07/26/2011 05:57 pm ET Updated Sep 25, 2011

Court Rules Kraft's 401(k) Plan May Have Holes

A recent ruling from the United States District Court, Northern District of Illinois, Eastern Division (George v. Kraft Foods Global, Inc., No. 08 C 3799), should strike fear in the hearts of trustees and plan administrators for both defined benefit plans and defined contribution plans (typically 401[k] plans).

The plaintiffs are participants in Kraft's defined contribution plan, which had assets ranging from $1.5 billion to $5.4 billion between 1994 and 2010. They brought a class action alleging that Kraft and others breached their fiduciary duty by including two actively managed funds, a Growth Equity Fund and a Balanced Fund, among the investment options available to plan participants.

The consultants to the plan only considered funds with a minimum seven year track record, with at least $500 million under management. They focused on the past returns of the funds selected, which were the primary determinant.

This focus on past performance is typical of the way actively managed funds are selected, even though (as everyone except consultants to benefit plans is aware) past performance is not predictive of future performance. One study looked at hiring and firing decisions by 3,700 plan sponsors (public and corporate pension plan, unions, foundations and endowments) over a 10 year period from 1994 to 2003. Three years prior to hiring, the fund managers selected all had stellar records of beating their benchmarks. Post hiring excess returns were zero or less.

Notwithstanding the utter stupidly of selecting funds on the basis of past returns, this charade continues all over the country every day. Plan consultants pour over data trying to pick the next fund winner, blissfully ignorant or willfully blind to the data indicating this process makes no sense.

Here's the problem:

Those in charge of Kraft's defined benefit plan had already seen the light. They limited the investment options in the plan to fixed income and an S&P 500 index fund. The defined benefit plan had no actively managed funds based on the finding of the Investment Committee of "...the challenges of selecting consistently successful active managers, low costs of indexing, performance of indexing in down markets, and composition of the popular S&P 500 index."

In their lawsuit, the plaintiffs asserted the retention of two actively managed funds in the defined contribution plan violated Kraft's duty of prudence. They claimed the plan administrators in this plan should have followed the lead of the trustees in the defined benefit plan and dumped all actively managed funds.

In a stunning decision, Judge Ruben Castillo agreed to let this issue proceed to a jury trial. He held that, based on the conclusion of the Investment Committee for the defined benefit plan to drop all actively managed funds, a jury could conclude that the decision of the plan administrator and consultants to the defined contribution plan to retain two actively managed funds was a breach of fiduciary duty.

The ramifications of this holding are broad. A bevy of consultants, advisers, fund managers and insurance companies extol the merits of actively managed funds to retirement plan administrators. The cost to plan participants caused by the failure of most of these funds to equal the return of their benchmark index is in the hundreds of billions of dollars over time.

This decision should be a wake-up call to all trustees and plan administrators of retirement plans. Either they should pay attention to the data and replace actively managed funds with index funds, or risk the possibility of being liable for the shortfall.

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