In its 2009 decision in Hecker v. Deere & Co., the 7th Circuit U.S. Court of Appeals reaffirmed the lower court's dismissal of the plaintiff's complaint and ruled that 401(k) fiduciaries are not in breach of their responsibilities if they include funds with excessive fees in the investment menu and that fiduciaries are not bound to explain to participants the elements of those fees, specifically "revenue-sharing."
This decision concerns many adherents of fiduciary best practices, and others have already drawn attention to its many flaws. However, now that the 8th Circuit U.S. Court of Appeals has remanded similar issues for re-hearing by the lower court in 2009's Braden v. Wal-Mart, a further look at the Deere decision is warranted.
First, let's look at the facts. Deere & Co. offered two 401(k) plans, retaining final fund selection authority for both and appointing Fidelity Trust as the trustee and recordkeeper.
Fund options consisted of 23 retail Fidelity mutual funds managed by Fidelity Management & Research Co., two funds managed by Fidelity Trust, a Deere stock fund and a Fidelity brokerage window, BrokerageLink which provided access to another 2,500 funds managed by different companies. Combined plan assets exceeded $2.5 billion.
The plaintiffs alleged that Deere breached its fiduciary obligations by offering investment options subject to excessive expenses and failing to disclose revenue-sharing between Fidelity Trust and Fidelity Research. The court dismissed the case.
In dismissing claims related to revenue-sharing, the court declared that Deere had no duty to disclose the arrangement between the Fidelity units, which allowed payment of the Deere plans' recordkeeping fees.
This was because the court found that Deere discharged its fiduciary obligations by disclosing total fund fees in the plan documents and fund prospectuses delivered to participants. Such information, the court found, was the only expense-related information relevant to participants' investment decisions.
In dismissing the plaintiffs' claim that Deere violated its fiduciary responsibilities by selecting investment options with excessive fees, the court said the Deere 401(k) plans offered a sufficient mix of investments for its participants, with a wide array of expense ratios among 20 Fidelity funds and 2,500 other funds through BrokerageLink.
The court found it important that all of these funds were available on a retail basis, thus offering market competition, and that the availability of other funds with lower expense ratios was irrelevant because nothing in ERISA requires every fiduciary "to scour the market to find and offer the cheapest possible fund."
The court found that under ERISA Section 404(c), Deere was entitled to "safe harbor" protection from fiduciary liability for losses resulting from a participant's exercise of investment control over his/her individual account. The court rejected the plaintiffs' argument that Deere was not entitled to such protection because the company had imprudently selected funds with excessive fees.
The court found that section 404(c) required Deere to offer a broad range of investment options that allowed participants to meet three regulatory goals:
1. Affect potential return and degree of risk in the participant's portfolio.
2. Offer choice from at least three investment alternatives, each of which is diversified and has materially different risk and return characteristics.
3. Diversify sufficiently to minimize the risk of large losses.
Pointing to the 20 Fidelity funds and the 2,500 funds available through BrokerageLink with fees ranging from 0.7% to 1%, the court found "implausible" the allegation that these investment options did not provide participants with a reasonable opportunity to accomplish the three regulatory goals cited above.
The court concluded that, if participants lost money and did not earn as much as they would have liked, the outcome was attributable to their individual choices and that Deere could not be held responsible.
The real mischief of the Deere decision is that in its reasoning the court failed to apply ERISA's "prudent expert" standard. Here's where the Deere decision began to go wrong. The court said:
"We see nothing in the statute that requires plan fiduciaries to include any particular mix of investment vehicles in their plan. That is an issue, it seems to us, that bears more resemblance to the basic structuring of a plan than to its day-to-day administration."
This was said in the context of the plaintiffs' argument that it was imprudent to select only funds from a single family. The court concluded that even if restricting fund choices was a fiduciary function, no fiduciary breach resulted. However, this remark clearly shows that the court did not recognize portfolio construction and fund selection as fiduciary functions governed by ERISA's prudent expert standard, but rather saw them as nonfiduciary plan design functions. This failure permeated the court's decision, resulting in several errors:
Whether a particular fund is a good choice for a 401(k) plan depends on whether all of the selected funds can be used in combination, in whole or in part, to construct diversified asset-allocation portfolios that meet the needs of participants with different appetites for risk and return, and provide the opportunity to minimize the risk of large losses.
While mentioning the regulatory goals of portfolio construction, the court did not consider how conformity should be measured. The court blithely assumed that participants could construct prudent portfolios simply because there were 20 core funds and 2,500 additional funds available through a brokerage window. That kind of analysis is a sure road to retirement income insecurity!
First, to suggest that including an overpriced fund is justified solely on the basis of having multiple choices is to define the very essence of imprudence. Second, without portfolio construction analysis, who's to say what fund is appropriate? The court simply failed to apply a prudent expert standard.
A prudent expert would note that excessive expenses destroy investment returns and that unless otherwise justified, prudence would exclude a high-expense fund from an investment menu, irrespective of the number of other available choices.
Further, ERISA permits fiduciaries to pay only reasonable expenses and prudence requires that they are monitored and evaluated on a continuing basis. Expenses paid as a percentage of assets need particular attention to ensure that they are reasonable and that they don't escalate out of proportion to the value of the services received, such as recordkeeping. The court failed to consider this.
A plan participant is entitled to make investment choices on an informed and reasoned basis. Thus, if a participant knew that Fidelity Research was sharing its revenue from the Deere plans to pay Fidelity Trust for the plans' recordkeeping expenses, he could choose to allocate his investments exclusively among funds other than Fidelity funds to avoid that charge. Failing to disclose this arrangement deprives participants of this opportunity and is a fiduciary breach.
Faced with a plan with $2.5 billion in assets, a prudent expert would seek funds with lower expense ratios than many of those offered by the Deere plans. These would be funds available only to institutions, such as retirement plans, or other funds offering class Y shares.
While, as the court said, fiduciaries are not bound to select the lowest cost provider, the decision to select a fund with high expenses would have to be reasoned and documented. Failure to evaluate this opportunity would be a fiduciary breach.
In summary, the court in the Deere case failed to recognize that the prudent expert standard creates fiduciary obligations regarding portfolio construction and manager selection. Instead, the court imposed its own theories of prudent investment practices.
The facts in the Wal-Mart case are different, but the substance of the allegations is similar: that Wal-Mart failed to evaluate investment options in its 401(k) plan and included funds with excessive fees that were subject to undisclosed revenue-sharing.
It is critical, therefore, that the court should apply a prudent expert standard to the issues when the Wal-Mart case is reheard. Otherwise, the prudent expert standard may be further eroded.
Roger Levy, LLM, AIFA, is the CEO of Cambridge Fiduciary Services, LLC, a fiduciary advisor and audit firm with offices in Greenwich, Conn., and Scottsdale, Ariz.
