On Dec. 6, the U.S. Supreme Court hosted the oral arguments for a defined-contribution case, Hughes v. Northwestern University. The court previously has adjudicated other defined-contribution suits, with Intel Corporation Investment Policy Committee v. Sulyma and Tibble v. Edison International, but those debates were narrow, involving statutes of limitations. In contrast, the Northwestern dispute is broad, addressing several plan-sponsor responsibilities.
(Northwestern offers a 403(b) plan for its employees, rather than the more familiar 401(k). For technical reasons, public schools and tax-exempt organizations use the 403(b) structure, while private enterprises adopt 401(k)s. However, the legal issues are similar, as both systems are covered by the Employee Retirement Income Security Act of 1974, also known as ERISA.)
The primary issue before the court was specific: whether to overturn a 7th Circuit judgment that defined-contribution plans that offer both acceptable and unacceptable investment offerings fulfill their fiduciary duties, because employees may freely choose the sound options while ignoring the duds. (Presumably, if investors were defaulted into the inadequate funds though an automatic-enrollment program, the conclusion would be different.)
That question may have been answered. When pressed by Justice Elena Kagan, even the defendant’s lawyer admitted that plans should not be “insulated from making bad decisions” because they have also “made some good decisions.” To use the lawyer’s analogy, defined-contribution plans can’t defend serving contaminated oysters by responding that some of their shellfish was fresh. It therefore appears that the 7th Circuit’s ruling will be at least modified, if not outright reversed.
The Third Generation
Most of the discussion, however, ranged elsewhere, and messily at that. (The transcript's first 25 pages are particularly painful.) The plaintiffs relitigated their case, which is complex and relies upon understanding the industry's details. Struggling to follow, the judges frequently interrupted by seeking clarifications. Were the proceedings to be diagrammed as a sentence, they would look like this.
Fortunately, I can simplify the claim. Northwestern's plan was sued for being outdated. Before November 2016, when it was overhauled, the plan occupied the industry's third generation. (The lawsuit applies to the period before the plan was updated; indeed, the plaintiffs argue that the reconstitution tacitly admits the university's guilt.) The first generation of defined-contribution plans were supplemental savings accounts, which the second generation made mainstream. The third generation brought choice. The more funds, the merrier.
Few were merrier than Northwestern's plan, which featured 242 investment options. This, of course, was an absurdly high amount. In 2019, the average number of investment selections within 403(b) plans, per the PSCA Retirement Survey, was 25. The comparable figure for large 401(k) plans was lower yet, at 16. The fourth and current generation of defined-contribution plans shrinks investment lineups rather than increasing them.
Reasons for Change
Three motivations underlie the industry’s transformation, two of which the court addressed. Left unspoken was investor behavior. With some items, consumers favor long lists. Examples include bar drinks, television stations, and video games. They enjoy browsing and thinking through such selections. Not so with 403(b) selections. Most employees want easy, quick answers. Experience has taught plan sponsors--and the providers that serve them--to simplify the process.
The second factor: fewer fund failures. Inevitably, plans that offer hundreds of investment options will have several dozen laggards. (Even index funds sometimes trail the averages over extended time periods.) Plan sponsors have learned to avoid both employee complaints and potential litigation by paring their investment lineups. Shorten the menu by dropping specialized funds, retaining only core holdings. Such funds can't go too far wrong.
Finally, shrinking the investment list tends to reduce plan costs. Sometimes this occurs because cutting funds means eliminating excess overhead. That held for Northwestern’s plan, which featured multiple recordkeepers, each of which administered its own set of funds. Per the plaintiff’s allegation, Northwestern’s plan charged participants well above the record-keeping norm.
The other reason that fewer funds can lead to lower fees is economy of scale. Plans that invest in 15 funds rather than 240 are likelier to receive volume discounts, in the form of qualifying for institutional share classes. Whether Northwestern could have bargained for institutional shares anyway, given its plan’s substantial size, is disputed by litigants. At any rate, it did not; the university’s plan held more than 100 retail share classes of funds that also offered institutionally priced shares.
The courts have become investment-savvy. It is difficult these days to sway them by appealing to hindsight bias, arguing that it was imprudent to select once-successful funds that subsequently flopped. But they listen closely to arguments that a plan sponsor needlessly selected a pricier share class, when a lower-cost version of that very same fund, owning the very same investments, was available.
The court reviewed this case at the request of the United States Solicitor General's office, which concluded that the 7th Circuit's ruling was incorrect. States the solicitor general's brief, "It is no defense to respondents' alleged imprudent failure to take [the required] steps that they offered some prudent, low-fee options. ERISA fiduciaries may not shift onto plan participants the burden of identifying and rejecting investments with imprudent fees."
Should the court agree with the solicitor general’s office, which seems likely as no justice challenged either its representative’s oral presentation before the court or Justice Kagan’s concurrence, the industry’s third generation will become that much more obsolete--and dangerously open to litigation. Expect plan sponsors to prune their fund lineups even more aggressively, particularly their retail shares.
Whether the court will address the many other issues raised by the Hughes v. Northwestern suit, such as the proper number of recordkeepers or if large plan sponsors should be held liable if they do not negotiate volume discounts, remains to be seen. Suffice it to say that the defined-contribution industry, including both sponsors and providers, will welcome any guidance that the court supplies. The current legal backdrop is distressingly unclear.
John Rekenthaler (email@example.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.
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