The U.S. Supreme Court vacated an appellate court’s decision in Hughes v. Northwestern, in a ruling issued Jan. 24. This lawsuit had hinged on the “duty of prudence” outlined in the Employee Retirement Income Security Act of 1974 (ERISA), related to the selection of the investment options in defined contribution (DC) plans and recordkeeping fees. These are common themes in ERISA DC plan litigation, and this ruling may have broad impacts for the industry.
History Behind the Northwestern DC Ruling
Hughes v. Northwestern involves a challenge to investment fees and recordkeeping fees in two 403(b) plans maintained by Northwestern University. The plaintiffs alleged that Northwestern violated its duty of prudence under ERISA by providing employees with an investment menu that caused participants to incur excessive fees—because too many options were offered (187 options in one plan and 242 in the other) and because of the high fees charged for certain options.
In 2019, the 7th U.S. Circuit Court of Appeals essentially held that a few bad apples do not spoil the bushel; that a plaintiff cannot state a plausible claim based on a few imprudent investment options when the investment menu is diverse and contains prudent investment options. Importantly for the DC industry, this standard would have been broadly protective, as the presence of prudent choices could potentially shield fiduciaries from liability. Without this standard, liability arises for each individual investment option.
The 7th Circuit also conflated the cost of recordkeeping with the cost of investing, noting that “plan participants had options to keep the expense ratios (and, therefore, recordkeeping expenses) low.” This decision conflicted with the 3rd Circuit’s decision in Sweda v. University of Pennsylvania, triggering the Supreme Court review.
Before the Supreme Court agreed to hear the case, the Solicitor General’s Office submitted a brief urging the court to grant the petition for a writ of certiorari and review the following range of issues:
- Money, money, money: Lower courts have disagreed whether failing to use the lowest-cost share class supports a claim. The solicitor general took the position that the plan fiduciaries knew (or should have known) that there were lower-cost but otherwise identical share classes available to large plans and that similarly situated fiduciaries had negotiated less expensive share classes. The solicitor general also took the position that the plaintiffs had stated a claim by alleging that the plan fiduciaries could have reduced recordkeeping fees by negotiating lower fees, conducting a competitive bidding process, or using one recordkeeper instead of two.
- The good outweighs the bad: The 7th Circuit reasoned that the wide array of investment options allowed plan participants to choose cheaper index funds. The solicitor general argued that each individual investment option should be assessed independently, and that offering a broad array of investment options with varying expenses does not excuse the inclusion of imprudent investment options.
- Comparing apples and oranges: The solicitor general also suggested that the Supreme Court clarify the “benchmark” that can be used to dismiss. Most courts have held that—outside of the share class context—a plaintiff cannot state a claim merely by alleging that a less-expensive or better-performing alternative investment option exists. At the same time, some courts have failed to define what constitutes an appropriate benchmark for a particular investment, functionally giving plaintiffs a free pass at that stage.
In a unanimous decision, the Supreme Court vacated the 7th Circuit’s decision and remanded the case to the 7th Circuit for re-consideration. The opinion is relatively narrow, especially when viewed against the questions posed by the solicitor general, but with broad implications. The Supreme Court found that the 7th Circuit had erred by focusing on a different facet of the duty of prudence: a fiduciary’s obligation to assemble a diverse menu of options. Specifically, the Supreme Court held that courts should consider whether a plaintiff has alleged facts demonstrating that a plan fiduciary has breached its duty to monitor individual investment or recordkeeping expenses, and to remove imprudent investments or recordkeepers within a reasonable timeframe, based on the standard laid out in Tibble v. Edison. The Supreme Court held choice is not a categorical defense and that placing the burden “on the participants’ ultimate choice over their investments [does not] excuse allegedly imprudent decisions by fiduciaries.”
Notably, the Supreme Court also looked to its prior decision in Fifth Third Bancorp v. Dudenhoeffer dealing with company stock in 401(k) plans. The court concluded that “[b]ecause the content of the duty of prudence turns on the circumstances … prevailing at the time the fiduciary acts, the appropriate inquiry will necessarily be context specific.” The Supreme Court also emphasized that “[a]t times, the circumstances facing an ERISA fiduciary will implicate difficult tradeoffs, and courts must give due regard to the range of reasonable judgements a fiduciary may make based on her experience and expertise.”
While yet to be seen, the ruling may limit the ability of plaintiffs to form a class action due to the focus on the individual harm to participants based on the specific options in question. Additionally, the reference to Dudenhoeffer may also provide coverage to fiduciaries who document the circumstances and specific context considered when making decisions.
Even though the decision is only six pages, there are a variety of potential takeaways to consider. Perhaps most importantly for plan sponsors is that fiduciary conduct must be judged in a context-specific fashion based on the circumstances at the time and recognizing competing considerations faced by fiduciaries. This emphasizes the need for plan fiduciaries to follow a process and document the steps taken, decisions made, and rationale for those decisions. Plan fiduciaries can reduce risk by holding regular fiduciary committee meetings, monitoring the investment options and plan expenses on an ongoing basis, engaging experts to help satisfy the duty of prudence, conducting a recordkeeper RFP or benchmarking study, negotiating plan fees, and keeping meeting minutes and copies of plan materials to document the informed and deliberative process.