Lawsuits regarding fees charged in 401(k) plans have become common headlines in the retirement plan industry news. Allegations are typically made against plan fiduciaries and come in several flavors, including that fees were hidden, improperly negotiated, or the product of conflicted relationships. Implicit in all of these cases is the allegation that plan fees of all kinds are too high.
An assumption made by many plan fiduciaries is that use of low-cost or index strategies will limit fiduciary exposure to fee litigation. Almost 50% of fiduciaries surveyed by Cerulli in 20131 stated that they were considering using an all-passive investment lineup to “alleviate the risk of lawsuits.”
Under ERISA, a plan fiduciary is required to make decisions based solely on the needs of the plan participants and beneficiaries. ERISA does not, and has never, required plan fiduciaries to offer only the cheapest investment options on their plan menu. Nor does ERISA dictate that a plan offer only passive investment strategies. What ERISA does require is prudence. Fiduciaries must act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims . . . ”
With this definition in mind, we will review a recent lawsuit against a plan sponsor that utilizes low-cost, mainly passive strategies on its plan menu.
According to the complaint filed in December 2015, Anthem, Inc. sponsors a 401(k) plan with approximately $5 billion in assets. By any measure, this is a very large plan. Due to its size, Anthem has bargaining power over its service providers and investment managers. The lawsuit claims that the plan fiduciaries breached their duty to participants by failing to obtain the most advantageous recordkeeping pricing and share classes available . . . which means, the complaint alleges, that the plan participants overpaid for their investments and recordkeeping.
The point of the lawsuit is that the fiduciaries had an obligation to be sure their participants did not pay more than they needed to under the circumstances. But it doesn’t end there. Not only is Anthem taken to task for not obtaining the best possible deal from its provider, the company also has to explain why it was using mutual funds within the 401(k) plan. According to the complaint, a plan the size of Anthem’s is eligible for another arrangement that allegedly costs less than a mutual fund: a Collective Investment Trust (CIT). Anthem’s failure to utilize this vehicle, which was available from its provider, was allegedly a breach of fiduciary duty because it would have cost participants less than the mutual funds did.
Frequently abbreviated as “CIT,” a Collective Investment Trust is a tax-exempt trust that combines assets for multiple investors meeting specific criteria. In the retirement plan context, investors are limited to qualified retirement plans.
CITs are not new to the retirement plan industry. In fact, they have been a preferred option for many defined benefit plans since the late 1930s. The first CITs were pools of securities traded manually and typically valued only once per calendar quarter. Early CITs were unique to each bank and portfolio manager, so performance and holdings information was not publicly available.
When 401(k) plans were developed in the 1980s, CITs were an option in many of the early plans. Despite this, because of operational constraints of CITs and lack of widely available information, mutual funds soon became the preferred vehicle in most 401(k) plans. Mutual funds offered many of the features that CITs lacked: a wider array of investment objectives, daily trading and valuation, broad availability for both retail and institutional investors, and publicly available information that was easy to follow in the news media.
In 2000, the National Securities Clearing Corporation (NSCC) added CITs to its mutual fund trading platform, Fund/SERV®, allowing CITs to trade daily and as fluidly as mutual funds. As of December 31, 2014, over 3,200 CITs are open for investment and covered by Morningstar, Inc., representing 75 different Morningstar categories (this number includes all share classes open for investment).
CITs are regulated either at the federal level by the U.S. Treasury, or at the state level by state banking regulators. A bank or trust company exercises authority over all the administration, management, and investment decisions for the trust. CITs are not regulated by the Securities and Exchange Commission, as they are exempt from registration under both the Securities Act of 1933 and the Investment Company Act of 1940. CITs assume the same investment risk as other investments and are not guaranteed by the bank or by the Federal Deposit Insurance Corporation (FDIC).
The ERISA prudence standard is “baked into” CITs, because Trustees of a CIT, unlike mutual fund managers, are considered investment managers under section 3(38) of ERISA. Trustees are therefore co-fiduciaries with respect to asset allocation and stock selection decisions within the fund.
In recent years, as 401(k) and other defined contribution plans have grown to become the primary retirement savings vehicles, many plan sponsors are once again considering CITs as investment alternatives. CITs can be less expensive to create and their fee structures may be more flexible than mutual funds. CITs are not required to incur SEC compliance costs related to disclosures, filings, proxies, prospectuses, and Statements of Additional Information. Mutual funds that are widely marketed to advisors and retail investors incur sales and distribution costs that would not normally be incurred by a CIT, because participation is limited to qualified retirement plans. Investment expense is typically the largest expense of a retirement plan. The lower expenses provided by CITs can offer considerable savings for plan participants.
Key factors that have helped to increase the popularity of CITs in today’s market:
The allegations in the Anthem lawsuit are, at this point, only allegations, and the case will likely take several years to resolve on the merits. Plan fiduciaries who have a documented prudent process for reviewing their menu options on a regular basis may insulate themselves from allegations of this type in the future.