The Truth about Member Litigation; Should DC Pension Trustees be Concerned in 2018? | Wolters Kluwer
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  • The Truth about Member Litigation; Should DC Pension Trustees be Concerned in 2018?

    By Martyn Oughton

    Published January 30, 2018

    Whilst there have been a number of significant developments in the area of Defined Contribution (DC) pension scheme regulations over the past few years in the U.K., one theme that has emerged in the U.S.A. is that of pension scheme members (in particular, the 401(k) schemes prevalent over there) taking legal action, primarily against the sponsoring employers, but in some cases, advisers too. However, this activity appears not to be linked to returns from the pension funds failing to meet members’ expectations, as you might expect.

    Sponsoring employers and trustees in the U.K. will have been wise to at least observe this growing trend in the U.S.A., which has been gathering pace over the last ten years in particular. Class actions have been won in court on the basis that employers have taken sub-optimal decisions when it comes to the investment funds offered to scheme members, both in terms of their performance track record and the fees they charge.

    So far, the exposure to such claims in the U.K. does not appear to have followed the trend on the other side of the Atlantic, and this particular issue is not being highlighted by legal advisers as one which trustees should be making any kind of preparations for. But does this mean that trustees should ignore what is happening?

    The storm across the Atlantic 

    As far back as 2010, the Financial Times was reporting of a potential increase in the amount of litigation being brought by pension scheme members against their trustees. However, this was not just to do with choice of funds and fund performance. Issues such as delays in payment of contributions were being flagged as well as the choices members had to make in terms of the type of annuity available.

    In the meantime, whilst this was going on, the U.S.A. was seeing itself in the grip of an increasing trend of cases being brought against employers who sponsored the 401(k) plans for their employees. These plans are the closest comparators to the trust-based DC pension arrangements in the U.K., with fundamental similarities in terms of the risk effectively being passed to the employees. However, one group of lawyers in particular saw an opportunity to bring about collective action against employers for structural deficiencies in their schemes, alleged to be disadvantaging employees.

    At the forefront of this trend was St Louis-based attorney Jerome Schlichter and his firm Schlichter, Bogard & Denton. Since bringing about the first lawsuit in 2006, Mr Schlichter has succeeded in obtaining approximately $300million worth of settlements, and counting. Such activity has reportedly made him something of a household name in the USA. But why?

    The basis for his success has been the filing of class action lawsuits against primarily 401(k)-sponsoring employers, on the accusation that they have either chosen funds for which the fees charged to members have been excessively high, or were not the best funds available, in terms of performance track records.

    Some of these cases have been settled out of court, but others have been fought all the way through the system. However, Mr Schlichter has been successful in winning one judgment in particular, in the U.S. Supreme Court in 2015, the case of Tibble v Edison.
    And it does not stop there. The latest targets are a number of major academic institutions in the U.S.A., with suits being brought against the 403(b)-type schemes operated by such institutions on behalf of their employees.

    In these instances, disadvantage is being claimed on the basis that a large number of fund options with high fees have weakened the buying power of the employer when it comes to the fees they can negotiate.

    In all cases, however, the claims appear to be about the fees negating the value of the potentially greater returns that can be achieved from an active investment strategy, against a passive strategy that simply tracks particular stock market indices.

    Add to that, in some instances, employers have been accused of a conflict of interests by providing access to funds that are operated by companies within the same group. This effectively means that the employer, particularly if it is the parent company, is profiting from the investment management fees which are ultimately being paid for by the scheme members.

    The root cause of these cases’ success is the fiduciary duty imposed on employers when setting up these schemes; employers have failed to act in the best interests of their members.

    Watching from across the pond 

    For DC pension scheme trustees and their sponsoring employers in the U.K., the concern is that the underlying principle of the investment risk being borne by the members is being challenged. Although there are significant structural differences between U.S.A. and U.K. occupational scheme arrangements, this fundamental principle holds true on both sides of the Atlantic.

    However, it is not whether expectations of a particular level of pension have been met that is being brought into the question – it is the structural integrity of the investment choices made available now that is being challenged. Whether or not those choices ultimately produce the level of investment returns that make for happy scheme members, even after the fees have been taken, is another matter.

    So, on the basis that employers providing 401(k) plans are now watching their backs carefully, does this mean that DC scheme trustees in the U.K. should be similarly concerned?

    Pensions are not what they used to be 

    To say that the pensions landscape in the U.K. has changed in the last three years is something of an understatement. The change in the rules allowing people to take their pension funds as cash, which came into effect in 2015, has meant that a whole new range of possibilities are available to scheme members – and a new set of decisions need to be made about how to arrange income in retirement. At the same time, the regulatory landscape around DC occupational pensions has seen a significant number of major changes. In effect, this has become one of the most challenging times to be a trustee of a DC pension scheme.

    Matters have also been complicated by the introduction of automatic enrolment which will apply to all qualifying employers by February 2018. The principle of enrolling workers into their pension plan unless they consciously opt out if doing so, means that many more people are now members of schemes, meaning trustees have more members to care for than before. Back in July 2017, The Pensions Regulator reported this extra number of people as having exceeded eight million.

    Catering for the needs of these extra people is not an easy task, but has the regulatory framework served to steer trustees away from a number of issues that could have caused them problems further down the line?

    Regulation at work

    In order to deal with the challenge of taking on many more members and getting them to invest their contributions somewhere, pension schemes must offer a default investment option for those who do not want to make a decision on which funds to invest in.

    Regulation also goes a step further by requiring that default funds must not charge an annual fee any greater than 0.75 per cent. This came into force in April 2015, and has just recently been reviewed by the government. The outcome of that review was that the cap should remain at 0.75 per cent in future.

    This could be seen as the U.K. facing up to the threat of trustees and sponsoring employers being challenged over the costs of the funds they offer to members. A gap theoretically still remains, as this charge cap only applies to default funds. However, in practice, the numbers of members in percentage terms investing in other than default funds appear now to be very small.

    Also, on both sides of the Atlantic, the trend of fees charged on the different types of DC pension plans appears to be going down. In the U.K., the average annual charge for schemes that are members of The Pensions and Lifetime Savings Association is now below 0.5 per cent. In the USA, the flurry of lawsuits has resulted in a move away from actively managed funds to index trackers. This will no doubt help to continue the reduction in total plan costs for 401(k) plans, which have been reported by one particular survey as reducing to 0.91 per cent of assets in 2012 from 1.00 per cent in 2009. Also, the average plan member was only suffering costs of 0.53 per cent in 2012.

    So, it would appear that both the U.K. and the U.S.A. have arrived at a similar place, but via very different routes.

    All of this sounds positive for people joining schemes now and in the recent past. But given that many schemes will have been in place for decades, what about those people who have been members for a long time?

    The past is not forgotten 

    Back in 2014, the commissioning of the Independent Project Board by the government resulted in a review of the charges levied on what were termed “legacy” DC plans. Annual fees were reported in some cases as high as 3 per cent borne by members. Scheme trustees were required to produce a plan into how these charges could be reduced.

    By the end of 2016, the FCA, which was also involved in the process, reported that only about 2 per cent of assets under management in trust-based schemes had not been subject to acceptable measures to reduce the charges to a level required by the review (with the benchmark being a 1 per cent annual charge).

    And then there is more… 

    This is not the end of the push towards clarity and value for money on charges. Whilst transaction costs are specifically excluded from the charges cap, from the start of 2018, pension scheme governing bodies will be able to obtain details of transaction costs from their fund managers – so they will be able to have complete transparency on the overall expenses of running each investment fund.

    The big conclusion

    So, taking all of the developments in the U.K. into account, should trustees be worried that the wave of lawsuits in the U.S.A. relating to DC pension schemes floating across the Atlantic and resulting in time and money being spent defending court cases?

    On balance, the answer appears to be no – at least for the time being. Firstly, any complaints of this nature would need to be dealt with through the scheme’s internal dispute resolution procedure. Trustees would hopefully be able to point not only to the regulatory measures which have driven down costs and increased value for money, but also to the strength of their own internal governance, designed to achieve consistently good outcomes for members. Failure to resolve complaints this way would result in them needing to go to The Pensions Ombudsman before they can go anywhere near the courts. So, the chances of the U.S.A. situation replicating itself in the U.K. is quite slim.

    Add to this the combination of regulation and market forces (exacerbated no doubt by economies of scale brought about by automatic enrolment), as well as the overwhelming percentage of scheme members now invested in passive funds (a core choice for many default options). The basis for claims of the nature seen in the U.S.A. simply does not exist in the U.K. anymore – although arguably it did back in 2006 when the actions began.

    So, trustees can thank both regulators and changes in the pension landscape for not being too concerned about members expressing their dissatisfaction with their scheme investments in the same way as in the USA. However, the cases demonstrate that no assumptions about the way that DC schemes are run are exempt from potential challenge.

    The main lesson to be learned is that schemes must look to ensure that their governance arrangements are as robust as they can be – and stay that way. Also, that when it comes to the risks associated with running DC pension schemes, nothing is taken for granted!

    About the author: Martyn Oughton is a financial services professional with over 20 years’ experience in the industry. He has been a compliance professional since 2007. In 2009, he became a Professional Member of the International Compliance Association (ICA), and has recently been an examiner for the ICA, marking exam papers and assignments for their U.K. and International Compliance, Anti-Money Laundering and Financial Crime Diplomas. A regular contributor to Wolters Kluwer Compliance Resource Network, he also regularly writes for the ICA’s members’ journal “inCompliance”, and is also a freelance business-to-business copywriter and article writer. 

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