401(k) lawsuits are on the rise from unhappy employees

You would think most investors are fairly happy with their results, 10 years into a rising stock market and with solid gains delivered by bonds, too. But that apparently isn’t the case at a lot of 401(k) workplace retirement plans.

Unhappiness over high fees, inappropriate investment options and other issues have led to a spike in lawsuits in recent years, according to a study by the Center for Retirement Research at Boston College. The flip side is that many 401(k) programs have gotten better in recent years, partly because of increased litigation risk.

These trends affect nearly two in three adult workers with money invested in 401(k)-style plans, which have replaced traditional pensions as retirement mainstays in the workplace. The plans feature tax-saving benefits and allow workers to contribute money automatically from each paycheck. Many employers offer matching funds to encourage further saving.

But unlike traditional pension plans, where managers hired by employers call the shots, workers in 401(k) plans must make investment decisions on their own (although some companies provide guidance). Poor investment choices, high fees, a lack of transparency and other problems can lead to subpar results and dissatisfaction.

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Backlog of cases — 60% pending

Not surprisingly, 401(k) lawsuits, which are typically class-action cases, jumped when the economy soured and the stock market tanked roughly a decade ago.

From eight lawsuits filed against employers in 2006, the numbers surged to 18 in 2007 and 107 in 2008, before declining for the next five years, according to the Boston College report authored by George Mellman and Geoffrey Sanzenbacher.

But since bottoming at just two lawsuits in 2013, litigation has risen again, with 56 suits in 2016 and 51 in 2017, the two most recent years tracked.

Of the roughly 430 cases evaluated by the Boston College, 60% are still pending, 20% were dismissed/closed, 16% were settled/decided, and 4% are on appeal. In an interview, Sanzenbacher said he sensed the trend of increased 401(k) litigation is continuing, though the researchers haven’t included more recent numbers.

Among notable cases cited in the report, health insurer Anthem agreed to pay $24 million to settle a complaint filed by employees, as did Franklin Templeton Investments ($14 million) and Brown University ($3.5 million).

Still, Sanzenbacher said it’s difficult to determine whether employees or employees have gotten overall better results. Many cases are still pending, and even when a settlement is reached, “The defendants don’t always admit any wrongdoing,” he noted.

Excessive fees are common complaint

Roughly a decade ago, inappropriate investments were the primary problem, driving nearly all of the lawsuits back in 2008, for example. Inappropriate investments include high concentrations of an employer’s own stock within a 401(k) program. Workers who pack their 401(k) account with just one stock often are lacking in diversification, meaning a downturn for that company can drag down a person’s portfolio.

“You generally don’t want more than 10% of your assets in a single investment, such as company stock,” said George Fraser, managing director at Retirement Benefits Group in Scottsdale.

Along with company stock, fewer 401(k) plans now feature industry-focused sector funds, which also often lack diversification, he said.

But more recently, excessive or unreasonable fees paid by employees have emerged as the dominant catalyst for lawsuits. It’s not that 401(k) plans must offer the lowest-cost investment choices, but they must be reasonable and subject to periodic review.

This includes the expenses charged by mutual funds — the primary type of investment vehicle in 401(k) plans — and any program fees for recordkeeping, shareholder communication and other administrative tasks.

Index, target-date funds mitigate some concerns

Index funds have become more popular in 401(k) plans, partly as a way to minimize the excessive-fee risk that employers otherwise might face.

The spread of index funds is a big reason 401(k) investors generally are paying overall lower costs. Among stock funds in 401(k) plans, average shareholder-borne expenses declined from an average $7.70 per $1,000 invested in 2000 to $4.10 last year, according to the Investment Company Institute. Average bond-fund expenses dropped from $6 per $1,000 invested to $3.40 over that span.

Index funds also tend not to blow up from poor stock selection, which minimizes the risk of lawsuits. Index funds merely strive to match the performance of a market barometer such as the Standard & Poor’s 500. They’re not trying to beat the market by making big bets on certain stocks or other assets that might not pan out.

Many 401(k) plans now use target-date funds as default options, for when workers don’t select other choices in which to invest. These funds, which hold a mix of stocks and bonds suitable for people at specific ages, typically follow a low-cost indexing approach.

While lower fees are welcome, they aren’t the only consideration.

“You can have the lowest-cost plan in the world, but if only 40% of employees participate or if they don’t have properly allocated portfolios, it’s not working,” Fraser said.

He cited automatic enrollment of workers and regular portfolio review sessions for workers as features that can help boost participation.

Investors’ interests must come first

A third driver of lawsuits is “self-dealing” allegations.

Simply put, companies offering 401(k) plans, and the investment firms they hire, are required to put the interests of workers above their own. They owe a fiduciary obligation.

Self-dealing allegations arise when, for example, investment managers offer their own proprietary line of mutual funds rather than unaffiliated choices, of if they make other moves that smack of a potential conflict of interest.

Alan Norris of Norris Wealth Management in Phoenix, Arizona, said he still sees poor-performing proprietary funds inside 401(k) plans. But too much employer stock and other potentially unsuitable investments have become less common, he added.

When providing a lineup of investment choices, and in other program details, employers and the financial companies they hire must follow a “careful, prudent process,” the Boston College report noted. The lack of a formalized process, rather than poor results per se, is often what gets employers in trouble.

The Boston College researchers said they see a silver lining in the rising litigation trend, as the threat of lawsuits has helped make 401(k) programs better, especially in terms of lowering fees and weeding out inappropriate choices.

“Participants should make sure their plans have low-cost investment options available, such as index or target-date funds,” said Sanzenbacher.

The flip side, he said, is that litigation risk might be making employers less willing to experiment with potentially rewarding innovations. He cited annuities as an example.

While often more complex and expensive than mutual funds, these investment contracts pay a steady flow of income in retirement. They can help ensure that retired workers don’t outlive their savings.

Reach Wiles at russ.wiles@arizonarepublic.com or 602-444-8616.