403(b) Plan’s Use of Actively Managed TDFs Challenged in Lawsuit

A former participant of the MedStar Health Inc. Retirement Savings Plan has filed a proposed class action lawsuit against MedStar, its 403(b) retirement plan committee and individual committee members for breaching their fiduciary duties under the Employee Retirement Income Security Act (ERISA).

The lawsuit says the defendants not only selected and retained high-cost and poorly performing investments, but also failed to fully disclose the expenses and risk of the plan’s investment options to participants.

A significant amount of space in the complaint is dedicated to trying to discredit the use of the Fidelity Freedom Funds—a suite of 13 target-date funds (TDFs)—rather than “the substantially less costly and less risky” Freedom Index Funds or any other TDFs offered by Fidelity or any other provider. The participant alleges that the defendants failed to compare the actively managed Freedom Funds and index suite. “A simple weighing of the benefits of the two suites indicates that the index suite is a far superior option, and consequently the more appropriate choice for the plan,” the complaint states.

The lawsuit claims that designating the Freedom Funds as the plan’s qualified default investment alternative (QDIA) “exacerbat[es] defendants’ imprudent choice to add and retain the active suite.” It notes that approximately 58% of the plan’s assets were invested in the funds.

The lawsuit challenges the level of risk taken by the Freedom Funds’ portfolio managers across the glide path and delves into the underlying assets. “The active suite allocates approximately 1.5% more of its assets to riskier international equities than the index suite. The active suite also has higher exposure to classes like emerging markets and high-yield bonds,” the complaint says.

The Freedom Funds underwent a strategy overhaul in 2013 and 2014, giving managers the discretion to deviate from the glide path allocations by 10 percentage points in either direction, according to the court document. “Fidelity encouraged its portfolio managers to attempt to time market shifts in order to locate underpriced securities, which the firm dubs ‘active asset allocation,’” the complaint states, which it alleges “heaps further unnecessary risk on investors.”

The lawsuit alleges that since the strategy overhaul took effect, the index suite has outperformed the active suite in four out of six calendar years. In addition, it says the active suite “has substantially underperformed the index suite on a trailing three- and five-year basis.”

Finally, the complaint compares the fees for the Freedom Funds with those for the Freedom Index Funds. “While the Institutional Premium share class for each target year of the index suite charges a mere 8 basis points [bps] (0.08%), the K share class of the active suite—which the plan offers—has expense ratios ranging from 42 basis points (0.42%) to 65 basis points (0.65%),” it states.

Two other funds in the 403(b) plan’s investment lineup were mentioned in the lawsuit as being high-cost and low-performing, one of which had been removed in 2018. However, the lawsuit says, “Defendants’ failure to replace this underachieving investment option with better performing alternatives earlier than they ultimately did was a severe breach of fiduciary duty.”

The plaintiff alleges the defendants also failed to monitor the average expense ratios charged to similarly sized plans, saying “participants were offered an exceedingly expensive menu of investment options, clearly demonstrating that defendants neglected to benchmark the cost of the plan lineup or consider ways in which to lessen the fee burden on participants during the pertinent period.” According to the court document, from 2014 through 2018, the plan paid out investment management fees of 0.45% to 0.47% of its total assets, which it says is considerably more than those of comparable plans.

“The most recent Brightscope/ICI study published in June 2019 indicates that the average Total Plan Cost (TPC) for a plan with over $1 billion in assets [is] 0.28% of total assets as of 2016. Just the investment management fee component that the plan paid during the relevant period was 61%-68% higher than the average total cost for other large plans,” the complaint states.