By Arris Reddick Murphy

The Employee Retirement Income Security Act (ERISA)’s Section 404(c) protection is commonly relied upon by plan fiduciaries to lessen potential liability in the event that participants, who are directing their investments in employer-sponsored 401(k) plans, suffer large losses.

It is well-established that a plan fiduciary must prudently select the plan’s investment options and provide sufficient information for participants to make informed investment decisions in order to shift the potential liability to participants. However, a recent ruling in the U.S. District Court in the Northern District of Texas suggests that there are additional requirements that must be satisfied for this expected fiduciary protection to occur.

Background

An ERISA Section 404(c) plan is an individual account plan that gives a participant the opportunity to exercise control over assets in his or her individual account and choose, from a broad range of investment alternatives, (emphasis added) the manner in which some or all of the assets in the account are invested.

A 401(k) plan offers a broad range of investment alternatives only if, among other things, the participant has a reasonable opportunity to choose from at least three investment alternatives, each of which is diversified and has materially different risk and return characteristics.

It is customary to satisfy the diversification requirement through three classifications—capital preservation, fixed income, and equity alternatives. However, based on the arguments raised in a recent case, it is advisable for plan fiduciaries to offer diversified investment options within each of the three classifications.

Recent Case

Salvador Ortiz v. American Airlines Inc. et al. (No. 4:16-CV-151-A, N.D. Texas; 2016 U.S. Dist. LEXIS 160588) was filed as a class action claim by participants in the 401(k) plan for employees of participating AMR Corp. subsidiaries.

The complaint named American Airlines (AA), the American Airlines Pension Administration Committee, and American Airlines Federal Credit Union (“AA credit union”) as defendants. The plaintiffs claimed that defendants violated their fiduciary duties by offering only one income-producing, low-risk, liquid investment option: the American Airlines Credit Union Demand Deposit Fund (AA CU Fund).

In addition, the plaintiffs noted that the AA CU Fund investment returns were 0.22% and 0.24%, respectively, for the 12-month periods ending November 2015 and January 2016. At the same time, returns on AA CU checking accounts for the same period offered depositors 2.27% interest for balances up to $5,000.

The plaintiffs claimed the credit union should have paid them at least the same rate of interest it was offering to its other customers, and by failing to pay the plan participants a reasonable rate of return on investments in the AA CU Fund the credit union breached its fiduciary duty and was liable for losses to the plan.

Further, plaintiffs argued that a stable value fund would be an appropriate complement to the capital preservation alternatives for the plan, primarily because such funds are designed to provide capital preservation, liquidity, and steady, positive returns that are expected to exceed the returns of money market investments over time.

American Airlines sought dismissal of all claims in the case and presented a few arguments in its defense. Specifically, the company argued:

• That the credit union was not a fiduciary to the plan so it could not have breached any fiduciary duty;
• That the AA CU Fund was but one option in the plan’s investment line-up into which participants could direct assets;
• That any stable value fund would have greater risk of investment loss than the AA CU Fund; and
• That the comparison of returns of a stable value fund with those of the AA CU Fund was not a fair one.

Defendants also clarified that checking account customers, who may have earned a higher interest rate, were subject to account limitations and, to the extent applicable, would have received a lower rate of 0.05% interest on deposits greater than $5,000.

Capital Preservation

Diversifying the asset class is doable because there are several investment options with the objective of capital preservation, including a demand deposit account, a money market fund, and a stable value fund.

A money market fund invests in short-term debt securities such as U.S. Treasury bills and commercial paper, while a stable value fund consists of a diversified portfolio of fixed income securities with longer maturities than money market holdings that are insulated from interest rate movement by synthetic guaranteed investment contracts issued by banks or insurance companies.

At the time of the ruling, the AA retirement plan offered the AA CU Fund, two money market fund options, and a stable value fund that was added to the investment line-up at the end of 2015. Instead of responding to the defendants’ motion to dismiss, the plaintiffs opted for private mediation and proposed a settlement agreement in the case.

Terms of the proposed settlement include payment by the fiduciaries of $8.8 million, some of which will be allocated to affected participants, and the requirement that the fiduciaries hire an investment consultant to assist with the selection of a stable value fund.

The federal court, however, had some misgivings about the proposed settlement and on November 18, 2016, expressed concern that the monetary amount might be insufficient to restore participants’ lost earnings. The details of supporting documentation revealed that, based on performance returns for money market funds and stable value funds over a 3-year period, if participants in the AA retirement plan had had those options available, they could have earned an additional $30 million to $48 million, or $55 million to $88 million, respectively.

The court gave the plaintiffs until December 6, 2016, to decide how they wanted to proceed, but plaintiffs’ counsel later asked for an extension until December 20 (at the publication time of this column) to continue working with the defendants and to “present the most complete” support for their case to the court.

Diversified Investment Choices

Simplification has been the recent trend when it comes to 401(k) investment options, and plan fiduciaries are warned against selecting too many options in a particular class to avoid confusing participants as they distinguish between alternatives.

Yet when it comes to the differences in underlying holdings and earnings rates between money market funds and stable value fund investments, both may be necessary in order to achieve prudent alternatives for capital preservation of retirement assets.

It is also important to note that there are scenarios when a money market fund may be more suitable. For example, a money market fund works well when a participant wants to move temporarily out of equity investments and seek a holding place for a few days, perhaps until an alternative investment is selected.

ERISA Section 404(c) requires fiduciaries to offer a diversified investment line-up that has differing risk and reward characteristics. After the Ortiz case, the retirement plans community must take another look to make sure that participants who seek a low-risk, income-producing investment option also have a choice within the plan’s designated investment options.