Low 401(k) returns may cause lawsuits

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As baby boomers retire over the next few decades, a wave of lawsuits may develop against former employers and plan sponsors for failing to invest people’s 401(k) money wisely.

“I think there’s going to be an influx of suits, because 401(k) plans have become the primary retirement vehicle for Americans,” said Derek Loeser, a Seattle plaintiffs’ lawyer who specializes in ERISA fraud cases.

Doug Hinson, who handles employee benefits for employers, agreed.

“I think we’re seeing the leading edge of this trend,” said Hinson, who practices with Alston & Bird in Atlanta.

To date, these cases have generally been brought as class actions against larger companies. But Hinson predicted that in the next round of litigation there will be more suits against small companies and more individual suits, with plaintiffs’ lawyers hoping to recover attorney fees under ERISA.

According to Loeser, who practices with Keller Rohrback, a plan fiduciary could be held liable under ERISA if the plan fails to have a method in place for selecting and monitoring its employees’ 401(k) investments, or doesn’t follow the process it has set up and knows or should have known that the investment choices it offered were “imprudent.”

“If you are an officer or director and you know fraud or other illegal activity is going on that affects the investments, then it’s not ‘prudent,’” he said. “And if you have made a mistake because you didn’t go through the proper steps to evaluate whether the investments you provide are ‘prudent,’ you’re liable under ERISA for procedural imprudence.”

In addition, a plan fiduciary that went through the necessary steps to assess its investments — but did so inadequately —could also be held liable under ERISA.

When Suits May Happen

Some of the common circumstances that might cause a class of plaintiffs to sue over 401(k) shortfalls include:

• Investments in company stock

  The most common situation to date that has led to suits over 401(k) investments is when a company invests its employees’ retirement funds entirely or nearly entirely in company stock.

  This was the allegation with Enron, WorldCom and many other cases Loeser and his firm have handled, which have resulted in sizable settlements.

  “If plans have huge percentages of total assets invested in the stock of the employer, that’s perilous for employees,” he said. “If the corporation is not responsible or engages in fraud or illegal activity, that investment gets decimated.”

  Loeser said that generally an employee’s 401(k) money winds up in company stock either because participants are given company stock as one of their investment options or because the company pays its matching contributions with company stock.

  “It’s very attractive for companies to match with their stock,” he said, noting that usually matched stock contributions are restricted and can’t be sold until a certain age.

  With Enron, matched stock couldn’t be sold until a participant was age 55.

• High-fee mutual funds

  Another investment situation that might lead to suits is when a company invests its employees’ 401(k) dollars in high-fee or poorly performing mutual funds.

  If a plan is “determined to offer a group of mutual funds but they are the worst performing and most expensive, they have not engaged in the type of thorough analysis ERISA requires fiduciaries to follow,” said Loeser.

  One reason why there haven’t been more cases involving mutual fund investments, believes Hinson, is that even if a company invested in poorly-chosen mutual funds, there isn’t necessarily as large an amount of money lost as there would be with company stock investments.

  However, “when it comes to mutual funds that are sizable, if we see significant drops in value we will see these kinds of lawsuits,” he predicted.

• Undisclosed financial relationships

  Allegedly improper mutual fund investments, or other imprudent investments, can be the result of undisclosed financial relationships in which the plan fiduciary or employer gets a kickback for investing its employees’ 401(k) funds.

  An inappropriate investment might be “purchasing real estate in a toxic waste site as an investment of employees’ 401(k) funds because you got a huge kickback,” Loeser said.

  It would also be inappropriate for a plan to invest in a fund that charges excessive fees just because the company owner is related to or knows someone who works for the fund.

  Hinson expects that future cases might hinge on “subtle relationships.”

  For example, an employer might have “an investment banking relationship with a company, and use that company as an advisor for its 401(k) plan,” he said.

  Whether a case involving an undisclosed relationship is worth bringing depends on whether employees have significant damages as a result of that relationship.

  “An incestuous relationship might be a breach of fiduciary duty, but an employee can’t point to real damages unless there is a big drop in fund value coupled with this incestuous relationship,” said Hinson.

Advice For Employers

Employers can protect themselves from lawsuits if they have a careful system in place for monitoring their employees’ investments.

“Build a procedure for monitoring investments in the 401(k) and have a clear trail of who is responsible for doing that,” recommended Hinson.

The monitoring procedure should include a fiduciary committee holding periodic meetings about investments and creating detailed minutes of those meetings.

“Whoever appoints the fiduciary committee has the duty to monitor it, and the committee itself ought to be reporting up the chain once a year,” Hinson said.

In addition, “the single most important thing a company can do to avoid being sued in this situation is to hire an expert investment advisor to advise about plan investments.”

The advisor should be
responsible for creating reports about investment performance, monitoring changes in fund managers and assessing mutual fund fees in comparison to other similar funds. Hinson emphasized that all of this should be thoroughly documented.

Loeser said plan fiduciaries should also have sufficient insurance to cover 401(k) losses if they occur.