The 401(k) Conundrum in Corporate Law

With over $10 trillion in assets, employer-sponsored defined-contribution retirement plans play an important role in the corporate governance ecosystem. Yet the governance of such plans has been largely overlooked in existing corporate law scholarship.

In The 401(k) Conundrum in Corporate Law, forthcoming in the Harvard Business Law Review, I draw on recent developments in employee benefits law—including the dramatic rise of retirement plan litigation—to fill in gaps in the academic analysis of the relationship between institutional investors and corporate retirement plans.

Scholarship on institutional investors has emphasized that the largest fund managers also have business lines that offer services to retirement plans sponsored by U.S. companies, including the 401(k) plans now commonly offered by private-sector employers. As a result, scholars have advanced the theory that institutional investors—and particularly mutual funds—have been deferential to corporate management at least in part out of fear of losing the corporations’ retirement plan business. Under this theory, the incentives to preserve or grow their 401(k) business—for example, to be selected as the recordkeepers or to have their index funds included on the investment menus of corporate plans—may cause mutual fund managers to vote with corporate management, even when doing so may not be in the best interest of the fund investors.

Despite its prevalence in corporate law scholarship, the “retirement business” theory has relatively limited empirical support, much of which predates recent developments in retirement plan governance. Moreover, the existing empirical and legal scholarship focuses almost exclusively on the incentives of the asset managers and their ability to meet their fiduciary obligations vis-à-vis their investors. In focusing on the decisions of mutual fund managers, the existing scholarship overlooks how decisions about retirement plans are made, who makes them, and the laws and lawsuits that constrain the decisionmakers’ actions.

The relevant constraints come from the Employee Retirement Income Security Act of 1974 (ERISA), which governs the administration of employer-sponsored retirement plans. ERISA imposes institutional requirements on plan decisionmakers and subjects such decisionmakers to fiduciary standards of loyalty and prudence. Those deemed ERISA fiduciaries must make decisions for the retirement plan—including decisions about the selection of service providers and investment options—solely in the interest of plan participants and beneficiaries.

Although ERISA’s fiduciary obligations date back five decades, enforcement by private plaintiffs has increased dramatically as 401(k) plans have become more prevalent in the United States. Unlike participants in traditional defined-benefit pension plans, participants in 401(k) plans are directly exposed to and affected by the administrative and investment decisions made for the plan. A review of fifteen years of ERISA litigation shows that since 2006, hundreds of lawsuits have specifically challenged how corporate retirement plans have been run, with special scrutiny of the selection of mutual funds and service providers. The cases have challenged the selection and retention of allegedly overpriced and underperforming investments, and have alleged that excessive recordkeeping and administrative fees have been charged to plan participants.

The spike in litigation and the subsequent settlements, which now exceed $1 billion in total, have led to institutional changes in plan administration and governance. In particular, survey findings suggest that plans have increasingly delegated decision-making away from corporate boards and executives to committees comprised of employees and advisers with relevant expertise and fiduciary training. Under the watchful eyes of plaintiffs’ attorneys, plans have formalized and professionalized decision-making, with an emphasis on procedural prudence. Insurance companies that provide fiduciary liability insurance have responded to the rise in ERISA litigation by raising rates and eligibility requirements, and by scrutinizing plan governance and investment menus before issuing policies.

Taken together, these changes constrain the ability of plan fiduciaries to use retirement plan assets to extract institutional investor support for corporate management in matters put before a shareholder vote. Diminished concern about managerial retaliation through the retirement business is consistent with recent mutual fund votes, with evidence of increased fund activism, and with newer empirical work documenting declines in funds’ so-called “management bias” between 2015 and 2020. While the reasons for growing fund activism are multifaceted and may include both pressure from current investors and competition for future clients, developments on the retirement plan side likely factor into the changing behavior.

A closer examination of retirement plan governance also informs several current debates in both corporate law and employee benefits law. The retirement business theory has been invoked not only in academic debates about the rise of institutional investors but also in regulatory debates about the scope of disclosure requirements for registered investment companies. In addition, a richer understanding of ERISA requirements and of retirement plan governance illuminates the tensions in recent shareholder proposals seeking board review of retirement plan investment menus. Finally, while the retirement business theory focuses on the relationship between mutual fund advisers and corporate managers, they are no longer the only relevant decisionmakers. The retirement plan fee litigation has pushed plans to outsource ever more elements of plan administration to various third-party professionals and to shift a rapidly growing percentage of 401(k) plan assets out of mutual funds and into lower-cost collective-investment trusts. Such developments must inform future efforts to study the relationship between corporate retirement plans and institutional investors.