Recently, I listened to an insightful interview of Jerry Schlichter by Rick Unser of the 401(k) Fridays Podcast. In 2006, Jerry was the first private attorney to file lawsuits alleging excessive fees in 401(k) and 403(b) plans. Since then, his firm - Schlichter Bogard & Denton - has won more than $600 million in settlements on behalf of plan participants. He’s also won the only two 401(k) fee cases ever heard by the U.S. Supreme Court - Tibble v. Edison and Hughes v. Northwestern University. I consider the Jerry Schlichter interview a must-listen for 401(k) plan fiduciaries.
The reason? It includes great insights about the drivers of 401(k) fiduciary liability. Here are my key takeaways for employers.
Takeaway #1 – Apply a Prudent Expert Standard When Selecting 401(k) Investments
Minutes 5:58 through 9:40 cover the standard of care that employers must meet when selecting 401(k) investments under ERISA. In the interview, Jerry says the courts expect a “prudent financial expert” standard. If the employer cannot meet this standard themselves, they should get help from a qualified consultant.
The easiest way I know for employers to meet the “prudent financial expert” standard? Model their 401(k)'s investment menu after the federal Thrift Savings Plan using index funds from leading providers such as Vanguard, Fidelity or Schwab. I've never seen one ever fail to meet its investment objective – market-correlated returns – for low fees. For that reason, I consider leading index funds to be indisputably prudent 401(k) investments. They also tend to outperform comparable active funds over time, net of fees.
Need a consultant? Hire a 401(k) financial advisor that’s subject to the Investment Advisers Act of 1940. Unlike brokers and insurance agents, investment advisers have a legal obligation to give impartial (conflict-free) advice.
Takeaway #2 – SDBAs are a Risky Bet
Minutes 9:40 through 18:44 touch on Self-Directed Brokerage Accounts (SDBAs) – a “brokerage window” that can give 401(k) participants access to a nearly limitless investment options. In the interview, Jerry considers SDBAs a risky bet for 401(k) fiduciaries due to a “lack of clear guidance.” He goes on to say, “if you care about your employees and retirees, and you wanna limit your exposure, I would not recommend someone to have a brokerage window because that will be, that may be the subject of, for their clarification in the courts.”
SDBAs have made me nervous for years. With no clear monitoring guidance from the Department of Labor (DOL), I think employers could find themselves liable for SDBA losses in the courts down the road.
Takeaway #3 – Active Funds Can be Tough to Justify
Minutes 18:44 through 25:04 wade into the index fund vs. active fund debate. In the interview, Jerry says, “So we start with the fact that multiple Nobel prize winners in economics and finance have said that over time, nobody beats the market after fees. And even if you're Warren Buffet who isn't doing as well recently, has he has been earlier a difference there is they actively manage, they, they run companies. They're not just financial managers. So faced with that, that body of evidence. Then if you choose and, and there's nothing illegal of course, about having actively managed funds in your plan. And there's nothing that says you must have index funds in the law, but if you make the choice to do so to have actively managed funds, as opposed to index funds, then you're going to need to be prepared to make the case as to why there is a strong likelihood that your, these funds are going to beat the market after fees.”
There's simply no excuse for 401(k) participants to earn less than index fund returns over time, net of fees. If a 401(k) fiduciary wants to try to earn more with active funds, they had better be ready to defend that decision if plan participants end up earning less.
Takeaway #4 – 401(k) Providers are Looking for New Revenue Streams
Minutes 25:04 through 33:19 get into how 401(k) providers are looking for new revenue streams as 401(k) fiduciaries insist on lower fees. In the interview, Jerry says, “recordkeeping fees have come down in the industry and fees in general investment management fees, what non-fiduciaries, who are service providers are doing is, is what I call whack-a-mole. They're finding other areas of revenue to pop up. What do I mean by that? I mean, using, for example, record, keep the role of record keeper to then take the confidential information that employees have given them, because they're the record keeper or that the employer has given and use it to sell stuff to cross-sell the products outside the plan like IRAs and insurance and bank accounts and credit cards using the confidential information, social security number to asset balances to investment choices to year are still retirement to do so. And the fiduciaries have to monitor that, have to regulate that.”
Employers should never let their 401(k) provider market non-plan financial products to participants – even if that access means lower out-of-pocket 401(k) fees. Otherwise, they could find themselves liable for overpriced – or otherwise harmful – products.
Takeaway #5 – Small 401(k)s Aren’t Sued, But All Can Learn from Lawsuits
Minutes 33:19 through 58:53 get into the cost of 401(k) litigation and the factors that determine whether a case is pursued or not. In the interview, Jerry says, “in my entire career, I have never sent a client, a bill period, everything that I and we have done in my office is on a contingent fee basis because our clients can't pay an hour rate unlike the defendants in these cases. So you take a case on a percentage and you invest in that case, by putting in the money for all the costs, expert witnesses are a big part of the cost in these cases, as you can. Well, imagine for investment management, finance record, keeping fiduciary practices, et cetera. And of course those costs, those are paid win or lose, and not at the end of the case as you go. So obviously there has to be a judgment that the case is, has merit. I can tell you, and maybe some of your listeners would find this surprising, but that we have rejected 90% of the cases that we've been asked to look into or have looked into.”
Little surprise that private attorneys don’t sue 401(k) plans with little to no assets due to the cost of litigation. However, all employers should understand the drivers of 401(k) fee litigation because avoiding them today can help their plan participants retire years sooner than decades from now.
Takeaway #6 – ESG Investments are Fine, Private Equity Not So Much
Minutes 58:53 through 1:01:43 cover ESG Environmental, Social, and Corporate Governance (ESG) and private equity as 401(k) investments. In the interview, Jerry says that ESG investments that don’t underperform benchmarks should be fine, but private equity is a “much riskier area because private equity by its very nature is not set up as the kind of vehicle to be a fund in a 401k retirement plan. Why is that? Well, the typical timeframe for those investments, first of all, they're high price, high cost. The idea that is they're gonna have a great payoff time investment is eight to 10 years typically, and they're quite illiquid in that timeframe and difficult to value. So my advice would be very, very, very carefully vet any private equity investment and avoid. It would be better advice.”
Of course, private equity is a risky bet for 401(k) fiduciaries. Fund managers can charge brutal fees and the valuation of these funds can be subjective.
Takeaway #7 – The DOL Needs to Do More
Minutes 1:04:36 through 1:06:01 bemoan Department of Labor (DOL) inaction about excessive 401(k) fees. In the interview, Jerry says “If the DOL had brought a couple of enforcement actions early on for excessive fees or prudent investments. And what difference would that have made? It would've meant that no defendants would've thought they could put the government out of business. Like they tried to put my law firm out of business. There wouldn't have been this years and years of battling with that in mind. And it would've been a clear statement at the outset of ERISA that the DOL is going to enforce it seriously, that in turn would have meant much greater retirement assets for a whole generation of tens of millions of Americans. That didn't happen because that wasn't done.”
Agree 100%. Better yet, DOL should help employers stay out of trouble in the first place by establishing “safe harbor” rules for meeting 401(k) fiduciary responsibilities. Top of the list? A 401(k) investment menu that will automatically satisfy ERISA “prudence” standards.
Understand the Drivers of 401(k) Liability to Avoid It!
Employers are often concerned about their 401(k) fiduciary liability – little surprise when they can be personally liable for fiduciary failures. To mitigate this risk, I recommend employers understand the drivers of 401(k) liability. This knowledge can make 401(k) liability easy to avoid.
I think Rick Unser’s interview of Jerry Schlichter did a super job summarizing the top drivers of 401(k) liability today. I recommend all 401(k) fiduciaries check it out.