Fear of Litigation Causes Plan Sponsors to Pare Down Investment Menu

Many plan sponsors, particularly those managing large retirement plans, are reacting to increased litigation risk by reducing their investment menu options.

As a result, employees are prevented from investing within the plan in certain asset classes, which have the potential to grow participants’ assets significantly, according to Michael Gropper, a Ph.D. candidate at the University of North Carolina, who spoke at the Defined Contribution Institutional Investment Association Academic Forum on Wednesday.

Gropper is also a research associate at the Employee Benefits Research Institute. He spoke on the panel along with Ben Reilly, an attorney at Goodwin Procter LLP, who specializes in Employee Retirement Income Security Act cases.

Impact of Litigation on the Investment Lineup

Gropper explained that the initial wave of 401(k) cases, from 2006 to 2015, involved allegations that plan sponsors were violating their fiduciary duty by including “inappropriate investments” in their plan.

For example, one case brought against Boeing in 2006 alleged, among many other issues, that fees associated with the inclusion of a science and technology sector mutual fund was a violation of Boeing’s fiduciary duty under ERISA.

“The inclusion of these so called ‘inappropriate assets’ may be driving some of the reluctance to include other types of assets, which may be appropriate,” Gropper said.

In particular, Gropper found in his research that more volatile asset classes are being dropped by jumbo and large plans, and the types of assets that remain are safer investments. Small-cap funds, for example, have higher-than-average volatility, and Gropper found that these funds are most likely to be excluded by large plans, which tend to be the ones most subject to litigation risk. Safer investments, like money market funds, tend to stay on investment menus, he said.

Impact on Employees’ Savings

To explore how the elimination of these asset classes impacts employees’ 401(k) savings and investment returns, Gropper used a database of more than 2.5 million public sector employees coming from the Public Retirement Research Lab.

With this data, he found that the average allocation to higher-risk, high-volatility asset classes—such as small-cap or emerging markets mutual funds and real estate funds—was about 15%.

After analyzing the 401(k) savings of a group of 200,000 public employees who did not have access to a pension, Gropper concluded that, on average, having access to these higher-volatility investment options increased participants’ retirement wealth by roughly 3%. He noted that the research followed a 10-year investment horizon period.

For individuals who did not have access to mid-cap funds, Gropper found that the average account balance in a 401(k) plan was roughly $75,000, controlling for salary, age and other factors. But for individuals who did have access to these funds, they had a much higher average account balance of more than $100,000.

However, Gropper also found that 5% of individuals had an allocation to higher-volatility investment options of greater than 50%, causing them to have lower account balances than individuals who did not have access to these funds at all.

“From a litigation standpoint … having a small-cap fund in your plan is a good tool when used in a broader portfolio to grow your retirement assets,” Gropper said. “But if you over-allocate to it, you can do harm to your account.”

Challenge for Plan Sponsors

While Gropper found that the effects of having access to these funds is positive, he also said it is a “tricky problem” for plan sponsors when deciding whether to offer these options, as some participants may over-allocate to them.

“I think that plan sponsors face difficult trade-offs,” he said. “But I think it’s particularized to each plan and each individual.”

Reilly said the fact that participants’ account balances grew by 3% over a 10-year investment horizon is significant.

“I find that very compelling from a litigation standpoint, because the way that courts rule, it’s always a six-year horizon for these cases,” Reilly said. “It’s very easy for plaintiffs to look back over a truncated window and … claim damages. … We’re constantly trying to educate courts that you need to look at a large snapshot [of time].”

Since 2016, the majority of ERISA 401(k) lawsuits have tended to allege excessive fees from a particular investment product, such as target-date funds. Gropper said his research only used data up until 2019, and the impact of excessive fee lawsuits was not the focus of this study.