Guidelines for 401(k) Fiduciaries on Mutual Fund Selection

Fiduciaries who handle investments for self-directed 401(k) plans are increasingly exposed to liability for their investment decisions. Those fiduciaries, including employers and individuals charged with investment selection, are being second guessed in court actions for the investment funds they select. Plan fiduciaries are being sued for a variety of allegations ranging from excessive fees, poor investment performance, self-dealing and lack of transparency. Many of these actions are filed as class action and, like other fiduciary liability claims, they assert personal liability against plan fiduciaries.

Recent court decisions have grappled with the basic issue of low cost index funds versus actively managed (and higher cost) mutual funds. Is the extra administrative cost of an actively managed fund (which reduces investment return to plan participants) justified? Further, is any cost difference justified even if the actively managed fund has investment returns which lag behind an index fund with comparable investment goals? Although the courts are divided, there are some guidelines that plan fiduciaries need to consider when reviewing their plan's mix of mutual funds offered for participant investment:

• Include index funds in your plan's investment choices. These low cost funds frequently outperform comparable actively managed funds and are favored by the courts.
• Be careful in selecting and monitoring actively managed funds. Their costs are higher and if their performance also lags, as alleged in a number of pending cases, a plaintiff's lawyer may be in a position to assert a breach of ERISA fiduciary duty. Actively managed funds should be justified on the basis of providing additional services and a different investment focus from index funds. Actively managed funds that invest in, say, farmland or infrastructure, may make more sense than a fund that invests generally in the stock of large cap companies in competition with broad based index funds.
• Plan fiduciaries should always select the lowest cost class of a selected mutual fund that is available. The plan's collective buying power may allow it to provide a less expensive class of a particular fund than a participant could purchase on his or her own. Make sure to provide this additional costs savings (and increased investment return) whenever possible. At least one court has held that a failure to do so is a breach of duty on the part of plan fiduciaries responsible for this oversight.

And do not forget to follow an appropriate process when selecting and monitoring your plan's investment funds. New funds may be selected and old funds may need to be rejected based on updated information. Plan fiduciaries should meet regularly and document the basis for their investment decisions. The court's will grant significant latitude to fiduciaries who follow a prudent process - even if the investment results of those decisions are less than optimal.

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