Capital Ideas^™ 
Investment insights from Capital Group

401(k) lawsuits are nothing new, but their numbers have been on the rise. A record number of suits were filed in 2020, more than double the amount filed in 2018 and an 80% increase over 2019, according to Groom Law.

The initial upsurge in lawsuits from more than a decade ago was focused primarily on conflicts of interest and excessive participant fees. Recent lawsuits have homed in on investment results, and two trends have emerged:
 

• Passive funds — even with lower fees and less management discretion — are being targeted.
• Poor investment results are being invoked more frequently as a barometer of whether the fiduciary due diligence process was sufficient.

Passive funds do not get a free pass

The recent legal challenges have upended the strategies of many plan sponsors to fill up plan menus with passive index funds in the belief they are lower cost and less likely to be challenged from a fiduciary perspective.

But the truth is, passive funds have not been exempted from these challenges. Consider the following lawsuits against 401(k) plans that used passive investments:

These cases are consistent with what Groom Law Group, a firm specializing in ERISA law, had earlier concluded in a paper commissioned for Capital Group: that passive strategies do not reduce fiduciary liability.

Ironically, active funds may be less vulnerable to a fee challenge. With an active fund, a plan sponsor can argue that the higher fees are justified because they can potentially offer better risk-adjusted results.

Investment results in the spotlight

Fee-related litigation may have formerly dominated the headlines, but recent settlements involving two of the largest retail employers have pivoted on results, not fees. Walgreens reached a $13.75 million settlement in a lawsuit that accused the plan of selecting passive target date funds that were “chronic poor performers.”^‡ Lowe's reached a $12.5 million partial settlement in a lawsuit that accused the company of investing $1 billion in plan assets in an underperforming and unpopular growth fund.^§

These lawsuits and subsequent settlements make it clear that plaintiff attorneys have raised the bar on what plan sponsors need to do to get their participants the best investment results possible.

Better results generate better outcomes

This may be a welcome development, as strong investment results can meaningfully improve participant outcomes. Consider the hypothetical scenario below. Early in a participant’s career, at age 25 in the example, 94% of their account balance comes from contributions. Fast forward to the traditional retirement age of 65 and roughly 70% of total wealth can come from investment returns while just 30% is from contributions. Boosting results on that 70% can meaningfully move the needle for retirement readiness, demonstrating the compounding value money creates while making money.

That’s why investment selection might be the most important decision plan sponsors make. Even small increases in returns can dramatically improve outcomes, adding years of retirement spending.

Three metrics for long-term investment success

As a retirement plan professional, you have a unique opportunity to help plan sponsors identify the right investments to pursue dignified retirements for participants. While no metric can predict results for any fund or manager, consider these three metrics when looking for funds that have generally been associated with stronger equity results over the long run (especially with active funds):
 

• Low expenses: Some active managers may not be able to justify their expenses compared to passive peers. It might be worth looking into those that can.

• Manager ownership: Fund managers’ interests may be better aligned with a participant’s when they invest in their own funds, as both then share in a fund’s potential risk and reward.

• Downside capture: Reducing the effect of market volatility may not only boost long-term results, it can positively affect participant behavior.

Enhance the manager selection process

While the pace of 401(k) lawsuits shows no signs of slowing down, the best way to manage 401(k) litigation is to avoid being sued in the first place. And while a prudent process is essential, it may not be enough when investment results are now being targeted along with fees.

These screening factors above may enhance the manager selection process, which in turn could help plan sponsors select investments that may have the potential to deliver the best long-term investment outcomes to their participants. And better participant outcomes, at the end of the day, is the noble quest all of us in this industry share.