Do Actively Managed Funds Breach Fiduciary Duties?

Casey Yamasaki

On November 5, 2015, Boeing Co. ("Boeing" or the "Company") decided to pay $57 million to a class of employees who filed a lawsuit claiming Boeing allowed a retirement plan to charge excessive fees. Although Boeing did not admit to any wrongdoing, the employees argued that the Company had breached its fiduciary duties because it hid information regarding fees and expenses, which funneled into a revenue-sharing program and ultimately resulted in lost retirement savings (Sege, 2015).

Boeing's defined contribution retirement plan at issue included a number of actively managed mutual fund ("active funds"), which attempt to beat the market by requiring investors to pay fees to have an expert manage their investment funds (and for which higher fees are almost always charged). However, research has found that active funds rarely ever do better than their alternative, passively managed counterparts ("passive funds" or "index funds"), which brings us to the question of whether employers (in their capacity as plan sponsors for 401(k) and other retirement plans) that offer their employees active funds are breaching their fiduciary duties. To explore this, we will look further into an employer's fiduciary responsibilities, the differences between active funds and index funds, and whether offering active funds may be considered a breach of fiduciary duties.

ERISA and Fiduciary Duties

Workers and laborers drive the productive force of our nation, but individuals cannot be expected to work their entire lives. Accordingly, retirement plans help ensure that workers have some security after they retire because many employers contribute money into their employees' retirement funds in return for loyal employment. There are two types of retirement plans: defined benefit plans and defined contribution plans.

Defined benefit plans identify the specific benefit that will be payable to you at retirement by your employer, which is based on a formula that factors in the years you have worked and your salary. On the other hand, defined contribution plans, such as 401(k), involve investing money in a mutual fund within a retirement plan and are much more common now than defined benefit plans. The amount you have at retirement depends on how much your employer contributes to the plan, how much you saved in the plan, how long you leave those funds invested, and how well your investments perform - net of expenses.

Since employer-sponsored plans are institutionalized in our system, laws have developed to protect employees' retirement savings, including the Employee Retirement Income Security Act ("ERISA"), which generally regulates defined benefit plans and private sector defined contribution plans, including 401(k) plans. Among other things, ERISA is designed to make certain that employers are running these plans in the interest of their beneficiaries. These obligations are usually referred to as fiduciary duties.

According to the Department of Labor, fiduciary duties require the employer/fiduciary to:

  • Exclusively provide benefits and pay plan expenses;
  • Act prudently and diversify the plan's investments in order to minimize the risk of large losses;
  • Follow the terms of plan documents to the extent that the plan terms are consistent with ERISA; and
  • Avoid conflicts of interest, meaning do not engage in transactions on behalf of the plan that benefit parties related to the plan, such as other fiduciaries, services providers, or the plan sponsor.

Passive v. Active Funds

As noted above, defined contribution plans typically invest retirement savings in mutual funds, which is essentially a way for investors to hire someone else to manage their money. Mutual funds are legal entities with the sole purpose of investing in other assets. After employers offer different investment options to participants/beneficiaries, the participants/beneficiaries of the plan buy shares from the fund. Each share is proportional to the assets in the fund and is priced based on the fund's net asset value. The assets are managed by a fund adviser, who is paid directly by the fund for its services. There are two categories of mutual funds: passive funds and active funds (Kwak, 2013, p. 491-492).

Passive funds attempt to imitate the performance of a market index, such as the S&P 500, by buying all the securities that make up the index. Therefore, passive funds provide gross investment returns that are very close to those of the market segment tracked by the index with relatively low costs to the plan's participants (Kwak, 2013, p. 493).

Active funds have higher expenses mainly because of the higher costs of active stock-picking, the ability to charge higher prices because they offer a more differentiated product, and the higher transaction costs due to more frequent buying and selling. Active funds are hopeful of beating the market and, if fund managers can beat the market by five percentage points per year, then paying one percentage point more to hire them would be well worth it. However, the benefits of active funds are rarely realized (Kwak, 2013, p. 493).

Most existing literature comparing active funds to passive funds has found that active funds fail to achieve what they set out to do. According to one study, fund managers for active funds generally make inadequate selections of stocks and their market timing skills are not efficient enough to outperform the market return. In fact, the same study showed that the raw return of active funds was lower than that of passive funds (Rompotis, 2013, p. 134); see also http://www.nytimes.com/2014/07/20/your-money/who-routinely-trounces-the-stock-market-try-2-out-of-2862-funds.html?

Breach or no Breach?

Attorneys that believe active funds constitute a breach of fiduciary duty argue, under ERISA, that fiduciaries that provide active funds in their list of retirement plans are breaching their duty because they are not acting in the best interest of their employees. However, many courts, particularly in Jones v. Harris Associates L.P., 527 F.3d 627, 634 (7th Cir. 2008) vacated and remanded on other grounds, 559 U.S. 335 (2010) and aff'd, 611 F. App'x 359 (7th Cir. 2015), have declared that due to the already high regulation of mutual funds, the responsibility to invest in the participants' best interest shifts to the beneficiaries themselves. They argue that, in a competitive market, investors that pay fees must be getting their money's worth even if the actual return is not better than passive funds because they are the ones who determine how much advisory services are worth. Moreover, since money tends to flow from mutual funds with high expenses to funds with low expenses, wise investors can profit from others who make bad choices (Kwak, 2013, p. 504).

But should the responsibility to invest prudently shift to the participant or should the fiduciaries remain responsible? ERISA was explicitly intended to guarantee that plan participants receive the benefit of sensible, skilled investment management. However, because ERISA was written for defined benefit plans, some of its provisions are irrelevant or even harmful in the context of defined contribution plans. Specifically, ERISA section 404(c) relieves plan fiduciaries from liability for any losses when participants exercise control over their own accounts. Therefore, section 404(c) seems to imply that the duty to prudently invest plan assets shifts to beneficiaries from fiduciaries. In practice, employers have interpreted this to mean they can include expensive active funds as part of their defined contribution plans without worrying about ERISA's fiduciary duties (Kwak, 2013, p. 509). A strong argument can be made, however, that this position is neither legally nor economically defensible.

Despite the common interpretation of section 404(c), experts find the section is misleadingly broad and recommend that it should be restricted to plans that only offer low-cost index funds. If one of the fiduciary duties is to act prudently and diversify the plan's investments, then that is most easily achieved through passive funds. Furthermore, defined contribution plans are intended to provide income security for retired employees. With more retirees depending on defined contribution plans due to decreasing social security funds and the effective elimination of defined benefit plans from the marketplace, as well as the increasing pressure to spend instead of save money as a result of declining incomes, retirement security cannot solely rely on a competitive market. Thus, plans that meet fiduciary duties would minimize the risk and cost for a given level of expected returns. Individuals may have a valid reason to invest in an unorthodox fund, but that is unlikely true for an employer-sponsored plan (Kwak, 2013, p. 520).

Conclusion

Litigation regarding whether or not active funds legally breach fiduciary duties is likely to increase in future years. Moreover, it is important for employers to adopt practices and investments that are in the best interest of their employees. As an employee, it is equally important to be aware of the differences in the mutual fund and other investments that your employer is providing to you.

The legal team at SFMS has substantial experience in litigating ERISA and other employment matters. If you have any questions regarding this subject or this posting, please contact James E. Miller ( [email protected]), Chiharu Sekino ( [email protected]) or Alec Berin ( [email protected]). We can also be reached toll-free at (866) 540-5505.

Shepherd, Finkelman, Miller & Shah, LLP, is a law firm with offices in California, Connecticut, Florida, New Jersey, New York and Pennsylvania. SFMS also maintains affiliate offices in England, and Milan, Italy, and is an active member of Integrated Advisory Group ( www.iaginternational.org), which provides our firm with the ability to provide our clients with access to excellent legal and accounting resources throughout the globe. For more information about our firm, please visit us at www.sfmslaw.com.

SOURCES

Kwak, James. (2013). "Improving Retirement Savings Options for Employees." University of Pennsylvania Journal of Business Law, Vol. 15:2, 483-538.

Rompotis, Gerasimos G. (2013). "Actively vs. Passively Managed Exchange Traded Funds." The IEB International Journal of Finance, Vol. 6, 116-135.

Sege, Adam. " Boeing to Pay $57 to End Suit Over Retirement Plan Fees." Law360. Last modified on November 5, 2015.

United States Department of Labor. "Fiduciary Responsibilities." Available at http://www.dol.gov/dol/topic/health-plans/fiduciaryresp.htm

Somer, Jeff, Who Routinely Trounces the Stock Market? Try 2 Out of 2,862 Funds (New York Times, July 19, 2014), http://www.nytimes.com/2014/07/20/your-money/who-routinely-trounces-the-stock-market-try-2-out-of-2862-funds.html?