Compliance July 19, 2021

Judge Moves Forward Lawsuit Challenging Use of Active TDF Suite

She found the allegations were sufficient to plausibly allege a fiduciary breach and said the determination for appropriate benchmarks for funds is not solved at the motion to dismiss stage.

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A federal district court judge has denied dismissal of two claims in a lawsuit against Prime Healthcare Services.

Current and former participants of the Prime Healthcare Services Inc. 401(k) Plan filed a proposed class action lawsuit last year against the company and its 401(k) plan committee alleging they failed to fully disclose the expenses and risk of the plan’s investment options to participants; selected and retained high-cost, poorly performing investment options; and allowed unreasonable expenses for recordkeeping.

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A considerable amount of space in the complaint is dedicated to challenging the plan’s offering of the Fidelity Freedom Funds target-date fund (TDF) suite. The lawsuit alleges that the defendants failed to compare the actively managed Fidelity Freedom Funds to the passively managed Freedom Index Funds TDF suite and consider their respective merits and features. The complaint says the actively managed TDF suite was riskier and more expensive than the index suite.

In her discussion regarding her reasoning for allowing the breach of Employee Retirement Income Security Act (ERISA) fiduciary duties claim to move forward, Judge Josephine L. Staton of the U.S. District Court for the Central District of California noted that of the 29 Fidelity funds in the active TDF suite, 17 of them trailed their respective benchmarks over their respective lifetimes as of September 2020.

According to the court document, the active suite also had a significantly higher expense ratio than the index suite, despite consistently underperforming the index suite based on three- and five-year annualized returns. The active suite further underwent a “strategy overhaul” in 2013 and 2014 that gave its managers discretion to deviate from glide path allocations to time market shifts to locate underpriced securities. As a result of this “history of underperformance, frequent strategy changes and rising risk,” investors began to lose confidence in the active suite, as indicated by significant capital outflow; in 2018, the series experienced approximately $5.4 billion in net outflows, and the plaintiffs allege that nearly $16 billion has been withdrawn from the fund family over four years prior to 2018. The defendants continued to use the active suite as the plan’s qualified default investment alternative (QDIA) for as long as it was an option in the plan’s investment menu.

Staton found these allegations sufficient to plausibly allege that the defendants failed to act “‘with the care, skill, prudence and diligence’ that a prudent person ‘acting in a like capacity and familiar with such matters’ would use.”

The defendants argued that the complaint does not include any allegations about the process plan fiduciaries used to select the Freedom Fund TDFs as opposed to the index TDFs or other types of investments. But Staton agreed with the plaintiffs that “to state a claim for breach of fiduciary duty [under ERISA], a complaint does not need to contain factual allegations that refer directly to the fiduciary’s knowledge, methods or investigations at the relevant times.” She found the allegations sufficient to allow a reasonable inference of a flawed process.

The defendants also argued that the plan fiduciaries removed the active suite from the plan in 2019 and that the plaintiffs do not allege any facts showing the defendants acted imprudently with regard to the active suite during the period the plan actually held those funds. For example, the defendants point out that the three- and five-year performance analysis in the complaint is based on data as of September 20, 2020, which would include a period of time during which the plan did not offer the active suite. Staton said that at the pleading stage, this data is sufficient to support an inference that the active suite was consistently underperforming the index suite during the relevant time period. In addition, she found that the plaintiffs did allege additional facts supporting an inference of imprudence preceding the plan’s removal of the active suite.

Lastly, regarding the breach of fiduciary duties claim, the defendants argued that “courts routinely reject attempts to create an inference of an imprudent process through comparisons of the performance and fees of actively managed funds to those of passively managed funds.” Staton agreed that, where plaintiffs allege “‘a prudent fiduciary in like circumstances would have selected a different fund based on the cost or performance of the selected fund,’ they must provide a sound basis for comparison—a meaningful benchmark.” However, citing prior case law, she said, “Courts have specifically held that the determination of the appropriate benchmark for a fund is not a question properly resolved at the motion to dismiss stage.”

Regarding the plaintiffs’ failure to monitor co-fiduciaries claim, Staton noted that the defendants argued that this claim is derivative of the plaintiffs’ first claim and must be dismissed if they cannot adequately plead an underlying breach of fiduciary duty. However, because Staton found that the plaintiffs did adequately plead their first claim, she declined to dismiss the failure to monitor claim on this basis.

Staton did, however, grant the defendants’ motion to dismiss the plaintiffs’ third claim which alleged that “in the alternative, to the extent that any of the defendants are not deemed a fiduciary or co-fiduciary under ERISA,” they are liable for participating “in a knowing breach of trust.”

Staton gave the plaintiffs 21 days to amend their complaint to address the deficiencies she identified in her discussion.

Investing July 19, 2021

How Multiemployer Plan Sponsors Can Manage Relief Payments

With PBGC dictating interest rate assumptions and permissible investments, there are steps plan sponsors should take to make the relief work as intended.

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The American Rescue Plan Act (ARPA) allows multiemployer plans that are in critical and declining status to apply to receive a lump sum of money to make benefit payments and pay expenses for the next 30 years, or through 2051. They must track the money they receive and earnings on that money separately from other funds.

The Pension Benefit Guaranty Corporation (PBGC) has issued an interim final rule that lays out the requirements for special financial assistance (SFA) applications and restrictions and conditions on the amounts received. This includes the interest rate assumption to be used in calculating a plan’s benefit obligations to be considered when calculating the amount of assistance, as well as how the SFA assets can be invested.

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Shivin Kwatra, head of liability-driven investing (LDI) portfolio management at Insight Investment, says PBGC made it clear that the rate plans will need to use is the lesser of the third segment rate plus 2.5 basis points (bps), which is roughly 5.5%, or the interest rate the plan used in its Form 5500 filing with the Department of Labor (DOL). Kwatra says that for most plans, that is also 5.5%, but for certain troubled plans it will be lower. For example, for the Central States, Southeast and Southwest Areas Pension Plan, it is 3%.

He notes that there is a potential for inequity because of the discount rate some plans use versus others; plans might have the same obligations but get different SFA payments.

“We were hoping for better alignment with market rates, but that’s not the direction regulators wanted to take,” Kwatra says. He notes that in the interim final rule, PBGC said it was only sanctioning investment-grade bonds as permissible investments for the SFA payments at this time, which could be a critical challenge for plans. Kwatra says yields on those today are closer to 3%, so there will be a gap between what the relief assets earn and the obligations plans will need to pay out based on a 5.5% interest rate assumption.

Sue Crotty, senior vice president and multiemployer practice leader, Segal Marco Advisors, says under the existing investment restrictions, there isn’t a way for plans that get assistance to get to a 5.5% return.

“Even a high-yield bond today is returning around 3.8%, and that isn’t even contemplated at some durations,” she says. “Investment-grade bonds return around 2%, and there’s no leverage on that, so it’s a problem.”

Crotty points out that the PBGC interim final rule allows for 5% of the SFA assets to be invested in so-called “fallen angels.” She explains that PBGC says if plan sponsors bought a vehicle that was considered investment grade at the time, but fell to a lower rating, they can hold onto such vehicles for up to 5% of the portfolio. “Fallen angels will be trading above investment-grade bonds, but that won’t help to reach the 5.5% needed return,” Crotty says.

Plan sponsors are left with looking at the combination of the two pools of assets—SFA plus legacy—to get to a point where they can meet benefit obligations at least through 2051, says Crotty. Adding equities may be one way to try to get the combined pool of assets to meet obligations. “Since many plans close to insolvency had been de-risking, they can now consider putting more back into equities,” she says.

Adam Levine, investment director of Aberdeen Standard Investments’ Client Solutions Group, says once the separated funds are placed in investment-grade fixed-income vehicles, there’s an opportunity for multiemployer plan trustees to revisit their overall investment strategy.

“Certainly, the portion of assets not dedicated to SFA can be tweaked to reach the plan’s overall goal,” he says. “The overall allocation should be examined after factoring in the requirements for separated assets.”

Levine says that could potentially mean taking more risk with legacy assets. “I’m not saying equities are the right answer, but potentially they are,” he says. “We also think it’s a positive advancement in investment strategy to focus on meeting obligations. That provides a metric to be measured and a goal.”

Levine explains that the plan’s overall allocation will experience an increase in fixed income with the mandate for segregated assets, so there’s an opportunity to reallocate current assets. He adds that a cash flow-driven investment strategy should be at forefront.

“Using buy-and-hold fixed-income strategies, where maturities line up with the benefits owed, can increase the likelihood of fulfilling benefit obligations through a certain amount of time,” Levine says. “Plans will likely remain underfunded, so that strategy won’t be successful for the longer term, meaning more risk assets will be needed. So it’s a combination of buy and hold, higher yielding strategies for short-term investments that potentially have less risks, and then risk assets to potentially cover the longer-term obligation—ideally those that provide a return benefit to make up for underfunding.”

Kwatra says plans that are better funded can continue to use a liability-matching approach to investing, but those that aren’t well-funded might be forced to take more risk. He echoes Levine’s sentiment that if a plan takes on more risk in investments, it must also manage its cash flow. He notes that many of these plans are in decumulation—meaning there are more retired participants than active ones—so it will be important to manage cash flow to make sure they can pay out benefits.

The SFA is designed to cover obligations for the next 30 years, but most plans probably will be paying out benefits longer than that. If they re-risk and there’s a downturn in the market, the plans could run out of money. Kwatra says plans’ trustees boards will have to make decisions about how to invest existing assets. A “high certainty” approach would be to use LDI, matching liabilities with investments, while also considering cash flow needs. However, those plans that are less funded wouldn’t want to do this because they don’t want to lock in their inability to meet their benefit obligations, he says.

Good Governance

Crotty suggests that the same board of trustees manage both pools of assets.

“They would be better off using the combined buying power to hire investment managers for SFA assets,” she says. “They need low-cost vehicles or separate accounts, depending on the plan’s size, to help meet obligations.”

Crotty also notes that PBGC said plan sponsors don’t necessarily have to pay benefits and expenses out of one pool of assets. “Plan trustees could pay benefits and expenses out of legacy assets if they want, but the reality is, if they’re trying to get to a 5.5% rate of return, it might be best to pay benefits out of the SFA pool,” she says.

Finally, Crotty says multiemployer plans should focus on their fiduciary responsibility for the combined pool of assets. “They should make sure they have investment advisers that take full fiduciary responsibilities,” she says.

Crotty notes that PBGC was very explicit asking for comments—there were four questions asked—so it’s possible the regulator will expand on its permissible investments.

Kwatra says, “In conversations with regulators, we were arguing for a market-based discount rate, which would allow plans to get more money to be better funded and pursue a liability-based investment approach and ensure they can pay benefits.” With the parameters the PBGC set, he adds, “we think it will be a balancing act between return generation, risk management and cash flow management. Plans will have to be cognizant about selling risk to have the cash flow they need.”

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