Market volatility and defined contribution pensions: a new dawn for mass claims?

The recent fallout in global markets as a result of US President Trump’s trade tariff announcements may recall, to the minds of UK pension scheme sponsors, the fallout from the liability-driven investments (LDI) pensions crisis of October 2022. During this time, many defined benefit (DB) schemes faced urgent collateral calls due to a sharp rise in gilt yields. We considered (see here and here) the risk of legal claims arising from any losses suffered by DB schemes as a result of the LDI crisis. 

It appears that the DB scheme market has learned its lesson since in the current funding environment, most (well-run) DB schemes are now relatively well-hedged against market volatility. But what about DC schemes? The storm clouds may be gathering from a litigation perspective, as it has been reported in the financial press that DC scheme members have typically experienced a reduction in their projected retirement income due to volatility in 2025 of up to 20%.

Below, in the first of a series, we consider the potential risks of claims against employers and providers arising from losses suffered by DC scheme members as a result of sudden market downturns. We focus on default funds in which the vast majority of DC member pots are invested under both contract-based and trust-based arrangements. Based on experience in other markets, these funds can create litigation and reputational risks, because employees rely on the choices made by employers, trustees, and providers as regards asset allocation and ‘lifestyling’ strategies as individuals approach retirement. 

The US experience and class action claims

DC-related claims have yet to materialise in any meaningful way in the UK pensions context, where the transition from DB to DC has been a relatively recent phenomenon compared to the US market. In contrast, in the US claims brought against the employers of 401(K) plans – analogous to a UK workplace DC scheme – are relatively frequent. This is not least due to increased public awareness of financial matters since the 2007-2009 financial crisis, particularly for those members coming up to retirement.

In practice, claims under the applicable US regime (ERISA) are typically brought against 401(k) employers (as fiduciaries) for breach of ERISA duties in relation to selection, monitoring and payment of service providers, and for poor investment performance. There have reportedly been more than 500 such cases since 2016 alone.

Such claims are challenging to prosecute and many have not succeeded in practice, for several reasons. First, demonstrating breach of fiduciary duty under ERISA resulting in loss can be highly technical and difficult to evidence. Second, where an employer’s process for monitoring scheme investment is in line with prevailing market standards, the courts have tended to find no breach of the applicable standards. Third, where the investment fund selected by an adviser or provider underperforms, the courts interrogate the robustness of the selection process rather than the purely financial outcome from the employee’s perspective.

Nevertheless, despite these challenges, the associated reputational risks and the costs of defending class claims have created pressure on employers and service providers to settle such cases out of court (at considerable expense). 

Is the US experience a taste of things to come in the UK?

Many of the lawsuits targeting 401(k) fiduciaries (e.g. employers and investment advisers) in the US are structured as class actions. These mass claims are common in the US, which operates an ‘opt-out’ regime for financial services class actions. In contrast in the UK, financial services mass claims are – at least for the time being – based on the ‘opt-in’ principle only. In practice, this is a not-insignificant hurdle that may go some way to explaining the different experiences in each market. 

However, there are proposals from the government and regulators to create an opt-out regime in the UK for breaches of consumer law protections. It is plausible to envisage DC member claims falling squarely within the scope of such a regime in the future, particularly as employees are expected to increasingly become treated as ‘consumers’ (and benefit from the FCA’s consumer duty) through their membership of commercially provided pension schemes in future.

In our view, drawing on the recent precedent in the UK of mass equal pay claims in the employment field, there is a real risk facing employers and providers that adopting a US-style ‘opt-out’ regime in the UK would encourage litigation funders and other interested parties to pursue DC mass claims in the right circumstances. Further, we think that the new regulatory changes relating to (amongst other things) pensions transparency proposed to be introduced by the government, which will enable DC members to compare pensions performance across products, will help to facilitate such claims and lead to additional risks for employers and providers. We’ll be covering these developments in Part 2 of this series. 

If you would like to discuss any of the issues discussed in this blog post, please get in touch with your usual Freshfields contact or any of the authors.