that Northwestern University had not violated its fiduciary duty by supplying a mixed bag of investments. The court wrote, "Plaintiffs failed to allege … that Northwestern did not make their preferred offerings available to them. In fact, Northwestern did. Plaintiffs simply object that numerous additional funds were offered to them as well. But the types of funds that plaintiffs wanted were and are available to them." (The italics are the Seventh Circuit's.)

However, unlike brokerage firms, companies that establish 401(k) plans must comply with a second set of regulations. The Employment Retirement Income Security Act of 1974, or ERISA, holds plan sponsors to a higher standard than it does brokerage firms (or, for that matter, mutual fund companies). As fiduciaries, plan sponsors must do more than just advocate "suitable" investments. They carry the duty of loyalty, which requires that they act in the sole interest of their beneficiaries.

In the oral argument for Hughes vs. Northwestern, Justice Sotomayor openly dismissed the Seventh Circuit's ruling as violating ERISA's tenets. To be sure, she stated, ERISA statutes shouldn't be used to micromanage plan sponsors' decisions. But neither should sponsors be excused for not taking "basic steps" to improve their offerings. Adopting the Seventh Circuit's reasoning, she argued, could not be done without "harming the beneficiaries."

The Supreme Court’s Verdict

As none of the justices objected to Sotomayor’s comments, I posited in early December that the court would vacate the Seventh Circuit’s judgment. That was a bold guess. Reading the Supreme Court’s tea leaves is a hazardous endeavor, especially for somebody whose legal education started and finished with an undergraduate class entitled “Introduction to Legal Studies.” In this instance, however, fortune favored the foolish: The court did indeed reverse the decision.

Wrote Sotomayor, in a unanimous opinion (save for Justice Barrett, who had recused herself), “The Seventh Circuit erred in relying on the participants’ ultimate choice over their investments to excuse allegedly imprudent decisions by respondents …. If the fiduciaries fail to remove an imprudent investment from the plan within a reasonable time, they breach their duty. The Seventh Circuit’s exclusive focus on investor choice elided this aspect of the duty of prudence.”

(That marks the first time that this column has used the word "elided." Nor, as it turns out, did Shakespeare ever do so.)

Unfortunately for 401(k) plan sponsors, the Supreme Court rejected the Seventh Circuit's defense without providing its own alternative. If a plan has one poor fund among its 20 offerings, has the sponsor been imprudent? Five funds? What about 10? The court gave no guidance. Similarly, although the plaintiffs also complained about Northwestern's recordkeeping fees, and wondered whether its revenue-sharing agreements were appropriate, the court said little about those allegations.

In other words, while the Supreme Court has affirmed that context matters, thereby precluding “categorical” rules of safety for fiduciaries, such as the one promulgated by the Seventh Circuit, the Court has not described that context. It will be determined elsewhere, presumably by future case law.

Looking Forward

The consequences of the Supreme Court’s verdict are clear. Current 401(k) trends will intensify. Plan sponsors will 1) further trim their investment lineups, thereby limiting their number of potentially bad options; 2) pressure fund companies ever more aggressively for institutional share classes, and 3) continue to swap their actively managed investments for index funds. Assuming that their fees are acceptably low, the latter won’t cause legal problems. The former might.

Regulating by lawsuit is inefficient. Plan sponsors would save time and money, not to mention legal headaches, if a federal authority provided the details. Thus, while the Supreme Court decided as it must, to protect the tens of millions of employees who invest in company-sponsored retirement plans, I do regret the difficulties that its verdict will make for 401(k) sponsors. The system should make it easy as possible for them to do the right thing, by providing a retirement plan for their employees. The present approach is not as easy as possible. Far from it.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.