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In Tussey v. ABB, the United States District Court for the Western District Of Missouri held that employer fiduciaries violated their fiduciary duty with respect to company 401(k) plans (the two plans are very similar and are hereafter simply called the “Plan”) in connection with a revenue sharing-based fee arrangement with Fidelity Trust. This is the first 401(k) fee case in which the employer has incurred significant liability. It’s important to plan sponsors for a number of reasons.
In this article we begin with a brief summary of the court’s decision on the four issues that relate directly to sponsors and the five “takeaways” that will be important for sponsors considering what this decision means for them. We then proceed with a detailed discussion of the court’s decision.
The case involves a number of issues. Four bear directly on sponsors:
1.Failure to monitor recordkeeping costs and negotiate rebates from the trustee. The court found, based on testimony of plaintiffs’ expert (a report prepared for ABB by Mercer), comparison with other plans, and Fidelity’s own data, that the revenue sharing arrangement between the Plan and Fidelity resulted in significant overpayment for trust services.
2.Failure to follow Plan procedures in de-selecting the Vanguard Wellington Fund and “mapping” assets that had been in that Vanguard fund into the Fidelity Freedom Funds. The court found that the Plan’s Investment Policy Statement (IPS) was a “governing plan document.” It found (1) that the IPS required reviewing five years of performance and putting a fund on a “watch list” before de-selecting it and (2) that the addition of a new fund (in this case, the Fidelity Freedom Funds) required a “winnowing” process involving the review of multiple alternative fund options. ABB fiduciaries, the court found, did neither of these things and thus violated ERISA.
3.Selection (for the fund menu) of share classes that had higher expenses than other available share classes. The court found that, with respect to six specific funds, ABB selected higher-priced share classes in violation of the provisions of the IPS and in order to perpetuate the improper fee arrangement discussed in 2.
4.Paying above-market fees for Plan services in order to subsidize the non-plan “corporate services” provided by Fidelity. The court found that there was evidence (an email and the Mercer report) that the Plan was being improperly over-charged in order to pay for unrelated services (including DB plan, health plan and non-qualified plan recordkeeping services) provided to ABB.
It’s likely that this decision will be appealed. But if the decision of the court stands, then we would identify the following as the key “lessons” it teaches:
1. The employer is a litigation target. The big loser in this case was not the trustee, it was the employer. The only thing Fidelity was held liable for was receiving certain float income.
2. Trust and recordkeeping fees are a litigation target. Most of the 401(k) fee cases we have seen so far have focused on investment fees, and plaintiffs in those cases have had a hard time proving that the investment fees involved are excessive. That is because investment fees, especially for actively managed funds, aren’t comparable — there’s no “standard” or “market” fee for an actively managed fund. But trust and recordkeeping services have to a large extent been “commoditized.” So it is possible to compare the fees that a typical large 401(k) plan is paying with an “industry standard.”
3. Revenue sharing is a target. To this court, at least, the right way to evaluate trust and recordkeeping fees is on a “dollars per participant” basis. There is probably significant support for that point of view in the consultant community. Revenue sharing — which typically involves asset-based fees — makes such an evaluation hard to do and presents the risk (as seen in this case) that the sponsor will not know, on a dollars per participant basis, what the plan is paying. Sponsors of plans that use revenue sharing/asset based fees for trust and recordkeeping services will, if this case stands, need to know what those fees “cost” on a dollars per participant basis. As discussed in detail below, the court did not find that revenue sharing is per se imprudent. But it did state that an evaluation of revenue sharing requires “more than a raw assessment of the reasonableness of expense ratios; particularly, given the inherent difficulty of identifying how expense ratios are broken down between administration and investment services.”
4. Investment policy statements can make you a target. This could well be the most important lesson to take from this case. While it’s not entirely clear, it’s possible to read the court’s decision as holding that, if it were not for the IPS, three of plaintiffs’ claims (on Issues 1., 2. and 3. above) would have failed. Moreover, it is certainly arguable, with respect to those issues, that the court read the IPS in a manner different from what had been intended. Bottom line: investment policy statements can get you in trouble. They are not required by ERISA. And if they are not scrupulously drafted, they can wind up providing a completely separate basis — separate, that is, from the requirements of the plan and ERISA — for an ERISA suit. Most critically, if you have an investment policy statement, you have to follow the procedures it describes.
5. Language in consultant’s reports can be used to prove plaintiff’s case. The Mercer report was used to prove plaintiffs’ case on Issues 2. and 4. Consultants aren’t lawyers, and their reports are generally not protected by attorney-client privilege. If a consultant says you have a fee problem, then you will have to do something about it. If you don’t, it’s possible that the consultant’s report will be used to prove a case against you for ignoring the problem.
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Now let’s turn to a detailed discussion of the case.
As we go into more detail on the court’s decision we have to remark on, for lack of a better word, its “style.” The court is very thorough — the decision is 81 pages long. But the court is not always rigorous in the way it applies ERISA or specific about which of ERISA’s fiduciary provisions has been violated in any particular case. To take just one example, the court speaks of the failure to follow a Plan document as “imprudent,” when such a failure is its own separate ERISA violation. This “style” makes it hard, in places, to say with precision exactly what the court is holding.
The case involves two 401(k) plans sponsored by ABB, Inc., the Personal Retirement Investment and Savings Management Plan and the Personal Retirement Investment and Savings Management Plan for Represented Employees of ABB, Inc. The two plans are nearly identical and, as discussed above, we are going to simply refer to them generally as the “Plan.”
The Plan is relatively large — in 2000 it had $1.4 billion in assets.
Plaintiffs sued ABB, Inc. (the Plan sponsor), the Plan’s administrative committee and investment committee, the head of the investment committee’s staff, Fidelity Management Trust Company (the trustee), and Fidelity Management & Research Company (the investment adviser to the Fidelity mutual funds offered by the Plan).
For the relevant period the Plan used a Fidelity “investment platform.” Participants could choose from a fund menu determined by the Plan sponsor. The trustee was paid by a revenue sharing arrangement. Quoting the court:
The revenue sharing came from some of the investment companies whose products were selected by ABB to be on the … platform. Those investment companies gave Fidelity Trust a certain percentage of the income they received from [Plan] participants who selected their company’s investment option. Fidelity Trust also derived revenue sharing from an internal allocation within the interrelated Fidelity companies. For example, Fidelity’s Magellan Fund, was one of the mutual funds placed on the [Plan] platform by ABB. When [Plan] participants invested in Magellan, a set number of basis points (i.e., a percentage) was transferred internally from Fidelity Research, which managed the Magellan Fund, to Fidelity Trust. This has been described by Fidelity and others as internal revenue sharing.
ABB had an investment policy statement, which the court found to be a “governing plan document.” Three elements of the IPS were critical to the court’s decision.
The IPS provided that:
“[At] all times, [Alliance] rebates will be used to offset or reduce the cost of providing administrative services to plan participants.”
Some would argue that this IPS language simply requires that, if there is any revenue sharing, it will be used to offset fees. But the court’s appears to have read this provision to require Plan fiduciaries to take affirmative action to use revenue sharing to “reduce” Plan fees, not just pay for them: in effect, a requirement that the fiduciaries get the “best revenue sharing deal possible” for the Plan.
It is true that revenue sharing is commonly used in the industry to pay for recordkeeping fees. In addition, a common method for determining the reasonableness of those fees is to examine the expense ratios of various investments. While both of these statements may be true as to what is commonly used in the industry, the Court finds that such inquiries are not sufficient as to the [Plan] because of the IPS. The IPS specifically requires that revenue sharing be used to offset or reduce the cost of providing administrative services to Plan participants. Thus, ABB may not choose revenue sharing as an appropriate method for compensating the Plan’s recordkeeper simply because many others in the industry use that method of compensation. Rather, ABB may deliberately choose revenue sharing as its method of recordkeeping if it will offset or reduce the cost of providing administrative services as compared to other methods of compensation, such as hard-dollar, per-participant fees.
As we’ll see, this reading of the IPS was a key element in the court’s decision.
The IPS and fund selection/de-selection
With respect to the de-selection of the Wellington Fund, the court found that the IPS required “examining a three to five-year period, determining if there are five years of underperformance, and if so, place the fund onto a ‘watch list,’ and then remove the fund within six months.” In selecting a new fund, the court found that the IPS required what it called a “winnowing process” — apparently, a process by which a large number of funds of a particular type are considered and compared before a final fund is selected.
The IPS and selection of classes of shares
The IPS included a statement: “When a selected mutual fund offers ABB a choice of share classes, ABB will select that share class that provides Plan participants with the lowest cost of participation.” The court found that this language required Plan fiduciaries to select share classes with the lowest expense ratio.
Now let’s turn to the four key issues on which the court held for plaintiffs and against the sponsor.
1.Failure to monitor recordkeeping costs and negotiate rebates from the trustee
With respect to Issue 1, the court found that a reasonable charge for recordkeeping for a plan the size of ABB’s was approximately $70 per participant per year. It based this finding on testimony of plaintiffs’ expert, certain Fidelity data, a report prepared for ABB by Mercer (a consulting firm) and a comparison with the Texa$aver Plan (the court found the recordkeeping and administrative services rendered to the Texa$aver Plan are comparable to the services rendered by Fidelity Trust to the ABB Plan). The court found, based on the testimony of plaintiffs’ expert, that the ABB Plan, on average, paid the following per-participant fees: $108 in 2001, $ 65 in 2002; $106 in 2003; $122 in 2004, $100 in 2005, $93 in 2006, and $180 in 2007.
Based on these findings, the court found that the Plan “overpaid for Fidelity Trust’s recordkeeping and administrative services as a result of the use of revenue sharing without any rebates to the Plan.”
The court’s holding on this matter is worth quoting at length, particularly for what it says about how revenue sharing should be evaluated:
[T]he process by which ABB determined to use revenue sharing as the Plan’s payment model was imprudent. [B]ecause it failed to calculate how many dollars would be or had been generated by revenue sharing for Fidelity Trust, ABB could not analyze how revenue sharing would benefit the Plan; nor was it in a position to negotiate revenue sharing (alliance rebates) with Fidelity Trust by leveraging the Plan’s size to offset or reduce recordkeeping costs. As the IPS is a governing Plan document …, ABB breached its fiduciary duties when it failed to comply with this provision of the IPS.
To be clear, the Court is not stating that revenue sharing is an imprudent method for compensating a plan’s recordkeeper, or that evaluating expense ratios may not, in some circumstances, comport with a prudent process for selecting a plan’s investment line-up. However, if a plan sponsor opts for revenue sharing as its method of paying for recordkeeping services, it must not only comply with its governing plan documents, it must also have gone through a deliberative process for determining why such a choice is in the Plan’s and participants’ best interest. Such an inquiry involves more than a raw assessment of the reasonableness of expense ratios; particularly, given the inherent difficulty of identifying how expense ratios are broken down between administration and investment services and the fact that the expense ratio doesn’t show whether there is a revenue sharing agreement with the recordkeeper or for how much.
The court’s holding can be read to require converting a percentage-of-assets trustee fee to a per-participant fee and comparing that fee with the “industry standard.” To go further, any large plan that is paying more than $70 per participant per year for trustee services should have explicit reasons for doing so. One qualification: it’s not entirely clear whether the court is saying that this is the ERISA standard or a standard created by the IPS.
The court held that, because of this failure, the Plan suffered losses, for which the ABB fiduciaries are jointly and severally liable, of $13.4 million.
2.De-selection of Wellington Fund, selection and mapping to Fidelity Freedom Funds
In 2000, the ABB investment committee approved the elimination of the Vanguard Wellington Fund, the selection of Fidelity Freedom Funds and the mapping of Wellington Fund assets to the Freedom Funds. The Fidelity Freedom Funds are target date funds. Target date funds use an asset allocation methodology based on a target retirement date; the asset allocation changes (gets more conservative) as the fund “ages.” The changing of asset allocation is called a “glide path.” “Mapping” is a process used when a fund is terminated and the assets of the fund are moved by default into another fund.
The court was very critical of each step of this process.
In 2000, the head of the investment committee’s staff told the investment committee that the performance of the Wellington Fund was deteriorating. But the court found that the fund’s performance, with the exception of one year, was “stellar” for that period. The court found that the investment committee did not follow the requirements of the IPS by “examining a three to five-year period, determining if there are five years of underperformance, and if so, place the fund onto a ‘watch list,’ and then remove the fund within six months.”
The court found that the decision to map Wellington Fund assets to the Freedom Funds was in part motivated by a desire to reduce or eliminate recordkeeping fees that ABB would otherwise have to pay. And, “[m]ore importantly, because ABB, Inc. used the Plan as a labor recruitment and retention tool, it was in its own best interests to have participation in the Plan appear to cost the employee as little as possible.”
Finally, it found that ABB fiduciaries, in selecting the Fidelity Freedom Funds, did not go through the winnowing process required by the IPS. Essentially only two target date funds were considered — Fidelity’s Freedom Funds and T. Rowe Price’s target date fund.
The court held that this transaction constituted a prohibited transaction under ERISA section 406(a)(1)(D) (prohibiting fiduciaries from “caus[ing] the Plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect . . . transfer to, or use by or for the benefit of a party in interest, of any assets of the plan.”). (ABB was the party in interest in this transaction.)
The court calculated losses with respect to this issue based on the difference between the performance of the Wellington Fund and the Freedom Funds. The court found that “the Wellington Fund consistently outperformed the Freedom Funds from 2000 to 2008. Had the Wellington Fund not been removed in violation of the IPS and its assets mapped to the Freedom Funds, participants who invested in the Wellington Fund would have achieved the higher returns associated with the Wellington Fund as opposed to the Freedom Funds.” The court held that, as a result, the Plan suffered losses, for which the ABB fiduciaries are jointly and severally liable, of $21.8 million.
3.Selecting higher priced shares
The 2001 agreement entered into between ABB and Fidelity in connection with the elimination of the Wellington Fund and mapping to the Fidelity Freedom Funds included a provision that “the agreed upon model for paying Fidelity Trust’s recordkeeping costs would be subject to change should the fund line-up or other Plan characteristics alter the revenue sharing paid to Fidelity.” Basically, if because of a change in the fund lineup Fidelity got less revenue sharing, Fidelity would be compensated by increased “hard dollar” fees. This provision was said to be aimed at keeping changes in the fund lineup “revenue neutral.”
In 2005 ABB removed the Fidelity Magellan Fund from the Plan’s fund menu. The court found that “after the Fidelity Magellan Fund was removed from the Plan fund line-up, ABB selected share classes with higher expenses than other available share classes for [six separate funds]. In sum, ABB selected these particular investments because of the investments’ effect on ABB’s method of compensation to Fidelity Trust. ABB did not select one investment over another solely because of a difference in their merit or value to the participants.”
The court held that the “IPS specifically requires use of a share class that has the least expenses. ABB’s decision to use classes of shares with greater expense ratios violates the IPS, a governing Plan document, and therefore violates ERISA’s duty of prudence.”
The court also held that the decision to keep fees “revenue neutral” was imprudent because it was part of (or, perpetuated) the earlier prohibited transaction (the Wellington Fund-to-Freedom Funds de-selection/mapping/selection). Further, “ABB’s process for arriving at their chosen compensation model [the one that, in 2005, was to be kept “revenue neutral”] was deficient, because among other reasons, it failed to determine the amount of income revenue sharing generated for Fidelity Trust and failed to negotiate with Fidelity Trust for rebates.”
The court did not assess any liability against ABB for ERISA violations with respect to this issue because “the loss from this fiduciary breach by ABB is directly related to ABB’s revenue neutrality agreement with Fidelity, and the Court has already awarded damages to compensate the Plans for the excess recordkeeping expenses paid to Fidelity.”
4.Payment of above-market fees to subsidize corporate services
Fidelity Trust also provided services to ABB unrelated to the Plan: recordkeeping for the defined benefit plan, the non-qualified deferred compensation plan, and the health and welfare plan, and payroll (the “corporate services”).
In connection with 2005 fee negotiations related to the removal of the Fidelity Magellan Fund from the fund lineup, Fidelity Trust provided revenue and cost information to ABB for all services. In connection with these negotiations a Fidelity official sent an email to an ABB official stating that services for the health and welfare plan were offered at below market cost, and that Fidelity did not charge fees for administration of ABB’s non-qualified plans. The court found that “[t]hese explanations were proffered to explain that these services for ABB corporate plans could continue only if revenue generated by recordkeeping the [Plan] remained constant even after Fidelity’s Magellan Fund was removed from the … platform.”
ABB also received a report from Mercer stating that “ABB overpaid for Plan recordkeeping services and that the Plan’s recordkeeping payments via revenue sharing appeared to be subsidizing services for ABB corporate plans.”
The court held that these communications put ABB on notice of this “cross subsidization,” and ABB’s failure thereafter to address this issue violated ERISA fiduciary rules.
As with Issue 3., however, the court found that “damages” for this violation — the difference between what the Plan did pay for recordkeeping and the reasonable market price for those services — were already included in the “damages” for Issue1.
The court held Fidelity liable for $1.7 million for “breaches concerning float.” We are not going to go into detail on this element of the case as it did not involve any direct sponsor liability and did not consider Department of Labor guidance on this issue.
As we said above, this case is likely to be appealed, and the appellate court (the Eighth Circuit) may modify or reverse this court’s decision. But in a number of respects — including the targeting of revenue sharing and trust and recordkeeping fees and the reliance on the IPS — this case represents a new “line of attack” on 401(k) plan sponsors. As such, sponsors and their counsel will want to read it closely and consider its implications for their procedures for monitoring 401(k) plan fees.