Compliance June 28, 2017

Waddell & Reed Charged in 401(k) Self-Dealing Suit

The lawsuit claims fiduciaries of the Waddell & Reed 401(k) plan breached their fiduciary duties and engaged in prohibited transactions in the selection of the plan’s investment lineup.
Reported by

Stacy Schapker, acting individually and on behalf of the Waddell & Reed Financial Inc. Section 401(k) and Thrift Plan and all participants in the 401(k) plan from June 23, 2011, through the present, has filed a lawsuit alleging breach of fiduciary duty and prohibited transactions under the Employee Retirement Income Security Act (ERISA) against Waddell & Reed Financial Inc. (“WR FINANCIAL”), which serves as the 401(k) plan’s administrator and one of its employer sponsors, as well as other defendants.

The complaint alleges that, instead of acting for the exclusive benefit of the 401(k) plan and its participants and beneficiaries, the defendants acted for the benefit of WR FINANCIAL and its affiliates, forcing the plan nearly exclusively into investments managed by WR FINANCIAL or an affiliated entity, which charged excessive fees that benefited WR FINANCIAL or its affiliated entities and which performed worse than comparable available options. The lawsuit says the defendants could have chosen nonproprietary, less costly, better-performing investment options for the plan.

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The defendants are accused of offering as investment options in the plan whatever investment products were part of the lineup of Waddell & Reed and Ivy Funds investment products then on the market—i.e., funds established and managed by WR FINANCIAL and its affiliates. According to the complaint, “the only criteria (or virtually the only criteria) used by Defendants when determining what investment options to make available to the 401(k) Plan participants was whether the investment product was part of the then-available line-up of Waddell & Reed and Ivy Funds investment products established and managed by the 401(k) Plan’s own Administrator, WR FINANCIAL, or its affiliates.”

In this way, the lawsuit claims, the defendants breached their fiduciary duties and engaged in prohibited transactions.

The complaint adds that, in a number of cases and during a substantial portion of the class period, the plan’s investment menu was duplicative in content but not cost—i.e., the same investment product with the same holdings cost more when branded as Waddell & Reed than as Ivy. In the complaint, Schapker also claimed that plan fiduciaries violated their duties under ERISA by failing to offer plan participants investment options that were operated and managed by someone other than WR FINANCIAL or its affiliates and that cost less and performed better.

Additionally, she said fiduciaries failed in their duties by selecting as the plan’s default investment option an investment product that WR FINANCIAL or one of its affiliates operated and managed, and by failing to concentrate assets so as to qualify for investment funds that had lower fees and leverage plan assets to drive down fees.

The lawsuit seeks losses that the 401(k) plan has sustained and the disgorgement of all unlawful fees, expenses and profits the defendants have taken, as well as any further equitable or remedial relief  appropriate under ERISA.

Data and Research June 27, 2017

Tracking Risk in a TDF Glide Path

TDFs typically address risk by switching to fixed income as opposed to equity as a participant ages, but a closer look under the hood can reveal deeper insights to downside protection.

Reported by

Pulling assets out of a defined contribution (DC) plan during a severe market downturn is one of the worst actions a plan participant can take, says Jake Gilliam, senior multi-asset class portfolio strategist, Charles Schwab.

The firm recently released a white paper exploring how understanding behavioral finance among other factors can influence glide path design in target-date funds (TDFs), one of the most widely used default investments in the DC space.

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Based on an analysis of its recordkeeping system as well as data from the Bureau of Labor Statistics and the Employee Benefit Research Institute (EBRI), Charles Schwab drew distinct investor profiles depicting how participants typically save at different age groups. For example, it found deferrals typically begin at 4% of salary per year for the youngest investors at around age 23 and steadily rise as salary, tenure, and age increase until a typical final deferral rate of 7% is reached.

Taking this and other data into consideration, the firm recommends plan sponsors selecting TDFs should thoroughly analyze their participants’ demographics and risk profiles to match them with the right TDF provider and glide path.

“Participants in general react very poorly to negative market events,” Gilliam explains. “They also are subject to performance chasing and overall inertia. Investors need to have a plan that helps them save for the long term and has the appropriate amount of risks, so they don’t abandon that plan at the absolute worst time.”

NEXT: Addressing down-side risk

To address these concerns, he says a glide path should focus on downside-risk protection and volatility control to defend against potentially negative behaviors investors may take during market downturns, especially near or in retirement when preservation of assets is crucial and time to recover is minimal.

Generally speaking, TDFs manage risk by becoming more conservative over time and devoting larger allocations to fixed income versus equity. But Gilliam argues that underlining securities deserve just as much scrutiny as the asset mix itself.

He says investors also need to be protected at “the sub-asset class level." Within stocks and bonds, there may be higher exposure to asset classes that might have more volatile events like emerging markets and international equity when participants can tolerate it earlier in their careers. "By the time you’re in retirement, we would have removed the direct exposure to emerging markets. Within fixed income, we’re blending active and passive exposures to make sure that we have a balanced approach to safe government and agency type securities as well as prudent exposure to credit. And we’re also introducing a dedicated allocation to TIPS 10 years prior to retirement. And we’re increasing our short duration and cash exposures to make sure we have an appropriate amount of interest-rate sensitivity and liquidity,” he adds.

To develop the glide path for its own TDFs, Charles Schwab used a proprietary metric called the risk-proxy. This outlines a projection of appropriate risk level at different age groups and investment phases: Initialization, accumulation, transition, and retirement. It also takes into account financial capability or a measure of the present value of existing accrued savings balances, and human capital or present value of future income and how that may translate to future contributions. All things being equal, low financial capital indicates higher risk tolerance. But this tends to increase with age presumably putting a higher account balance at risk as investors accumulate more.

Gilliam suggests that the glide path of a TDF should consider these evolving risk levels during retirement as well. Its research finds the typical retirement age to be 65 and life expectancy to be 85.

“We know the retirement needs of every investor will vary,” Gilliam notes. “What we’re assuming is a very conservative approach that there will be no post-retirement job. We’re looking at what people have accumulated through the glide path and how that could help them live in retirement under various withdrawal scenarios.” He says the right glide path should aim to prepare someone to withdrawal even 5% to 6%, adjusted for inflation, for decades into retirement.

He adds that the glide path needs to address the real dollar value that’s at risk and avoid exposing participants to what they can’t handle at the worse times. “Assume a 10% loss on retirement balances across the age range. For younger participants, say that’s on average a $600 loss. That will be minuscule in importance in the long term given the importance of contributions relative to volatility at that stage. Conversely, for someone who is nearing or in retirement, a 10% loss could be $40,000 to $50,000 or years lost in retirement savings.”

He says the glide path design needs to emphasize protection against downside events. “We want to encourage long-term savings behavior and not have a near retiree flee the market after a 2008-like event.”

Instructions for downloading a copy of Behavior-Driven Glide Path Design can be found at Schwabfunds.com.  

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