The Correlation Between Indexing's Rise and 401(k) Lawsuits


The number of lawsuits by investors against their workplace retirement savings plans skyrocketed during the global financial crisis in 2008. After a relatively short lull, though, complaints and court battles in subsequent years continued to proliferate.1 

That came even as financial markets kept rebounding from the 'Great Recession.' So if a rise in complaints against corporate sponsors of 401(k) plans took place in good and bad times for stock fund investors, what fueled such a surge in legal activity?

A common thread has been a burgeoning in popularity of index fund investing, according to analysts at Boston College's Center for Retirement Research (CRR). 

In research looking into the root causes for a heightened post-recession era in 401(k) legal cases, CRR researchers Geoff Sanzenbacher and George Mellman find several culprits.2 These include previous legal cases and regulatory rulings that brought into greater scrutiny many of the underlying practices used by fund manufacturers, consultants and plan sponsors in past years. 

In practice, CRR's analysis find that core processes for selecting, implementing, maintaining and disclosing fund information to 401(k) investors have undergone a fundamental period of legal fine tuning. 

As the authors note: "While the law is clear that plans must be administered for the 'sole benefit' of participants, it is less specific on many details: for example, how plan fiduciaries should select the type and number of investment options or determine a reasonable level of fees."

But analysts Sanzenbacher and Mellman dig deeper, relating ties between the rising popularity of index fund investing and plan participants feeling more compelled to take their retirement plan sponsors to court.

During this period of rising 401(k) suits, "both retail and institutional investors have been broadly transitioning from active to passive mutual fund options," the authors note in their research. 

As evidence, they compiled data from the Investment Company Institute, a fund industry trade group. In 2001, these numbers showed slightly less than 10% of U.S. stock fund assets as being invested in index funds. Fifteen years later, nearly a quarter of all assets were invested in such passive investment vehicles. (See graph below.)

It's probably no coincidence, the CRR study suggests, that as indexing was moving into investing's mainstream, lawsuits against 401(k) plan sponsors hit a zenith during the Great Recession years. 

While case numbers slowed for a few years immediately following the global financial crisis, lawsuits shot up again in subsequent years, according to data compiled by CRR.

Interestingly, such a resumption in complaints against 401(k) plans took a different course. (See graph below.) 

"This spate of 401(k) lawsuits focused on issues relating to transparency of underlying investments and excessive fees of actively managed funds," Sanzenbacher told 

In previous years, plan participants argued in court largely about "inappropriate" investment choices offered in their 401(k) plans, he explained. 

As early as 2013, such a legal profile changed, according to independent data collected by the center's researchers. In particular, charges significantly rose of so-called self-dealing. This is legalese referring to fiduciaries acting in their own best interests -- as opposed to putting plan participants front-and-center in any investment decisions. 

The other area of contention arising in what might be characterized as a second wave of 401(k) lawsuits was plan participants objecting to paying up so much for active stock pickers. In part, the report notes, this has been spurred by a Department of Labor regulation in 2012 requiring service providers to disclose their fees to plan fiduciaries.

"With the most recent increase in lawsuits focusing on excessive fees and transpancy, index funds afford a way for plan sponsors to check all of the boxes in terms of providing a strong fiduciary standard," Sanzenbacher said. "By having these available to plan participants, use of lower-cost index funds also typically reduces any possible conflicts of interest that can be a cause for future lawsuits." 

Use of passively managed funds also enable plan sponsors to avoid being challenged in court over concerns regarding performance-related issues, he added. "Since index funds are designed to follow specific parts of the market, it puts long-term performance onto a more level playing field," Sanzenbacher said. "There's just less risk of underperformance for a 401(k) plan sponsor. An index fund can do poorly over a certain period, but it's because of the market, not because it was a poorly run fund." 

The overarching issue driving 401(k) suits, Sanzenbacher and Mellman summarize in their study, is whether plan sponsors are "following a prudent process with participants' interests at heart."

Along these lines, the CRR analysts note that "policymakers may want to consider ways to encourage" greater use of index funds in 401(k) plans. "In any case, these lawsuits have been accompanied by an increase in the use of passive investment options," the study concluded, "and a fall in investment and administrative fees and it does not seem unreasonable to assume that the threat of litigation plays a role."


1-2: George S. Mellman and Geoffrey T. Sanzenbacher, "401(k) Lawsuits: What are the Causes and Consequences," Center for Retirement Research at Boston College, May 2018. 

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