In two recent cases the US Supreme Court has ruled on issues of employee investments that may improve investment options for employees. This month, in Tibble vs. Edison International the Court wrote an important opinion that is it not sufficient for employers to just set up a 401(k) with a reasonable set of investment options for employees, they must also continue to monitor the plan for any changes.
Separately, in June 2014 in Fifth Third Bancorp v. Dudenhoeffer the court found that Employee Stock Ownership Plans (ESOPs) were also subject to the Employee Retirement Income Security Act ERISA standard, and employers must make sure that stock offered in the plan is a good investment for employees. In both cases, the verdict of the court was unanimous. Basically, the Court is making clear that companies must keep employees’ best interests at heart when providing financial options. This is good news for investors.
As tax efficient investments go 401(k)s are a solid choice for many. You can generally shield both the initial contribution and the growth of your investment from tax. So if you’re saving for retirement your money is likely to grow faster in the 401(k) than in a regular taxable brokerage account.
However, the downside of 401(k)s is that in many cases you have a limited set of options to chose from. Historically many 401(k) haven’t kept up with the financial innovation in brokerage accounts in offering some of the best financial products available in terms of broad diversification at very low cost.
So, in financial terms, the tax efficiency and employee contribution matching of a 401(k) is great but the options can be a let down depending on your employer. Research shows that lower cost funds do better, but some of the well regarded, diversified and low cost funds aren’t always available in 401(k)s and unfortunately, some investments that may not make sense such as company stock are included. This problem is what the Supreme Court is starting to pay attention to. Last week the Court’s ruling was clear that a company should chose the lowest cost of two investment options for employees if they are identical. That’s a basic step in the direction of helping employees find better investment options.
As an employer, it might appear tempting to delegate 401(k) responsibility, after all typically a firm is focused on selling its own products rather than developing expertise in finance and investments. Hence, choosing a set of 401(k) options that seems good enough and then moving on is sadly the norm. However, the Court has demonstrated that there is now legal risk with this approach. Not effectively monitoring investments and providing any options to employees that are known to be “overpriced and excessively risky” presents a legal risk in light of the Court’s rulings.
For example on potential risk is company stock, ICI/ERBI data shows that on average, investors have 5-7% of their 401(k) in their company’s stock; some hold far more.
Holding significant stock in one company can be risky. Investing in one company is generally riskier than investing in a group of them. This is why diversified, low cost Exchange Traded Funds (ETFs) are generally a good choice in portfolios. But, with company stock the problem is worse because the performance of the company stock price will be linked to your salary and other benefits. The Enron scandal is one example of this. Many Enron employee believed wholeheartedly in their company, so much so that, at the time of the collapse, 62% of Enron employees’ 401(k) funds were in Enron stock. Some employees even held all of their 401(k) in Enron stock. When Enron filed for Chapter 11 bankruptcy in December of 2001, the employees not only lost their jobs, they lost a large part of their savings.
It’s not clear that company stock is a helpful option to have in a 401(k) for investors, though it may help the company’s stock price to include it. The Court has ruled that employers should be cautious when recommending stock to employees, in the case of Fifth Third, stock was offered to employees at a time when the subprime lending crisis was occurring and insiders at the company who also administered the plan apparently knew that Fifth Third financial performance was deteriorating. The Court ruled that offering stock to employees and not selling existing their stock was a breach of fiduciary duty under ERISA given the likely overvaluation of the stock at the time.
A growing trend in finance is for fiduciary responsibility, recently the Treasury also introduced rules to apply the fiduciary standard to broker dealers. It’s frankly, sad that this has to be a growing trend rather than the minimum bar. Fiduciary responsibility means putting your clients' interests first. This means that if you’re a brokerage you need to consider the interest of your client rather than be solely focused on the commissions on the products you’re selling, or as an employer you need to continually do your homework to make sure you’re employees are getting a good deal in funds your offer in 401(k) plans, so that you’re not putting your employees in a position where they only have bad choices.
The Supreme Court themselves appear to follow sound investment principles according to research done by the Center For Public Integrity. Most Supreme Court justices are millionaires, with assets often allocated to stocks and diversified funds. It’s encouraging to see the Court take steps over the past 2 years to ensure that employees receive the quality of investment choices that they deserve. As a result of the ruling many firms may be encouraged to take a much harder look at what investment choices are on offer to their employees or face the consequences, and that’s a good thing.
See my bio for full disclaimer. Not intended to serve as a forecast, a guarantee of future results, investment recommendation or an offer to buy or sell securities.
