U.S. courts order 401(k) sponsors to do the right thing

 The U.S. Supreme Court ruled this week that employers have a duty to protect workers in their 401(k) plans from mutual funds that are too expensive or perform poorly.

Monday’s unanimous ruling sends a strong signal that employers must improve their plans. And it comes just as the Obama administration prepares a landmark change of its own by issuing rules requiring that financial advisers put the interest of customers ahead of their own.

The high court ruled on a class-action lawsuit against Edison International. St. Louis lawyer Jerome Schlichter, who has made a cause of suing 401(k) plans to get them to shape up, brought the case on behalf of 20,000 retirees and workers at the large Southern California utility company.

The case now returns to the lower court for final resolution.


“It’s hard to say how sponsors will react, but certainly the law has always been that fees must be reasonable,” Schlichter says. “If there is a fund that is significantly less expensive than another comparable fund, the plan fiduciary must determine that cheaper is better.”

The message here is not that all 401(k)s are bad or too expensive. In fact, costs have fallen 30 percent over the past decade, according to the Investment Co Institute, as more plan sponsors turn to low-cost passive investing options.

But costs vary widely. Plans with more than $100 million in assets usually have total annual costs below 1 percent, and the biggest plans usually are below 0.50 percent, according to Brightscope, which tracks the industry. In small plans, costs can be as high as 2 percent.

Financial service companies can charge a range of management, administrative, marketing, distribution and record-keeping fees for 401(k) plans. Plan sponsors can assume the costs, but employees are paying 87 percent of all fees, according to a study for ICI by Deloitte Consulting.

Most workers do not know they bear the lion’s share of costs. A 2011 AARP survey found that 71 percent of retirement savers do not think they pay any investment fees at all.

Yet fees make a huge difference in returns over time.

The U.S. Department of Labor estimates that a 1 percentage point difference on a current account balance of $25,000 will reduce total accumulations by 28 percent over 35 years, assuming average returns of 7 percent and no further contributions.

The Edison battle centered on the 401(k) plan’s use of retail-class mutual funds when less-expensive institutional shares were available. The difference between those classes typically is 25 basis points, according to John Rekenthaler, vice president of research at Morningstar Inc.

The court decision will put pressure on large plans to cut costs further but will not have much impact on smaller plans, he says. That is because big plans have the buying power to negotiate better deals with fund providers – and because large corporations are much more attractive targets for litigation.

In particular, he expects more big plan sponsors to push for better deals than institutional funds by demanding “separately managed” versions of funds that offer specialized attention but also cut management fees to the bone.

“The big plans will get even cheaper,” Rekenthaler says. “A big plan sponsor might wind up paying one basis point instead of 10 basis points for the same fund.”

Even the bigger picture is looking brighter.

With a looming retirement security crisis as a backdrop, the court ruling and the Obama administration’s push for stronger fiduciary rules send a strong message: We need a more efficient, consumer-focused retirement saving system, one where financial service providers and plan sponsors do the right thing.

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