If you think workplace savings plans are “risk-free” to employers – think again; “value for money” changes that
Later this year I will be speaking at a conference about what we can learn from Canada and what Canada can learn from us.
Roger Mattingly at a recent NAPF meeting noted that in the debate we are having on “value for money” , employers need to be careful that they actually provide it through their workplace plan.
By coincidence, this article arrived on my timeline this morning, written by Colin Ripsman , a Principal at Eckler, a Canadian consultancy, it is with one of his colleagues that I will be speaking.
This article first appeared in Benefits Canada.
Earlier this summer, Fidelity Investments settled two lawsuits brought by employees over the company’s own 401(k) plan. The suits alleged the firm offered employees its own higher-cost mutual funds when cheaper fund options were available and charged recordkeeper fees that were too high for a plan of its size. Fidelity contends the suits were “without merit” but settled for $12 million, which will be shared among more than 50,000 employees.
While the Fidelity settlement was notable, it was by no means the first 401(k)-related class action brought against a U.S. employer—or even the largest. In 2011, for example, Wal-Mart and its 401(k) recordkeeper, Bank of America, agreed to a $13.5-billion settlement after employees of the retail giant filed a class action alleging “unreasonably high fees and expenses.”
Canadian DC plan sponsors, to this point, have largely avoided this class action litigation that is increasing against U.S. 401(k) sponsors. There are a few reasons for this. While the popularity of 401(k) plans began growing throughout the ’80s—meaning many employees are now reaching retirement having accumulated much of their retirement savings in these plans—Canadian DC plan growth didn’t take off until the late ’90s. Few Canadian DC plans require members to make a significant investment in their employer’s own stock—something that is a rich source of DC-related litigation in the U.S. And Canadians tend to be less litigious in general compared to their cross-border counterparts, with awards in successful Canadian lawsuits being smaller than in the U.S.
Still, there is a growing fear among Canadian DC plan sponsors that, as the average Canadian DC plan member’s accumulation grows, so, too, will the risk of litigation—particularly as more people retire with savings that have grown primarily in DC accounts and their retirement income expectations are unmet.
Risks to watch for
An Eckler-hosted roundtable discussion earlier this year brought together eight leading Canadian pension lawyers to discuss the risks DC plan sponsors face and how they can better protect themselves against potential legal action.
Participants agreed Canadian DC plan sponsors face an increasing risk of class action, with former employees of a sponsor company the most likely to drive such action. These former employees would have the most to gain, as they would likely have gained larger DC accumulations over their career—and the least to lose, since they would no longer be reliant on the sponsor for employment.
The lawyers also noted that, based on lawsuits in the U.S. and Canada, the following are most likely grounds for future class actions against Canadian DC plans:
1. Uncompetitive fees – Investment fees directly impact returns, as well as the retirement income levels that can be generated from DC balances. Under a DC plan, the employer typically negotiates fees, while the member pays all or a significant percentage of the fees. Where members are paying higher fees than those of plans with similar specifications—thereby eroding member accumulations under the plan—sponsors may be at risk of class action.
The best defence against this risk is to use an unbiased third-party consultant to regularly benchmark plan fees and to document and confirm that the plan remains competitive in the industry. Where benchmarking indicates that fees are uncompetitive, the plan sponsor should renegotiate fees.
2. Underperforming investments – Investments that underperform comparable funds erode the value of member accounts relative to better-performing options. A class action focused on investment underperformance would claim that a plan sponsor failed to take action to replace an underperforming investment option with a stronger-performing fund in the same category.
Due diligence is the best defence against this type of action. This involves adhering to the plan governance model, which would require regular ongoing monitoring of the investment structure and using a third-party expert to assist in this monitoring. Those governing the plan should document all monitoring reports, recommendations made and actions taken.
There is no expectation that sponsors are always able to offer the best performing funds in all asset classes. However, should the funds offered fail to meet performance expectations over a reasonable period of time, the sponsor should take action.
Read: Focusing on decumulation
3. Misleading communication – Depending on what and how a plan sponsor communicates, members may be misled to believe that their plan will satisfy all of their retirement income needs, or that accumulations will finance a larger retirement income stream than should reasonably be expected. Members may blame unrealized expectations on the plan sponsor’s misleading communications.
The best way for a plan sponsor to protect against this risk is to build member communication around messaging designed to properly manage expectations. It should clearly outline the plan’s purpose and clarify member responsibilities. Copies of all distributed communication material should be retained by the plan to assist in possible litigation. Also, any projection models used to demonstrate accumulation levels and retirement income should use conservative estimates and include clear disclaimer wording.
4. Defaulting to recordkeeper products on termination – Terminating DC plan members are often presented termination options by the recordkeeper. These options typically include, as a default, transferring the balance to similar investment options as the member held in the accumulation phase. However, these termination options are held directly with the recordkeeper. They are often priced significantly higher than the funds offered in the employer-sponsored plans, but at a small discount to competitive retail fees. While terminating members are not required to choose these recordkeeper options, evidence suggests a high percentage do.
Plan sponsors can protect against this risk by taking more control of termination options. If the recordkeeper default option is allowed to be presented to terminating members, the employer should satisfy itself that the offering is reasonable (given the profile of the employee base), prudently managed and reasonably priced. Related communication should clearly explain that employees have the right and responsibility to shop around before deciding where to transfer their funds.
Protect your plan
In addition to the suggestions outlined above, the lawyers offered the following take-aways and best practices for DC plan sponsors that want to ensure they’re as protected as possible against potential member-led class actions.
- DC plan sponsors that offer too much investment choice may face greater legal risk than sponsors that offer too little choice.
- Assisting terminated employees with options during the decumulation phase introduces no greater level of risk to the plan sponsor than the risk assumed by helping members through the accumulation phase. Decumulation assistance may also reduce the likelihood of a claim, to the extent that it acts to improve income efficiency in retirement and is aligned with CAPSA Guideline No.8.
- In jurisdictions such as Ontario, where an annuity is the only legislatively prescribed default decumulation option for registered pension plans, plan sponsors may not default pensioners into market-based termination options.
- Capital accumulation plans (CAPs) not covered by pension standards legislation (such as RRSPs and deferred profit sharing plans) may pose greater legal risk to plan sponsors, due to lack of clarity of responsibilities, resulting from the lesser regulatory standards and guidelines that govern them.
- The terms retirement and pension plan should be avoided in DC plan member communication. Instead, capital accumulation plan and savings program are preferable.
- Communication should reinforce that the DC plan is not intended to be the only source of a member’s retirement income. Members should also be reminded to look to government benefit entitlements and their personal savings outside of the plan.
- The best defence against legal action is due diligence, which consists of the following key elements:
- following the CAP Guidelines, as well as additional CAPSA Guidelines;
- following current market best practices;
- maintaining and following formal written governance structures;
- documenting all plan decisions and the factors used to reach decisions;
- using third-party expertise, when that expertise is not directly available to the pension committee;
- regularly monitoring plan investments and recordkeeper performance;
- regularly benchmarking plan fees; and
- ensuring the messaging in any off-the-shelf recordkeeper education material is tailored to the target employee base and is used is appropriately.
But while Canadian DC plan sponsors have largely avoided the kind of legal action faced by plans in the U.S., the risks will continue to expand as the number of Canadians in DC plans, and their respective balances, grow. Through effective plan design, prudent investment choice and clear communication, DC plan sponsors can set the groundwork now that will help protect them as more and more members retire from DC plans in the years to come.
Colin Ripsman is a principal at Eckler Ltd. The views expressed are those of the author and not necessarily those of Benefits Canada.