Funds and Fiduciaries

Early in 2022, the Supreme Court issued a unanimous ruling in a key case dealing with pension funds’ obligations to their participants. The decision established two guardrails that govern how fund managers do their job.

There is currently a rash of Employee Retirement Income Security Act (ERISA) class actions against large employers and universities over the investment structure of 401(k) plans and their nonprofit equivalents. In January 2022, the U.S. Supreme Court issued a short unanimous opinion on this topic in Hughes v. Northwestern University.

The key allegations in Hughes were that Northwestern and its Retirement Committee breached their fiduciary duties to plan participants by failing to choose cheaper institutional share classes over retail share classes; retaining two different recordkeepers who charged excessive fees; and including too many investment options, more than 400, which caused confusion. Lower courts dismissed the case for failing to state any valid claim. The Supreme Court reversed, directing the Court of Appeals for the Seventh Circuit to reconsider the case.

Two key takeaways: First, the Supreme Court held that fiduciaries cannot judge the prudence of higher-fee investment options based solely on the availability of other lower-cost investment options in the plan. As Justice Sonia Sotomayor wrote, “Even in a defined-contribution plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options.”

Second, the court recognized that plan fiduciaries have a range of judgments, all of which are proper provided they are reasonable. In Justice Sotomayor’s words, “At times, the circumstances facing an ERISA fiduciary will implicate difficult tradeoffs, and courts must give due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise.”

This erected, in essence, two guardrails for plan overseers to steer between. On one side, fiduciaries cannot merely “set and forget” a menu of higher- and lower-cost investment options. On the other, fiduciaries have a range of reasonable choices they can make so long as their process is prudent.

Two recent decisions from the Sixth Circuit, meanwhile—both written by Circuit Judge Jeff Sutton—illustrate the two sides of Hughes. First, Forman v. TriHealth. The court in Forman reinstated claims that a 401(k) plan violated ERISA by including retail shares of mutual funds rather than less-expensive institutional share of the same funds. This retail-versus-institutional class claim is plausible, given the bargaining power of an investor with hundreds of millions of dollars at its disposal. Why would such an investor pay for higher-priced retail shares when its size qualified it for lower-cost shares in the exact same fund with the same investment team and strategy? Taking the plaintiffs’ allegations in the most flattering light, the court held it was reasonable to conclude that the defendant “failed to exploit the advantages of being a large retirement plan that could use scale to provide substantial benefits to its participants.” The court applied the first holding in Hughes to reject a bright-line rule to insulate a plan from liability for simply offering “a broad menu of funds.”

In the second decision, Smith v. CommonSpirit Health, the court affirmed dismissal of a class action and held that a 401(k) plan does not violate ERISA by offering both index funds and actively managed funds. To assess the plausibility of the plaintiffs’ claims, the court contrasted actively managed funds, which charge higher fees for a “portfolio manager [who] actively makes investment decisions and initiates buying and selling of securities in an effort to maximize return,” with index funds, which charge less because they passively rely on “a fixed portfolio structured to match the overall market or a preselected part of it.” Relying on the second holding in Hughes, the court deferred to the defendant’s broad “range of reasonable judgment” in creating an investment menu with both fund types. “Just as there is still room for offerings of an index fund focused just on the S&P 500, so there is still room for offering an actively managed fund that costs more but may generate greater returns over the long haul.”

These two cases represent the two sides of Hughes. On one hand, a plan must independently evaluate all its options to ensure they are prudent. Forman shows that buying pricier retail shares can be imprudent if cheaper shares of the same fund are available. On the other, offering both index and mutual funds is reasonable. As Smith held, “A retirement plan acts wisely, not imprudently, when it offers distinct funds to deal with different objectives for different investors.”

Republished with permission. This article, "Funds and Fiduciaries," was published by Best Lawyers on November 2, 2022.