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In a Victory for Employees, the Supreme Court Sides With 401(k) Participants – and Creates Headaches for Plan Sponsors

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There was a time ‘way back a few generations ago when plenty of working Americans retired with company pensions. The arrangement was simple: in exchange for a set number of years working as a loyal employee, a worker entering retirement would start receiving regular pension checks. Often these payments, guaranteed by the reputation of the company (and typically with some government-backed protection), provided retirees with a comfortable and secure lifestyle as long as they lived.

The 401(k) Shifted Responsibility for Saving to Workers

Then in 1978 came a revolutionary idea called the 401(k), named for the applicable section of the IRS Code. Instead of the company setting aside those pension dollars, the money would be given t0 the employee via payroll deduction, often through a company match, and socked away in interest-bearing accounts to grow into a healthy retirement fund. At least, that was the idea. The reality has turned out far differently. Thanks to constant job changes and a lack of understanding on the part of employees, the promise of the 401(k) has never been realized.

It seems clear that eventually some disgruntled employees might be inclined to take some of their retirement-related frustrations to court. One such lawsuit, described in this Morningstar article by columnist John Rekenthaler, explains how the U.S. Supreme Court recently sided with employees who claimed that their employer was doing them a disservice by offering too many bad investment choices in their company-sponsored 401(k) plan. This ruling could shift some aspects of corporate retirement plans.

Too Many “Bad Apples,” Lawsuit Alleges

Rekenthaler writes, “The central issue of Hughes vs. Northwestern University, decided last week by the Supreme Court, was straightforward. Northwestern University’s defined-contribution system – which is formed under 403(b) regulations, but the court’s ruling applies equally to 401(k) plans –featured a whopping 242 investment options. Unsurprisingly, some of those funds were good and others were not.” The lawsuit blamed the University for offering bad apples among the good ones, and not helping employees choose more wisely.

As expected, Northwestern University presented a simple defense: employees weren’t forced to buy the under-performing funds. They could choose the better funds instead. But in a surprise decision, the Supreme Court said that’s not a good enough argument.

“Retail Investing” Has a Different Set of Rules

“Had the case involved retail investing, rather than within an employee-sponsored retirement plan, the defendant would have easily won,” Rekenthaler wrote. “Nobody expects brokerage firms to have only excellent funds. They cannot sell plainly unsuitable investments, but aside from that modest legal requirement, brokers are free to operate as they wish.” In other words, in the marketplace, clients will exercise their judgment, and the law will stay out of it.

At first, in the Northwestern University lawsuit, lower courts seemed to agree that – even with 401(k) and 403(b) plans – it was up to the buyer (or the employee) to choose wisely. “So maintained the Seventh Circuit of the U.S. Court of Appeals,” said Rekenthaler, “in finding that Northwestern University had not violated its fiduciary duty by supplying a mixed bag of investments.” The court made it clear: “The types of funds that plaintiffs wanted were and are available to them.” The University was not held liable for the employees’ poor choices.

ERISA Regulations Hold Companies to a Higher Standard

But there’s clearly more to the case, as Rekenthaler recounts. “Unlike brokerage firms, companies that establish 401(k) plans must comply with a second set of regulations,” he explains. “The Employment Retirement Income Security Act of 1974, or ERISA, holds plan sponsors to a higher standard than it does brokerage firms (or, for that matter, mutual fund companies).” The big difference is that companies and organizations that sponsor ERISA-covered plans must act as fiduciaries. “Plan sponsors must do more than just advocate ‘suitable’ investments,” Rekenthaler explains. “They carry the duty of loyalty, which requires that they act in the sole interest of their beneficiaries.”

(As Investopedia explains, not every retirement plan is governed by ERISA. “ERISA does not cover IRAs or plans set up and maintained by government entities and churches. Plans set up by companies outside the United States for nonresident employees are not covered by ERISA.” Some small businesses are allowed to set up retirement plans that technically fall under ERISA but “sidestep some of the confusing regulations.”)

When the appeal in Hughes vs. Northwestern reached the Supreme Court, Justice Sonia Sotomayor “openly dismissed the Seventh Circuit’s ruling as violating ERISA’s tenets,” says the article. The Justice said that, while ERISA wasn’t an excuse for “micromanaging” of retirement plans, “neither should sponsors be excused for not taking ‘basic steps’ to improve their offerings.” In Sotomayor’s mind, employees would suffer harm if ERISA were overlooked.

The Supreme Court Rules Unanimously

In a unanimous opinion (except for Justice Barrett, who had recused herself), the Supreme Court reversed the lower court dismissal. “The Seventh Circuit erred in relying on the participants’ ultimate choice over their investments to excuse allegedly imprudent decisions by respondents,” the decision said. By failing to “remove an imprudent investment from the plan within a reasonable time, [plan sponsors breach their duty.]

Rekenthaler’s column suggested that the decision leaves many details murky. “Unfortunately for 401(k) plan sponsors, the Supreme Court rejected the Seventh Circuit’s defense without providing its own alternative,” he writes. “If a plan has one poor fund among its 20 offerings, has the sponsor been imprudent? Five funds? What about 10? The court gave no guidance.” The Court, he argues, made it clear that employers offering retirement plans need to act as fiduciaries but failed to provide proper guidelines – leaving the door open to further suits.

401(k) Plans Will See Significant Changes

“The consequences of the Supreme Court’s verdict are clear,” Rekenthaler writes. Plan sponsors will “further trim their investment lineups, thereby limiting their number of potentially bad options.”  There will also be a further swing away from actively managed investment funds in favor of index funds with their much-lower fees. Other structural changes are probably on the horizon. But, Rekenthaler argues, the status quo needs clarification.

“Regulating by lawsuit is inefficient,” he writes. “Plan sponsors would save time and money, not to mention legal headaches, if a federal authority provided the details. Thus, while the Supreme Court decided as it must, to protect the tens of millions of employees who invest in company-sponsored retirement plans, I do regret the difficulties that its verdict will make for 401(k) sponsors.”  Rekenthaler advocates for a clear-cut system that “make[s] it easy as possible for them to do the right thing, by providing a retirement plan for their employees. The present approach is not as easy as possible. Far from it.”

Rajiv Replies, “The Current Law Makes No Sense”

We asked Rajiv Nagaich of AgingOptions for his take on these developments. As always, he had a fresh – and somewhat different – perspective.

“So,” he said, “Let me make sure I understand. If you work for an employer who offers an ERISA covered retirement plan you deserve better protections than if you work for an employer who is not covered by ERISA. That seems crazy to me!”

And what about protection for regular investors? “If you are dealing with a brokerage firm on your own, then current rules state that you don’t deserve to be protected from companies selling bad investments – so long as they offer a few good ones,” Rajiv adds. “Why?  Because you can simply go to Morningstar and find out which are the duds and which are the winners. Do you really expect your brokers to provide you with honest, objective research when they have sales commissions at stake? Especially when there are hundreds and hundreds of funds out there?”    

Rajiv’s view was clear. “That makes NO sense,” he scoffed, “but it is the law of the land.  Instead, sit down with a trusted financial adviser and get a financial dashboard prepared. With that tool, plus some unbiased input about the costs, risks, and returns associated with your portfolio, you can make informed decisions about your financial future.” 

My Life, My Plan, My Way: Get Started on the Path to Retirement Success

At AgingOptions we believe the key to a secure retirement is the right retirement plan – yet statistics show that 70 percent of retirement plans fail. That’s why for nearly two decades we’ve been dedicated to the proposition that a carefully-crafted, fully comprehensive retirement plan is the best answer to virtually any contingency life may throw your way as you age.  Our slogan says it all: My Life, My Plan, My Way.

When it comes to retirement planning, most people focus on one fairly narrow issue: money. Financial planning is an important component of retirement planning. However, people heading towards retirement often make the mistake of thinking that a little financial planning is all that’s required, when in fact most financial plans are woefully inadequate. What about your medical coverage? What if you have to make a change in your housing status – will that knock your financial plan off course? Are you adequately prepared legally for the realities of retirement and estate planning? And is your family equipped to support your plans for the future as you age?

The best way we know of to successfully blend all these elements together – finance, medical, housing, legal and family – is with a LifePlan from AgingOptions. Thousands of people have discovered the power of LifePlanning and we encourage you to the same. Simply visit our website and discover a world of retirement planning resources.  Make certain your retirement planning is truly comprehensive and complete with an AgingOptions LifePlan.  Age on!

Photo Credit: Flickr/Creative Commons

(originally reported at

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