Author: Steven Grieb
Supreme Court Decision in Northwestern Case – Scope of the ERISA Duty of Prudence
On January 24, 2022, the United States Supreme Court issued a decision in the case of Hughes vs. Northwestern University. The case involved several claims against two Internal Revenue Code ("IRC") Section 403(b) plans sponsored by Northwestern University ("the University"). Defendants included not only the University, but also its retirement investment committee and the individual officials who administer the plans.
While the case has specific warnings for IRC Section 403(b) plans that allow for multiple record keepers, the decision includes an important element for all defined contribution plans subject to ERISA that allow participant direction of investments.
The Plaintiffs' Claims
The plaintiffs in the case made three basic claims. First, they claimed that the plans' fiduciaries failed to monitor and control recordkeeping fees, resulting in unreasonably high costs to plan participants. Second, they claimed that the fiduciaries offered retail share classes of mutual funds and annuities when less expensive but identical share classes of the same investments were available. Finally, they claimed that the fiduciaries offered over 400 investment options for much of the period covered by the claims. The type and sheer number of investment options were likely to confuse the plan participants.
In recent years, the number of ERISA fiduciary breach claims have increased significantly. In particular, there have been numerous claims brought against universities that sponsor 403(b) plans similar to the University's two plans. However, the claims brought by the plaintiffs are not unique. Most claims of this type raise questions relating to the duty to monitor service providers and investments, excessive fees (including improper share classes), and offering too many or too few investment options.
Lower Court Decisions in the Case
The district court dismissed the complaint for failure to adequately plead a breach of the ERISA fiduciary duty of prudence. The Court of Appeals for the Seventh Circuit affirmed the dismissal. In its decision, the Seventh Circuit dismissed the lawsuit in part based on its determination that the plaintiffs' preferred type of low-cost investments were available as plan options. In other words, the plan's investment lineup offered the participants an opportunity to select a prudent portfolio for their account. As long as the participants had prudent investments to choose from, they had no basis for claiming a breach of fiduciary duties. The Seventh Circuit determined that the plan's fiduciaries had provided an adequate array of choices, including "the types of funds plaintiffs wanted (low-cost index funds)."
The plaintiffs appealed the decision to the Supreme Court. In 2021, the Acting Solicitor General of the United States, working through the Department of Labor, requested to the Supreme Court that they take the case because they felt that at least some of the plaintiffs' claims stated a plausible argument for breach of ERISA's duty of prudence. Following the request, the Supreme Court agreed to hear the case.
The Supreme Court's Decision
The Supreme Court issued a unanimous decision in the case. It agreed to overturn the decision issued by the Seventh Circuit and remanded the case back to the lower court to move forward. In reaching this decision, the Supreme Court ruled that the Seventh Circuit erred in relying on the participants' ultimate choice over their investments to excuse allegedly imprudent decisions by the two plans' fiduciaries. The fiduciaries' provision of an adequate array of investment choices, including the lower cost investments, does not excuse their allegedly imprudent decisions. The Supreme Court stressed that plan fiduciaries must conduct their own independent evaluation to determine which investments may be prudently included in the plans' menu of options.
According to the decision, ERISA fiduciaries have "a duty to monitor all plan investments and remove any imprudent ones" within a reasonable time. (Emphasis Added.) It's not enough for an investment fiduciary to have prudent investments in the lineup that participants are able to select from. Plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in a plan's menu of options. All investments available for selection by a participant must pass ERISA's prudent expert standard on a stand-alone basis. If the fund lineup has an investment that is not prudent, the investment fiduciaries have a duty to remove it within a reasonable time.
In reaching this principal, the Court did not distinguish between the plaintiffs' different claims in the lawsuit. Because the 7th Circuit dismissed each claim by focusing on a fiduciaries' obligation to assemble a diverse menu of options, the entire suit was remanded back to the district court. The lower court's incorrect "exclusive focus on investor choice" was the basis for dismissing each claim. As a result, the entire complaint must go back to the district court for hearing.
What the Supreme Court Didn't Say
Many retirement plan sponsors were hoping that the Supreme Court would use this opportunity to address pleading standards in ERISA excessive fee cases. The increasing number of claims based on fees in retirement plans have had varying and sometimes unpredictable results at the pleading stage. The inconsistencies create frustration for many litigators and ERISA fiduciaries, who were expecting the Supreme Court to bring some level of clarity and uniformity to the pleading standard for excessive fee claims. The Court's decision doesn't do that. While it's helpful to understand ERISA's requirements for selecting prudent investments, the Supreme Court has not clarified the necessary pleading standard for these types of lawsuits, and left future uncertainty for ERISA plan fiduciaries.
The Supreme Court's decision in the Northwestern case reminds ERISA investment fiduciaries of the prudent expert standard they must live up to. Each and every fund in the plan's investment lineup must be prudent, and should be selected independently and monitored on a regular, if not ongoing, basis. The funds should give the plan's participants the ability to build a prudent and diversified portfolio. But more importantly, fiduciaries should determine and thoroughly document why every fund in the plan's investment lineup meets ERISA's fiduciary requirements. Following the Northwestern case, ERISA fiduciaries will not be able to defend a questionable investment fund solely because the plan participants have other prudent funds to select from under the plan's investment lineup.
Gallagher investment advisors assist their clients in selecting and monitoring all plan investment funds for prudence. In the event of a lawsuit based on a fiduciary breach claim, the best defense is to have clear documentation that the plan's investment fiduciaries followed a prudent process in selecting and monitoring each and every investment option in the plan, and each investment is prudent for participants to invest in. The Gallagher approach has always been consistent with ERISA's fiduciary requirements as specified under the Supreme Court's decision in Northwestern.