Can 401(k) Lawsuits Help?

Serving Notice Are there any 401(k) plans left to sue?

I left for vacation two and a half weeks ago. During my absence, lawsuits were filed against the sponsors of defined-contribution retirement plans at Franklin Templeton, Neuberger Berman, Duke, MIT, Yale, and New York University. Apparently, it's better for plan sponsors if I remain in the country.

Then again, in the month before, American Century and New York Life were served. So, it's not as if this rash of 401(k) lawsuits is a new thing. It has accelerated recently, but this has been an ongoing trend for several years now. There has been a whole lot of moving and shaking going on with 401(k) plans. (I use 401(k) generically, as a substitute for the less wieldy term of defined-contribution. Technically, universities offer 403(b) plans, but close enough.)

The alleged culprits are an unlikely group, consisting of four investment managers and four large private universities. Thus, the lawsuits have targeted arguably the two most knowledgeable segments of 401(k) plan sponsors. Investment firms, of course, run money for a living, while the large universities have in-house professionals that run their pension funds. Both types of organizations are much better positioned to establish and monitor 401(k)s than is the typical plan sponsor.

Those institutions haven't been notably bad actors with their regular businesses, either. If you were to form a list of the worst mutual fund managers, the four defendants would not be near the top. Nor are the four universities in bad grace. Quite the contrary; they are universally regarded as being among the nation's elite.

Only the Good Die Young It's not surprising, then, that these plans look to be better than most. An independent rater of 401(k) plans, BrightScope, judges seven of the eight targeted plans as being superior to their peer-group average, with only Duke falling slightly below the norm. On the critical issue of costs, the plans fare better yet. Six earn BrightScope's top cost score of "Lowest Fees," with the other two having "Low Fees." Thus, all eight plans are cheaper than the average for their peer groups.

(By now, you are probably wondering about the alleged infractions. Most are that the plan's relatively low costs could be even lower, if the plan sponsor had been sufficiently diligent. Perhaps the sponsor could have trimmed the number of plan options; or used additional investment providers; or offered more index funds; or opted for collective investment trusts rather than registered mutual funds.)

Which brings us to the problem with how 401(k) plans are policed. Plans are penalized not by the severity of their crimes, but instead by the likelihood that they will pay a large fine. That is, in practical terms, the enforcement of 401(k) regulations does not come from the legal authorities. It comes instead from the possibility of a lawsuit--a lawsuit that is fruitless to its creators unless it leads to a sizable cash payment.

To use a traffic metaphor, a 401(k) plan that is traveling 90 miles per hour in a 55-mph zone will not be stopped if the car has large dents and a missing headlight. There's no money to be made by charging that driver. But a gleaming new Mercedes that is going 60 mph will be pulled over. In fact, it might be pulled over if it's traveling at 50 mph, with a search being conducted to see if its registration is current, and if the insurance is up to date.

Unintended Consequences Whether that constitutes "justice" is in the eye of the beholder. (It does not seem particularly equitable to me, but I could be convinced otherwise.) What is not open for discussion is the effect that this method of policing has on the 401(k) industry. It has pushed the largest (and often best) plan sponsors toward further cutting their costs, by swapping retail fund shares for institutional share classes, institutional classes for privately registered collective investment trusts (CITs), and active managers for passive managers.

The first of those items is unequivocally good, from the perspective of a fund investor. (And unequivocally bad, from the perspective of those who own the shares of an investment-management company, and thus benefit from higher profit margins.) Moving from retail to institutional shares has no downside. The underlying investments are the same, but the total return is higher because the fund's expenses are lower.

The other two items are a mixed bag.

CITs are cheaper than the institutional mutual fund shares that they clone (if the CITs were not cheaper, the swap would not be made), but the expense improvement comes with a regulatory loss. The CIT owner does not benefit from the many legal protections that are provided by the Investment Company Act of 1940, which governs mutual funds. The trade involves a trade-off.

Similarly, cutting a plan's active options, so that more employees invest passively, is also not a one-way street. True, such an action benefits 401(k) investors by (usually) lowering the plan's fund expenses and by giving them less rope with which to hang themselves by chasing performance. Far be it for me to criticize indexing. But even an index proponent should fear the side effects of herding--and it seems to me that herding is what will occur with large plan sponsors as a result of the legal actions.

Progress, One Stumble at a Time I won't criticize the lawsuits. In the absence of regulatory enforcement by the Department of Labor and the SEC, and the failure of Congress to improve defined-contribution rules (a few simple changes, such as opening up the federal Thrift Savings Plan to all employees, at all companies, or permitting nationally registered 401(k) plans, would render these lawsuits moot), these legal actions are the tool at hand. They push in the right direction. They just push very inefficiently. As legal-enforcement systems go, this one leaves much to be desired.

(The vacation was in Peru. I learned, among other things, that 16th-century Spaniards couldn't be trusted as far as they could be thrown--which wasn't far, given the weight of their armor--and that Denver is the lowlands. Oh, and I learned that coca-leaf tea isn't half bad. I couldn't take the leaves home, however. That's illegal for U.S citizens. However, Coca-Cola is permitted to import them--and does, to the tune of about 100 metric tons per year. True that.)

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.