Mutual funds managed $1.8trn (€1.2trn), or 48%, of assets in 401(k) and other defined contribution plans in the US as of end-June 2009. Annual management fees earned were more than $10bn but these are now at risk of being cut because of two pending legal decisions. One will be made by the Supreme Court on a case about how much money-management firms can charge. The other one will be made in Congress. The House education and labour committee has already approved the 401(k) Fair Disclosure and Pension Security Act, while the Senate special committee on ageing has its own legislation.

The momentum is particularly in favour of reducing the fees and making them more transparent. The mutual fund industry is under attack from both the tort lawyers, who are filing lawsuits on behalf of clients claiming they paid excessive fees, and the Obama administration, as the Securities and Exchange Commission is siding with them.

This political climate helps explain why Caterpillar has agreed to pay $16.5m to settle a lawsuit alleging that its 401(k) retirement plans charged excessive fees to employees. It maintains it has complied with federal law pertaining to its four 401(k) plans, but decided to avoid years in litigation. The suit was filed in 2006 by St Louis attorney Jerome Schlichter, who is also suing 10 other large companies over excessive 401(k) expenses.

A better disclosure of fees is one of the points of the 401(k) Fair Disclosure and Pension Security Act, which also provides incentives for 401(k) plans to offer at least one low-cost index fund investment option.

The US Supreme Court’s ruling will affect the pension industry in an indirect way. The case under examination is called Jones versus Harris Associates and was filed in 2004.

The plaintiffs are three shareholders in the Oakmark mutual fund family, which is managed by Harris. They allege that Harris charged Oakmark funds a 0.88% fee on $6.3bn in assets, nearly twice the 0.45 percentage rate for an unrelated institutional client like a pension fund. They add that Oakmark’s manager, William C Nygren, took home $12m in 2002, compared with the average portfolio manager’s pay of $800,000.

They conclude that the fund boards didn’t accomplish their fiduciary duty while negotiating management fees, because they are often too closely tied to advisers to drive hard bargains. Harris responds that servicing the Oakmark funds is more demanding than work for independent clients such as pension funds. John Bogle - founder of mutual-fund company Vanguard Group, which sells mostly low-fee index funds - has filed a friend-of-the-court brief backing shareholders. “The law just went down the wrong road and let management fees get totally out of hand,” said Bogle.
In 2007, a federal district judge in Chicago rejected the suit against Harris, citing the so-called Gartenberg standard for judging fund fees. This was established by a 1982 court ruling in the case of Gartenberg versus Merrill Lynch Asset Management.

The Gartenberg standard states that for a fee to be considered excessive it needs to be so “disproportionately large” that there is no way the fee negotiations could have been conducted at arm’s length. But Judge Easterbrook, writing the opinion in favour of Harris, said the district court need not have followed the 1982 ruling in the first place, “because it relies too little on markets”, and that in the mutual fund market the sophisticated investors who do negotiate on fees create a competitive pressure that protects the others.

During the first hearing at the Supreme Court, Chief Justice John Roberts agreed with that ‘free market’ view: “These days, all you have to do is push a button and you find out exactly what the management fees are. You just look it up on Morningstar and it’s right there and you can make… whatever determination you’d like, including to take your money out.”

The fund industry’s trade association, the Investment Company Institute, is concerned that if the Supreme Court changes the legal standard governing fees it will invite a deluge of investor suits. A ruling is expected before the end of June 2010.