Why We Should Expect More From Mutual Fund Directors

A Target on Their Backs Yes, I still work at Morningstar. Well, at least in theory. I took a lengthy vacation to exotic locales, felt great, got home, and promptly got whacked by a Yankee bug. I should have stayed in Nepal--it's safer there. (Aside from the flights; the airport justifiably rates among the world's worst.)

In my absence, the Supreme Court heard arguments on the first 401(k) case it has ever accepted, Tibble v. Edison International. Much of the discussion consisted of wrangling about what the Circuit Court had said in its previous ruling and definitions of the "monitoring" that is required from plan administrators. Not many thrills there. The views on fees, however, were thought-provoking.

More on that shortly, but first, some backdrop. The legal framework for the 401(k) industry continues to evolve even as the legislation does not. Congress hasn't touched 401(k) rules since 2006 (the Pension Protection Act, which was mostly about defined-benefit plans), a streak that is unlikely to be broken anytime soon. However, despite Congressional inaction, the fiduciary responsibilities of plan sponsors appear to be rapidly changing.

The primary spur has been a lawyer named Jerome Schlichter. Per The Wall Street Journal, the Tibble case is but one of 13 class-action 401(k) suits filed by Schlichter against large U.S. companies during the past eight years, mostly on the grounds of excessive fees. Seven of those 13 suits have so far been settled, at a collective cost of $187 million, thereby netting Schlichter's law firm $56 million in revenue. It's fair to assume that more filings will come.

A secondary factor has been media attention. Due to their wide reach, 401(k) plans are mainstream news. For example, when Yale professor Ian Ayres threatened to shame high-cost 401(k) plans a couple of years back by publishing a list of those companies' names, the story played prominently across the major television networks and newspapers. Naturally, companies would prefer not to read about the poor quality of their 401(k) plans on the Internet and to face hard questions from their employees. The experience may not be quite as unpleasant as facing a lawsuit, but it's no fun nonetheless.

The scrutiny has sharply affected how plan sponsors view the costs of the funds in their plans. Until recently, sponsors could safely select funds with average fees without fear of legal or media problems, as only those plans with abnormally high costs were singled out. Not so today. As ERISA expert Fred Reish notes in the WSJ article, large company plan sponsors these days are expected not just to find "reasonably priced investments, but to use their purchasing power to get the lowest-cost ones."

In Tibble's case, that means swapping its Retail fund shares for Institutional shares. The plaintiffs argue that the duty to monitor includes the duty to replace a higher-cost share class with a lower-cost version if the latter becomes available. The Court appears to agree.

For example, in response to Tibble's defense that the path to lower costs is not always obvious, Justice Alito stated, "If the investment advisor can simply look at the criteria for getting institutional shares and see that the fund would qualify and the costs for those would be less, then that seems like an obvious switch to make."

Justice Kagan: "In something like this, it's not like we're scouring the whole universe for cheaper funds. It's like we realize, oh, look, it's the exact same fund with cheaper expenses. In something like this, you make the change."

(The Justices are considerably more articulate when penning their formal arguments than when cited in an unedited transcript.)

So it seems clear: 401(k) plan sponsors have a fiduciary obligation to purchase the cheapest available share class. Giving their participants a good, low-cost option is insufficient if a great, lower-cost option is available.

All of this is fine, but it does raise a question. As Reish wrote to me in an email, does "this same reasoning apply to choosing between funds, collective trusts, and separately managed accounts?" That is, must 401(k) fiduciaries use their asset volume and bargaining power to push plan providers to give them the best price not only within a given investment type (such as mutual funds), but among all possible investment types? That is the logical next step.

In either case, it's clear from both the out-of-court settlements and the Court's recent comments that plan sponsors had better purchase institutional shares if they qualify.

The Double Standard Which leads to a second issue: Are 401(k) plan providers held to a higher standard than are other fiduciaries? It would seem so, at least with mutual fund directors. In contrast with the thriving 401(k) lawsuit business, there have been no fish reeled in by personal-injury lawyers in going after mutual fund costs. No mutual fund company has ever lost a lawsuit for excessive fees, nor has one settled a case out of court.

When the Supreme Court ruled on its one (and only) mutual fund case in 2010, Justice Alito wrote that fund companies are only liable if their fee is "so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's length bargaining." That is a long ways removed from the concept that a fiduciary must find the best possible price.

In truth, even that relaxed standard is not observed, as Jack Bogle demonstrated four decades ago. When seeking subadvisors for Vanguard's stock funds, Bogle negotiated asset-management fees that were a fraction of the industry norm. He accomplished that by bargaining at arm's length. If one vendor would not work for his stated price, then he would find another. His success vividly illustrated that few mutual fund companies truly fit Justice Alito's description. Emulating arm's length bargaining means threatening to leave if one's demands are not met. But mutual fund directors do not threaten to move assets from internally run funds so as to extract a lower management fee.

In short, being just OK is quite enough for fund directors. (Actually, it's more than enough, as historically even being dreadful has escaped punishment.) Meanwhile, being just OK has become a serious problem for 401(k) plan sponsors. I see no logical defense for the inconsistency. Why hold independent mutual fund directors to a lower standard than the corporate administrators of 401(k) plans? Indeed, there is an argument for expecting more from independent directors than from 401(k) plan administrators, as the former are paid from fund assets for the sole task of representing shareholder interests.

Ideally, at least for assuaging my sense of untidiness, all fiduciaries would be governed by the same rule. That will not happen in the United States during my lifetime. The rules will continue to be piecemeal, with different bodies and different traditions holding sway over the different investment areas. It is to be hoped, however, that fund directors and those who oversee them are watching the 401(k) industry's travails and are considering how they might do more.

The Supreme Court let directors off the hook in 2010. It might yet hear another mutual fund fee case, perhaps with a different outcome.

A Year Here, a Year There "There is still the general feeling that stocks are far riskier than people thought before the meltdown in 2007," said investment strategist Bruce McCain in Monday's Wall Street Journal.

I would have expected a fact-checker to catch that one.

John Rekenthaler 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.