Going Purely Passive May Raise Litigation Risk Exposure

by: , MainStay Investments

In response to the wave of 401(k) fee litigation in recent years, many plan sponsors have concluded that exclusively offering passively managed funds (i.e., index funds) in their fund line-ups and avoiding actively managed funds altogether may be a surefire way to avoid litigation exposure. However, this approach not only reflects a misunderstanding of fee litigation, but—ironically—may also lead to greater litigation risk.

Fee litigation generally involves allegations that a plan unnecessarily offers expensive investment options, when lower-cost alternatives are available. Such claims frequently relate to the offering of retail mutual fund shares, rather than lower-cost institutional shares. Due to the fact that actively managed funds are almost always more expensive than passively managed alternatives, it appears that many plan sponsors have gleaned that one lesson from fee litigation is that actively managed funds should be avoided, simply because they are more expensive.

This view is not only incorrect, but may also open the door to greater litigation risk. To date, neither the Department of Labor (the “Department”) nor any court has held that actively managed funds are inherently imprudent under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). Instead, the Department and courts have repeatedly emphasized that fiduciaries should employ a prudent decision-making and selection process, one in which investment cost is just one of several factors to consider. Importantly, ERISA neither prefers nor prohibits any particular class of investment or investment strategy.

Plan sponsors may have various reasons for preferring passively managed funds. In addition to the common perception that such funds are “safer” investments—with respect to both performance and litigation risk—passively managed funds may also be regarded as carrying lighter monitoring duties, a clearly favorable feature from a fiduciary perspective. Importantly, ERISA requires fiduciaries to act solely in the interest of the plan’s participants and beneficiaries. Thus, if the selection of passively managed funds is based on plan sponsors’ own preferences, rather than what is best for plan participants, such decisions may give rise to liability under ERISA.

Moreover, if plan sponsors employ a “purely passive” strategy, they may be subject to claims that the exclusion of actively managed funds precluded participants from the opportunity to earn above-market returns. Notably, very similar claims have been raised, regarding the availability of stable value funds and the relative underperformance of money market funds.

Plan sponsors should be aware that such claims could potentially be raised, regarding the exclusion of actively managed funds.

At the end of the day, plan sponsors should focus on employing a prudent process in selecting investment options, and should not jump to exclude entire classes of investments, based on their own preferences or fears of litigation. Plan sponsors should remember that as long as they act prudently, they are generally not liable for investment losses or underperformance.

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1. See e.g., Best Interest Contract Exemption, 81 Fed. Reg. 21,002, 21,032 (April 8, 2016) (noting that the Department “has not specified that any particular investment product or category is illegal or per se imprudent” under ERISA); Taylor v. United Techs. Corp., 2009 WL 535779, at *14 (D. Conn. Mar. 3, 2009), aff’d, 354 Fed. Appx. 525 (2d Cir. 2009)(unpublished) (finding no breach of fiduciary duties “in selecting and offering actively-managed mutual funds”).

2. See e.g., Pension Ben. Guar. Corp. ex rel. St. Vincent Catholic Med. Centers Ret. Plan v. Morgan Stanley Inv. Mgt. Inc., 712 F.3d 705, 716 (2d Cir. 2013) (the duty of prudence is an objective standard that focuses on the methods employed by the fiduciary); DiFelice v. U.S. Airways, Inc., 497 F.3d 410, 418-20 (4th Cir. 2007) (noting that prudence requires examining the thoroughness of a fiduciary’s investigation and that “a court must ask whether the fiduciary engaged in a reasoned decision-making process”); Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983) (noting that ERISA’s prudence requirement focuses on “the fiduciary’s independent investigation of the merits of a particular investment, rather than on an evaluation of the merits alone.”).

3. See e.g., White v. Chevron Corp., 2016 WL 4502808, at *2 (N.D. Cal. Aug. 29, 2016) (alleging defendants breached their duties of loyalty and prudence by “providing participants with a money market fund as a capital preservation option, instead of offering them a stable value fund”); Pledger v. Reliance Trust Co., No. 1:15-cv-04444, at 2 (N.D. Ga. Apr. 15, 2016) (alleging breaches for not offering a stable value fund and only offering an “extremely low-yielding money market fund”).

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MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company.

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MainStay Retirement Institute

MainStay Investments

MainStay’s Retirement Institute was created to assist plan advisers and plan sponsors as they navigate today’s evolving governance landscape. The Retirement Institute’s various initiatives seek to provide expert coverage of the industry’s most impactful issues and deliver

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