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Is Supreme Court About to Mislead 401k Investors & Fiduciaries?

September 04
19:45 2009

When an ERISA/401k fiduciary seeks to reduce fiduciary liability, it certainly makes sense to follow the path laid down by the various branches of government. But, as we’ve most recently seen with the DOL’s premature blessing of target date funds, just because the powers that be say it’s so, doesn’t necessary mean your average fiduciary can rely on the decree. Indeed, the Supreme Court of the United States appears poised rule in favor of mutual fund shareholders, yet, at the same time, mislead both 401k investors and fiduciaries.

The case in question – Jones v. Harris Associates – stems from a 2008 ruling by a three judge panel of the U.S. Court of Appeals for the Seventh Circuit. This panel dismissed a case involving a shareholder lawsuit against Oakmark Funds. The U.S. Supreme Court has agreed to hear an appeal. At question: Did the adviser charge too high a fee for managing and administering the mutual fund?

The decision can have potentially serious ramifications for 401k fiduciary liability. For three decades, the mutual fund industry, and the fiduciaries that employ it, has relied on the Gartenberg case when determining the appropriate standard for a court’s review of an excessive fee claim against a fund’s adviser under Section 36(b) of the 1940 Act. Simply stated, Gartenberg determined the fairness of a mutual fund fee should be predicated on the likelihood that two independent parties would have come up with the same amount.

Jones v. Harris Associates represents the convergence of two trends – mutual fund fee anxiety and executive pay envy. (If you think these sound akin to at least a few deadly sins, then you get my point.) On August 15, 2009, an article in The Wall Street Journal (“Can the Supreme Court Undress High Fund Fees?”) profiled the growing concern regarding mutual fund fees. This issue has festered since the Department of Labor (DOL) first elevated the fee issue years ago in commentary on the total plan expenses of 401k plans. Just three days after The Wall Street Journal story, The New York Times published an op-ed piece (“Supreme Court to Hear Case on Executive Pay”) fueling the traditional class warfare diatribe attacking high compensation.

Let me step aside for the sake of full disclosure. I have created and managed mutual funds. In addition, I regularly monitor mutual funds for 401k plan fiduciaries as an independent fiduciary consultant. So, not only do I have a stake in this game, I also know where all the skeletons are buried – and I get paid for uncovering those skeletons.

Ignore the class warfare digression (leave the politics of the issue to other commentators) and focus on the escalating DOL issue as it relates to fiduciary liability and, in particular, 401k investors. The DOL has mandated, among other duties, the ERISA fiduciary has an obligation to “pay only reasonable plan expenses.”

“Reasonable?” Aye, there’s the rub. Plan expenses primarily involve administrative fees (typically recordkeeping, investment management, fiduciary consulting, etc…). Mutual fund expenses are paid within the fund, not by the plan… usually. (There’s the aforementioned rub.) An Investment Company Institute (“ICI”) August 2009 report clearly shows fewer plan fiduciaries pay 401k administrative expenses from mutual fund investments (commonly through 12b-1 fees) than did a decade ago.

Furthermore, the ICI, in an amicus brief filed on September 3, 2009, maintains the Gartenberg standard provides “real and substantial protection to investors.” It also notes the “competitive nature of the fund industry, with fees falling even as investors have received more and better services.” The ICI reported the total cost of investing in both stock and bond mutual funds fell by about 60% from 1980 to 2008.

Last fall, the 7th U.S. Circuit Court of Appeals in Illinois ruled against the plaintiffs.

Using the Gartenberg standard, 7th U.S. Circuit Court of Appeals in Illinois Chief Judge Frank Easterbrook ruled against Jones and upheld the fees set by Harris. Judge Easterbrook made it clear the defendant did not breach its fiduciary duty because there was transparency and no fraud.

If the Supreme Court creates a different, more stringent standard, it could reduce fees for mutual fund shareholders industrywide, according to Morningstar Inc.

No shareholder has ever won an excessive-fee case in court under the Gartenberg standard, Morningstar has noted.

The DOL states plan fiduciaries have a “responsibility to ensure that the services provided to their plan are necessary and the cost of those services is reasonable.” Why is the upcoming Supreme Court case critical to the 401k plan fiduciary? According to the ICI report, 49% of all 401k plan assets were invested in mutual funds as of the end of last year. The Supreme Court will raise the visibility of the fee structure within the investments of nearly half of all 401k plan assets.

And that may mislead investors, regulators and the typical plan fiduciary.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


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