In December, defense contractor Lockheed Martin elected to settle an eight-year-old class-action lawsuit brought by more than 100,000 of its workers and retirees, alleging excessive fees inside the company’s 401(k) plan. While the suit was unusual in its size and scope, it was indicative of a recent trend toward greater employee awareness and vigilance with regard to the management of company retirement plans.
In all, more than 30 class-action lawsuits have been filed against 401(k) plans and employers since 2006, with a suit against ABB Inc. among the most prominent. And while more than half of those suits were ultimately dismissed, they can nevertheless be costly and time-consuming for employers to defend. Even Fidelity Investments, the nation’s largest retirement plan provider, was forced to settle a pair of lawsuits brought against it with regard to its own employee 401(k) plan. With the Supreme Court poised to hear a case with broad power to define the limits of liability for fiduciary duty in these defined contribution plans, it’s quite possible that the legal battles in this arena are just getting warmed up.
Given that intimidating backdrop, a business owner can be forgiven for simply giving up and not offering a retirement plan at all (and, according to research, about 75% of businesses with 50 or fewer employees do not offer one). But by getting to know your employees (and their needs) well, educating yourself about available plan options, and working with a qualified advisor to assist with plan design and maintenance, a plan sponsor can dramatically reduce–if not entirely eliminate–the possibility of a lawsuit from a disgruntled participant. We’re here to give an overview of some of those steps, and to help point you in the right direction.
Am I a Fiduciary?
Probably. According to Department of Labor (DOL) definitions, an individual or entity is considered to be in a fiduciary role if “it has any discretionary authority or discretionary responsibility in the administration of [the] plan.” It would be hard to imagine a scenario in which a plan sponsor would not qualify under that broad definition, as even a firm that fully outsourced its fiduciary duties would still bear the responsibility of vetting and overseeing the activities of that third-party advisor.
The current climate, meanwhile, is toward an expansion in that definition of fiduciary, one that is already quite broad. And yet, an AllianceBernstein study found that a full 60% of plan sponsors did not consider themselves to be fiduciaries, a proportion that was highest for the smallest plans in the study (79% for plans with less than $2 million in assets). That disconnect is, needless to say, troubling. Even if a sponsor does not directly design or administer the plan, it is still vital that the sponsor understands its roles and responsibilities.
Per the DOL, a fiduciary must:
- Act solely in the interest of the participants and their beneficiaries
- Act for the exclusive purpose of providing benefits to workers participating in the plan and their beneficiaries, and defraying reasonable expenses of the plan
- Carry out duties with the care, skill, prudence and diligence of a prudent person familiar with such matters
- Follow the plan documents
- Diversify plan investments
For the most part, it’s the first two points–particularly the reference to “reasonable expenses”–that have caused the most issues and consternation. To date, the majority of lawsuits (including the impending Supreme Court case) have centered around the usage of higher-fee retail mutual funds when lower-fee institutional funds were available. Of course, not all retirement plans have enough to qualify for these larger institutional funds (which can have minimum investment requirements as high as $1 million), but that doesn’t necessarily mean that fights about fund fees don’t apply.
After all, the fiduciary standard requires that a plan sponsor act solely in the best interest of the participants, which of course requires that you first know what the best interests of your participants actually are. It might go without saying, but not all participants are created equal–what might be in the best interests of one group of employees might run completely contrary to the best interests of another group with different backgrounds or demographics.
Know Your Employees
While an employee census typically serves as the basis for all 401(k) plan design efforts, providing basic information about participants’ ages, genders, and salaries, it’s not necessarily sufficient. In choosing investment options and other plan specifics that meet the “best interests” test, the entirety of an employee’s financial situation can be considered relevant. Further information-gathering efforts to glean data about participants’ living expenses, investment background and knowledge, risk tolerances, and overall financial goals can all help plan sponsors to design a plan that is nimble and flexible enough to meet a variety of participant needs.
Besides simply informing decisions about investment options, this kind of information-gathering can also inform basic plan design choices. For example, the strategy of using “stretched” matching contributions has become increasingly popular in recent years. In this kind of plan, instead of offering the standard dollar-for-dollar employer match up to a specified percentage of salary (say, 3%), a “stretched” match lowers the per-dollar match, but extends the range of matchable employee contributions–say, 50 cents per dollar up to 6% of salary, or 25 cents per dollar up to 12% of salary.
These kinds of plans have been shown to increase the amount of salary deferrals made by employees, which should generally be viewed as a good thing. But for some participants who may be on a particularly tight budget, raising the bar for how much they need to contribute could produce significant resentment, and could in fact be acting contrary to their best interests. Knowing whether or not a participant has sufficient budgetary flexibility clearly requires more information than the typical employee census provides; these sorts of issues are at the crux of the “best interests” issue facing fiduciaries. The more information you’re able to glean about participants’ complete financial picture, the more capable you will be of designing an optimal plan that meets everyone’s needs and goals.
Choose the Right Investment Options
Since every plan’s participants are unique and different, there are few hard-and-fast rules that govern which investment options or funds are the “right” ones to select. It is somewhat easier, though, to provide guidance on how many investment options are optimal. A summary of academic and regulatory information suggests that somewhere between 5 and 10 investment options is probably optimal, assuming care is taken to select “proper” funds. However, the industry average is running closer to 25, which might be self-defeating.
While in theory offering a participant more options should better allow a sponsor to meet its fiduciary responsibility, the opposite may be true. If the added funds are high in fees, or overly aggressive or specific for the plan participants, they might be doing more harm than good. Add in the Columbia University research that suggests that too much choice can paralyze plan participants and decrease their likelihood of participating at all, and it becomes fairly clear that more is not necessarily better. At the very least, if a large number of investment options are offered, sufficient participant education should also be offered alongside them, so that employees can make informed decisions.
Regardless of the ongoing debate regarding the optimal number of investment options, what has largely been settled is the importance (both legally and logistically) of a Qualified Default Investment Alternative (QDIA). In order for a plan sponsor to satisfy its fiduciary duty, a QDIA must be offered, and it must meet several criteria as defined by the DOL. Most notably, the QDIA should not be a stable-value fund or other cash option, except for short periods in the early days of an employee’s participation. Increasingly, target-date funds have become the default option of choice, but they may or may not be the best choice for your plan.
Revisit Your Design Often
The financial world is far from a static place, with new innovations and investment options arising every year. As of 2014, there were nearly 8,000 active mutual funds available (excluding funds of funds), with another 2,000 or so exchange-traded funds (ETFs) to round out the investing field. According to Bloomberg research, in 2014 alone, there were 199 new ETF launches, with more than 1,000 others in some form of registration, awaiting final approval from the Securities & Exchange Commission.
While the vast majority of these new entrants will be overly specific or otherwise unsuitable for inclusion in a group retirement plan (most leveraged ETFs, for example, are useful primarily as short-term trading vehicles, not long-term investments), it’s possible if not likely that a new investment option could be just what your plan’s participants are looking for. Staying abreast of these sorts of developments is a key part of the plan sponsor’s job, and requires ongoing oversight on at least an annual basis.
And beyond industry developments, changes in the makeup of the employee census could dramatically alter the needs of the plan participants. If a firm’s employee base is aging, or turning over frequently, or simply shifting in some more subtle psychographic way, the optimal plan design could change dramatically without the plan sponsor even realizing it.
Ultimately, plan design is not a one-day, one-week, or even one-year project. Providing a proper employee benefit that satisfies fiduciary requirements requires an ongoing study of the plan participants’ goals, desires, and investment proclivities. Essentially, being a good plan fiduciary requires activities similar to those of a financial planner, whose services may in fact be useful when designing a plan. Planning for a solid financial future requires consistent evaluation of goals and needs; so, too, does planning for a solid retirement plan.