The New 401(k) Argument: Vanguard Costs Too Much

The Lawsuits Keep Coming Last week, Anthem's $5 billion 401(k) plan was served with a class-action lawsuit, for holding funds with "excessive fees." That makes about 40 actions so far against large 401(k) plans. More will surely be filed, as plaintiffs have been encouraged by sizable out-of-court settlements in several cases, as well as a favorable Supreme Court decision earlier this year in Tibble vs. Edison International.

As the low-hanging fruit becomes plucked, plaintiffs must stretch further with their complaints. The Anthem case is particularly bold, setting three precedents for 401(k) lawsuits.

To start, Vanguard funds are accused of being too expensive. Following the familiar logical ground of Tibble vs. Edison, which argued that large plan sponsors are obliged to substitute institutional mutual-fund share classes (if available) for retail classes, the plaintiffs denounce the use of Vanguard's Investor shares. "For the exact same mutual fund option, instead of using the size of the Plan to benefit participants as required, Anthem provided much higher-cost share classes of Plan investment options than were easily available to the Plan based on its size."

That accusation appears to be correct, as Vanguard had indeed created institutional Admiral shares for those funds, and the Anthem plan was eligible to offer them. (Note: While the lawsuit focuses on the costs of Vanguard funds, Vanguard itself is not a defendant. The suit instead targets the plan sponsor, including the pension committee and Anthem’s Board of Directors.) It is ironic, though, to see the charge of high fees levied against a Vanguard-run plan. Aside from two funds offered by non-Vanguard companies (Touchstone and Artisan), the single highest expense ratio cited in the suit was 0.50%. Most funds were much lower. For example, the plans’ target-date funds were at 0.16% to 0.18%.

The irony is strengthened by the language of the claim, which comes straight from Vanguard founder Jack Bogle’s playbook. “Over time, even seemingly small differences in fees and performance can result in vast differences in the amount of savings available at retirement … a 1% difference in fees and expenses over 35 years reduces participants’ account balance at retirement by 28%.” In this instance, however, the example of a 1% annual saving is disingenuous, as there’s no way to shave a full percentage point, or any amount remotely close, from the expense ratios of funds that are already far under that mark.

The second precedent is that four of the cited funds are indexed. (So, too, are the underlying portfolios of the target-date funds, but as those funds’ asset allocations are actively run, the target-date series is not fully indexed.) Three had expense ratios from 0.20% to 0.24%, while a fourth,

VINIX, was a miniscule 0.04%. However, as the plaintiffs point out, even that final fund could be bought for less, as a lower-cost share class that had expenses of 0.02%. Sued for offering a fund at four basis points, when a fund at two was available!

The third and final claim — anticipated in this March 2015 column — is the boldest. The suit suggests that even switching to the cheapest available institutional share class may be insufficient. "Separate accounts have numerous advantages over mutual funds in a 401(k) plan, including the ability to negotiate fees, control by the plan sponsor over the investment guidelines, ability to avoid marketing fees built into the cost of mutual funds, and ability to avoid holding significant cash for shareholder redemption." With a separate account, "The plan sponsor can negotiate the best possible fee for the plan using its bargaining power."

Thus, “While certain of the Plan’s options after 2013 offered institutional share classes for the mutual funds, they did not, and still do not, capture the lower expenses available given the size of the Plan’s investment in each fund.”

Effectively, the accusation demands that any 401(k) plan that is large enough to warrant a separately managed account, insist that such an account be created and substituted for an otherwise identical mutual fund. Even if the fund is institutionally priced — even if it is the single lowest-cost mutual fund for its type, among the entire fund universe — the 401(k) plan sponsor is culpable if it does not pursue a cheaper option.

Now that’s setting a high fiduciary standard! As I’ve written before, 401(k) plan sponsors are already expected to work harder for their fiduciaries than are mutual-fund directors, who are expected only to prevent disaster. Few mutual-fund directors ever face lawsuits, and when they do, the charges are for serious matters of fraud, or massive investment losses. The gap in accountability between plan sponsors and fund directors appears to be growing even wider.

Of course, there's no guarantee that the Anthem plaintiffs will be successful. Or, if they do receive a settlement, that the rationale for the payment will break new ground. (After all, Edison vs. Tibble already established the need for plan sponsors to seek institutional shares, when appropriate and available.) But regardless of the outcome, the pressure on defined-contribution fiduciaries continues to increase. Which, in turn, will squeeze plan costs. In the 401(k) industry, pain for fiduciaries has reliably meant pleasure for beneficiaries.

Where Did the Lawyers Go? Of Tuesday's The Big Short, Partial Truths, and Market Bubbles, Terence Furth writes:

“When I got out of law school a job with the top enforcement agencies was highly coveted. The SEC enforcement division was highly coveted. Now the job is a first gig. The number of issuances and issuers has increased at least a thousand percent but the SEC budget is flat, adjusted for inflation. Our system is, de facto, a complaint system. Once it was a surveillance system.”

The Department of Labor’s oversight of 401(k) plans is also a surveillance system, as the DOL is insufficiently funded to deliver effective enforcement. But in the DOL's case, the enforcement gap is filled by lawyers. Such does not seem to occur in the bond market. Perhaps it should.

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.