Failure to investigate alternatives to retail class of mutual funds breached duty of prudence

The U.S. Court of Appeals in San Francisco (CA-9) has affirmed a federal district court ruling that 401(k) plan fiduciaries breached their duty of prudence under ERISA by selecting as plan investment options retail shares of mutual funds, rather than less costly institutional share classes of the funds. Although the retail share classes of the funds featured a revenue sharing arrangement that decreased employer costs and charged higher fees to plan participants than the institutional share classes, the selection of the retail class shares was not “categorically imprudent” and did not in itself constitute a breach of fiduciary duty. Nor did the revenue sharing arrangements, which were fully disclosed to plan participants, violate ERISA. Rather, the ERISA breach arose because the plan fiduciaries failed to conduct an independent investigation of alternatives to the retail share classes of funds recommended by a plan consultant, causing plan participants to incur a significant amount of unnecessary fees.

Mutual fund revenue sharing

A 401(k) plan offered a mutual fund window to plan participants, consisting of 40 retail mutual funds. Some of the retail mutual funds offered revenue sharing to the employer, pursuant to which fees were collected from fund assets and distributed to the plan record keeper and other service providers, thereby offsetting the employer’s costs. The revenue sharing payments were funded by the 12b-1 fees that the mutual funds’ investment managers charged to investors to pay for distribution and other shareholder service expenses. Unlike the situation at the core of other fee litigation, however, the revenue sharing arrangements were not hidden or disguised, but were fully disclosed to plan participants and their union representatives.

Plan participants brought suit under ERISA, claiming that the plan fiduciaries violated duties of prudence and loyalty by investing in retail share classes rather than the institutional share class of six specified mutual funds.

The retail share classes of each of the funds had higher expense ratios than institutional share classes. This feature resulted directly from the fact that the institutional share classes offered no revenue sharing. Institutional share classes do not allow for revenue sharing, but typically require a minimum plan investment. The funds at the center of the case did allow for the waiver of the investment minimum, especially with respect to large plans with a significant amount of assets (such as the employer’s plan). However, the only way a fiduciary could obtain a waiver of an investment minimum was by request. The plan fiduciaries (including the independent investment advisor) never requested a waiver of the minimum investment requirement from any fund, despite the fact that the established practices and history of the funds strongly suggested that they would have almost certainly have granted the request.

The gravamen of the participants’ ERISA claims was that the plan fiduciaries’ imprudent decision to invest in expensive retail share classes, where less expensive, but otherwise identical institutional share classes were readily available, effectively reduced the plan’s assets through the payment of excessive fees. The district court rejected most of the participants’ claims but found that the fiduciaries’ process of selecting the retail class shares violated ERISA.

Retail funds not categorically imprudent

The participants maintained that retail mutual funds were a “categorically imprudent” plan investment option. Accordingly, the participants averred, the plan fiduciaries must offer institutional investment alternatives, such as commingled pools or separate accounts which typically have lower expense ratios than retail funds. The Appeals Court, however, rejected the bright line standard pursuant to which a fiduciary must find and offer the cheapest possible funds. The final and most central issue on appeal was whether the fiduciaries, in neglecting to investigate institutional share alternatives to the retail class funds, failed to exercise the care, skill, prudence, and diligence acquired under ERISA.

The district court focused on the absence of evidence indicating that the fiduciaries ever considered or evaluated the different share classes under the funds when they were added to the plan. In fact, the investment committees were not presented with any information about the institutional share classes, but were merely advised to add the retail share classes of the funds recommended by the investment consultant without any consideration of whether the institutional share classes offered greater benefits to plan participants. The court found especially “telling” the fact that in the one instance in which plan fiduciaries actually reviewed the different share class of the funds, they realized it would be prudent to invest in the institutional share classes. The failure to exercise such due diligence earlier, the court concluded, caused the participants to pay unnecessary fees.

The fiduciaries maintained that their investment selection process was reasonable and thorough because they relied on an investment adviser in selecting the mutual fund share classes. The district court, noting that independent advice does not provide a complete defense to the charge of imprudence, found that the fiduciaries’ reliance was not prudent and reasonable absent evidence that the investment adviser reviewed or made a comparative analysis of the retail and institutional share classes under the funds at issue. The Ninth Circuit agreed, citing the Third Circuit for the rule that ERISA requires fiduciaries to review the data a consultant gathers, to assess its significance, and supplement it when necessary. The plan fiduciaries, however could not establish that the investment adviser followed a prudent process in considering share classes and presented no evidence indicating an appropriate evaluation of the adviser recommendations.

Source: Tibble v. Edison International (CA-9).

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer’s Benefits Reports.

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