The Supreme Court, per Justice Sotomayor, issued a unanimous opinion this week in Hughes v. Northwestern University.  That somewhat unusual moment of agreement among the Justices was likely due to the fact that the opinion clocked in at a mere 6 pages, and left the hard stuff unaddressed.

Hughes was about the duties of an ERISA plan administration when constructing a defined contribution plan menu.  In this case, Northwestern University maintained a defined contribution plan with 240 fund choices, some of which were very very good, and some of which were very very bad.  For example, the menu included low-cost index funds, but it also included retail share classes of certain funds even though the plan could have qualified for lower-cost institutional share classes.  The menu also, according to plaintiffs, included various underperforming and high fee funds that should have been eliminated.

The Seventh Circuit held that none of that mattered because the menu was sufficiently large to satisfy all preferences.  Calling the plaintiffs’ arguments “paternalistic,” the court explained that “[p]laintiffs failed to allege, though, that Northwestern did not make their preferred offerings available to them. In fact, Northwestern did. Plaintiffs simply object that numerous additional funds were offered as well. But the types of funds plaintiffs wanted (low-cost index funds) were and are available to them.” (quotations omitted).

The Supreme Court reversed.   The Court held that regardless of whether the plaintiffs’ preferred options were available, an ERISA fiduciary must conduct “their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options.  If the fiduciaries fail to remove an imprudent investment from the plan within a reasonable time, they breach their duty.”  Because the Seventh Circuit had not conducted that analysis, the Court remanded for a do-over.

So, first, it’s notable that the Court did not hold that plaintiffs had actually stated a claim.  The Court only held that an ERISA fiduciary has an independent duty to determine whether particular investments can be “prudently included,” and allowed the Seventh Circuit to decide in the first instance whether any of the funds identified by plaintiffs did not meet that standard.

Second, though, the opinion leaves open a lot of questions about what it means to say that funds should not be prudently included, and, in particular, just how “paternalistic” an ERISA fiduciary should be.  Retail vs institutional share classes are in some ways the easiest possible case; if retail classes are offered when institutional ones are available, the fiduciary is simply charging the beneficiary unnecessary fees.  Indeed, this is precisely why the SEC announced its “share class disclosure initiative,” to deal with investment advisers who recommend higher cost share classes to clients when lower cost ones are available.

But the more interesting question is whether options should be removed from the menu not because they are, standing alone, completely unsuitable for any beneficiary, but because the menu as a whole is too challenging for the beneficiary to be able to make good choices. 

We know that ERISA menus need to be considered as a whole; after all, as the Supreme Court said in this case, a fiduciary has an “obligation to assemble a diverse menu of options.”  It might be perfectly appropriate for a menu to include a low-cost diversified bond fund, but the menu would be imprudent if it included nothing but low-cost diversified bond funds.

What if, however, the menu included 50 diversified bond funds, and 50 diversified stock funds, and 50 target date funds, and so forth?  The plaintiffs, and their scholar amici, argued this too would be imprudent because it would simply be too difficult for a normal, unsophisticated plan participant to parse.  The plaintiffs, for example, mentioned the problem of “decision paralysis,” while the scholars highlighted investors’ “bounded rationality” and explained how long menus could tax investors’ attention spans and lead them to either make poor choices, or opt out of the plan entirely.  In the scholars’ view, 240 options was just way too many; a good plan should only include 20-30.

Significantly, though, the United States as amicus in support of the plaintiffs did not sign on to that argument; instead, it only agreed that plaintiffs had stated a claim with respect to the retail share classes (it also agreed with some arguments about recordkeeping fees).

Which is in some ways what I’d expect.  In my essay, A Most Ingenious Paradox, I argue that there’s a kind of a political interest in making sure that a broad array of mutual funds remain on the market – even if that’s not necessarily the best choice for retail investors.

Anyhoo, point being, all of these questions are still left unanswered, though it strikes me that the Seventh Circuit is unlikely to be a receptive audience for arguments about bounded rationality.