A participant in the 401(k) Plan administered by Edward D. Jones for its employees has filed a lawsuit alleging breach of fiduciary duty and prohibited transactions by the broker-dealer under the Employee Retirement Income Security Act of 1974, as amended (known as ERISA). All of the claims in the Complaint are allegations that will have to be proven at trial.
It's ironic that these claims will be initially decided by a United States District Judge. That's a privilege denied to customers of Edward D. Jones and other broker-dealers. They require their customers to submit to mandatory arbitration of disputes, administered by the Financial Industry Regulatory Authority (FINRA). I am among the many who believe this system is rigged against investors and should be abolished. To date, Congress has not had the political will to do so.
The flawed 401(k) system
In 2008, I wrote The Smartest 401(k) Book You'll Ever Read. I asserted the current system benefited" brokerage firms, brokers, pension consultants, insurance companies, insurance agents, the mutual fund industry and employers." I noted that employees "get the short end of this stick" and stated that "this must be changed."
It took a while, but the system is starting to reform. Not because the securities industry suddenly believes it has an obligation to do so, but rather it's a result of a combination of the DOL's new 401(k) rule mandating that advisors to these plans must put the interest of plan participants first, and a spate of lawsuits (like the one against Edward D. Jones) that expose the excessive costs and other conduct harmful to participants which is at the core of many of these plans.
The allegations against Edward D. Jones
The Edward D. Jones plan has 35,929 beneficiaries with assets of over $3.9 billion. The complaint notes that Edward D. Jones has a fiduciary obligation to these plan participants which is "the highest known to the law." As a fiduciary to its plan Edward D. Jones was required to act prudently and "defray reasonable plan expenses."
In my view -- which has not been accepted by any Court to date -- the only way to fulfill this high standard is to limit investment options in the plan to low cost target date funds, or portfolios of index funds, exchange-traded funds or passively managed funds, at different risk levels.
Retirement plans should accept no payments from fund managers (known as "revenue-sharing payments"). The receipt of these payments compromises the objectivity of the plan sponsor and encourages the selection of expensive, actively managed funds, likely to underperform comparable index funds over the long-term.
The complaint alleges that Edward D. Jones accepted both revenue sharing fees and "Networking and Shareholder Accounting Fees" from both affiliated and partner mutual funds companies, who were rewarded by the inclusion of their funds as investment options in the plan.
The revenue sharing fees were significant. The Complaint alleges that, in 2014, Edward D. Jones received $153 million from mutual fund revenue-sharing.
The Complaint alleges "The Plan's investments show a high correlation to mutual funds offered by mutual fund families that pay Edward Jones the most money." If true, it's a classic example of "pay to play." Everyone's a winner -- except plan participants.
The Complaint asserts that Edward D. Jones made decisions about which funds to include in the Plan (and remain there) based on the amount of revenue-sharing fees paid by those funds, rather than which funds were in the best interest of plan participants.
The Complaint has a number of other allegations, including the failure of the Plan to include lower cost share classes of identical mutual funds. Instead, the Plan allegedly kept higher-cost share classes, resulting in an excess cost to the participants of over of $13 million.
Significance of this case
This case places the issue of whether plan fiduciaries have an obligation to consider low-cost index alternatives to expensive, actively managed funds squarely before the Court. The complaint summarizes the impressive array of academic evidence supporting its position that plan fiduciaries do have this obligation, including this quote from Jill E. Frish, in an article published in the University of Pennsylvania Law Review. Ms. Frish is a Professor of Law and Co-Director at the University of Pennsylvania Law School, Institute for Law and Economics: "The most consistent predictor of a fund's return to investors is the fund's expense ratio."
Class action attorneys and plan participants will be closely following this case and hoping the Courts are persuaded by the academic evidence supporting an "evidence-based" approach to managing retirement plan assets.
The present system is in dire need of an overhaul.
Dan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read and his latest, The Smartest Sales Book You'll Ever Read.
The views of the author are his alone. He is not affiliated with any broker or advisory firm.
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