With more than 100 lawsuits filed against the fiduciaries of defined contribution retirement plans for breach of their responsibilities, litigation has plagued the retirement plan industry over the past decade.
While the original lawsuits focused on large corporate 401k plans, litigation has expanded to include large healthcare organizations and higher education institutions, with more than twenty suits filed against these sponsors since 2016.
Other lawsuits have even trickled down to medium- and small-sized retirement plans, rendering all plan sponsors as potential targets.
The claims in these lawsuits cover a broad range of topics and issues related to actions taken or not taken that may have limited the potential growth of plan participant account balances.
Most of the claims focus on fees charged in the plan, or investments used that have not performed adequately to yield the return participants should have received.
To address each of the alleged fiduciary breaches in one article would be a lengthy examination. Instead, we have developed a series of articles to provide a more in-depth exploration of the issues.
Topic No.1: Active versus passive investments
In many of the lawsuits filed against the fiduciaries of defined contribution retirement plans, there have been claims that the plan sponsor included one or more investments in the plan lineup that underperformed the particular benchmark for the fund’s asset class.
These are all actively managed funds. While passive investments seek to mirror the asset class index holdings, as to achieve the benchmark investment return less fees, active managers try to surpass the index net of fees. In practice, consistently beating the benchmark is a challenge that many managers fail to overcome.
Particularly in large-cap domestic equity asset classes, this has been especially true over the last 10-15 years with the growth in the equity markets. “While a fund manager may outperform for a year to two, the outperformance does not persist. After 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92% are trailing the index.”(1)
Additionally, actively managed funds cost more than index options. While passively managed funds may use a computer program to match the holdings of an index, active managers must conduct extensive research, often with a team of analysts, to identify investments that meet the fund’s objective and that will help the fund outperform the benchmark.
The research and analysis required of actively managed fund managers typically leads to much higher fees compared with the index options in the same asset class.
This results in some active managers underperforming their asset class benchmark while charging higher fees to participants. The fiduciary breach lawsuits state that the manager failed to competently select the underlying holdings, which cost the participants potential for investment return, and that participants are not receiving any value for these higher fees. Thus, the claims argue that fiduciaries should have used passive investment options instead of active ones in the plan.
In many of these lawsuits, this claim includes a comparison of a more expensive actively managed investment with a cheaper passive option in the same asset class.
This is reflective of a broad-based movement in defined contribution plans towards using index funds instead of active investments.
“When it comes to mutual funds and exchange-traded funds that buy U.S. stocks, those that passively track indexes now hold 48% of assets, according to estimates from Morningstar, Inc. They’ll top 50% in 2019 if the current trend holds.” Ten years ago, 74% of assets were held in actively managed strategies.(2)
In the proceedings of some of these lawsuits, the claim over the imprudence of offering active instead of passive options has survived the motion-to-dismiss stage. In Henderson v. Emory University, the plaintiff’s suit argued that the actively managed large-cap funds in the plan could have been merged into an index fund to save the participants money.
“Had Defendants removed the large-cap domestic equity blend funds and the amounts been invested in a lower-cost passively managed index fund, such as the Vanguard Total Stock Market Index Fund-Instl Plus, Plan participants would not have lost in excess of $117 million from these funds being retained in the Plans.”(3)
In some cases, this type of claim has incorporated the issue that the active option was a proprietary investment of the recordkeeper.
In Clark v. Duke University, the plan offered the full array of TIAA variable annuity investments, including CREF Stock. The plaintiff claimed that CREF Stock was imprudent because it significantly underperformed its benchmark, but was included in the lineup specifically because of the benefit to TIAA.
“Defendants failed to undertake such analysis when they selected and retained the actively managed CREF Stock Account, particularly due to TIAA-CREF’s requirement that the CREF Stock Account be provided in the Plan in order to drive revenue to TIAA-CREF. Defendants also provided the fund option without conducting a prudent analysis to determine whether this actively managed fund would outperform index funds, net of fees, over the long term.”(4)
The plaintiff’s argument is that the plan sponsor should have replaced the active CREF Stock option with an index fund. Surviving the motion-to-dismiss suggests a concern that the fiduciaries may not have sufficiently explored potential alternatives in each asset class, but instead settled for their recordkeeper’s actively managed investment options.
However, in other lawsuits, this claim has been rejected. In Divane v. Northwestern University, the judge dismissed the claim of imprudence for offering more expensive actively managed investments because low-cost index funds were also available in the plan lineup.
“Plaintiffs have alleged that the plans offered them the very types of funds they want. That is not a breach of fiduciary duty.”(5)
A similar result occurred in Cates v. Trustees of Columbia University. The plaintiffs claimed that the plan fiduciaries included active investments in the plan that were far more expensive than passive options in the same asset class also available in the plan lineup. This was among the counts in that lawsuit that were dismissed by the judge.(6)
This type of claim has also been defeated at trial. In Wildman v. American Century, the judge sided in favor of the defense, as the defense was able to show that the retirement plan committee thoughtfully debated the issue and opted to use actively managed options.
“The record also shows that far from being diametrically opposed to passively managed funds, the Committee had constant conversations about adding passive options to the Plan. In 2016, the Committee decided to add Vanguard index funds to the Plan.”(7)
Similarly, in White v. Chevron Corporation, the presiding judge acknowledged that active management has a place in a retirement plan, and that comparisons with passively managed investments are inappropriate, given the difference in strategy and objectives between active and passive management.
What does this mean for plan sponsors?
Based on the outcomes of the litigation surrounding this issue, it seems clear that plan fiduciaries can include actively managed investment options in their plans. There is nothing in the ERISA regulations that requires a plan to include any index investment options, or to select passive funds instead of active options in any particular asset class.
However, it will likely help lessen the chances of being sued on this issue if there are at least some index funds included in the investment lineup.
As per the Northwestern University case referenced above, the fact that lower cost index options were available within the investment array, despite the lineup also containing more expensive options, helped sway the judge into dismissing the claim.
Plan sponsors may want to consider including a mix of both active and passive investments in their plans.
For example, offering passive funds in a variety of asset classes, such as intermediate bond, large-cap equity, mid/small cap equity and international equity, allows a participant interested in investing exclusively in index funds to do so while fully diversifying his/her portfolio.
This enables the lineup to cater to all types of investors—those wanting only active options, only passive funds, and those seeking a blend of both.
SOURCES
(1) Data Source: S&P Dow Jones Indices, LLC, 12/2018
(2) Data Source: Morningstar, Inc., 11/2018
(3) Henderson v. Emory University, Complaint, 2016
(4) Clark v. Duke University, Complaint, 2016
(5) Divane v. Northwestern University, Dismissal, 2016
(6) Cates v. Trustees of Columbia University, Motion-to-Dismiss Memorandum, 2017
(7) Wildman v. American Century, Opinion & Order, 2019
Earle W. Allen, MBA, CEBS, serves as principal at CAPTRUST. He was formerly partner with Cammack Retirement Group.
