The Risks of Custom TDFs

How quickly does a fiduciary have to remove an underperforming investment from its plan’s investment menu? And under what circumstances can custom funds be deemed imprudent? Melina Jacobs v. Verizon Communications, a case brought before the U.S. District Court for the Southern District of New York in 2016, took on these questions.

The suit, like many brought under the Employee Retirement Income Security Act, was settled out of court—in this case, after seven years of litigation. Although settlements do not carry the force of precedent or contribute to case law, the case still offers some thought-provoking insights into these questions.

The Case

In February 2016, Melina Jacobs brought a complaint under ERISA alleging that her former employer maintained investments on its defined contribution plan menu that underperformed and had excessive fees.

Specifically, the suit alleged that Verizon maintained custom “funds of funds,” including a custom target-date fund suite, that carried “excessive risk and redundant layers of fees” and underperformed “off-the-shelf” TDFs. The complaint cited a Vanguard managed suite as an example of a target-date fund that had lower fees and higher performance than did the Verizon custom suite over the class period, starting in 2010.

The investments, the plaintiff alleged, underperformed partly because of their complexity and partly because of their customized nature—both of which drove up management fees—but also because Verizon failed to adequately monitor the component funds within each investment. 

The Global Opportunity Fund, one fund within many of the custom funds, was identified in particular by the plaintiff for underperforming its benchmark over several years and should have been removed, the complaint said. According to its prospectus, the Global Opportunity Fund is an actively managed global equity value fund that uses a strategy aiming to “add value, relative to its benchmark, by investing in the most attractive markets on a global basis, while simultaneously underweighting, or shorting, markets that are viewed by the fund managers as overvalued.”

The lawsuit characterized these funds as a “multi-dimensional labyrinth of actively managed ‘custom’ investment choices.”

In response, Verizon filed a motion to dismiss, which was denied in September 2017. 

The court ruled that the factual allegations in the complaint were adequate to state a claim: “The Complaint pleads that the Verizon defendants kept—as a ‘core asset’  most of the Verizon Plans’ investment options—a fund that had wildly underperformed its benchmark over a 10-year period. This fund also barely surpassed the return of a money market investment, which offered much less risk. Finally, the Global Opportunity Fund—despite its poor performance—featured an expense ratio higher than any other investment option available to Verizon plan participants. These allegations are sufficient to defeat a motion to dismiss.”

The parties went on to negotiate, this July, a settlement of $30 million for a class of approximately 160,000 participants. One-third of the settlement will go to the law firms representing the class, with the remainder going to plan participants as tax-deferred contributions to their accounts or rollovers into individual retirement plan accounts.

The Discussion

Despite the settlement, this case provides important insights for fiduciary retirement advisers.

Daniel Aronowitz, the owner and founder of  Euclid Speciality Managers, underwriters of  fiduciary insurance in Washington, says holding fiduciaries to account for investment underperformance over a brief period of time “could potentially open up many plans to allegations of underperformance.” 

The plaintiffs argued that fiduciaries should switch out investment options after 36 months of underperformance, but, Aronowitz says, this really is not long enough to fairly judge the prudence of an investment, especially in a retirement context.

Retirement investments are normally made with an eye toward the long-term, and one cannot determine whether the fund is underperforming unless “at least five to 10 years” have passed and the asset has shown clear signs of distress. Aronowitz says most advisers recommend against switching out retirement investments frequently, as this can result in unnecessary losses and higher fees.

… one cannot tell whether the fund is underperforming unless “at least five to 10 years” have passed and the asset has shown clear signs of distress.

The Global Opportunity Fund was first introduced to the plan in 2007 and removed in 2017, a 10-year span, but, Aronowitz notes, “2008 was a washout for the entire market,” and many other investments underperformed their benchmarks as well.

Further, Verizon made changes to its fund offerings in the meantime during its quarterly fiduciary meetings, “tinkering” with them and “was hardly asleep at the wheel.” 

Mark Boyko, an ERISA plaintiff attorney in St. Louis, along with partner Bailey Glasser, says that funds of funds such as those in Verizon’s plan, are not uncommon among larger plans. These funds do require “greater diligence on the underlying funds,” and this “generally involves higher fees,” but larger plans can often accommodate this burden prudently through “economies of scale.”

Yet, Boyko explains, custom funds, though not inherently imprudent, are still suspect. “Off-the-shelf” funds from asset managers “generally have lower fees” and “have asset allocations that have been tested across multiple economic cycles,” echoing arguments made in the plaintiff’s pleadings.

Some fiduciaries will create custom funds to meet the specific investment needs of their participant population, but this is something of a “cop-out,” Boyko says, because off-the-shelf funds, especially TDFs, are also designed with specific investment needs in mind. “The goal of all target-date funds,” custom or not, “is to prepare the participant for retirement around the date of that target-date fund.” There is thus little to no advantage in making custom TDFs, at least for most plan sponsors, he says.

Although “no investment is inherently prudent or imprudent,” under ERISA, according to Boyko, it is imprudent to include an investment if it has a lower return but with a similar risk profile as another similar product—which the plaintiffs alleged of various funds in the Verizon plan.

Boyko says the case law on timing is thin. How quickly an investment should be dropped due to underperformance is something that “experts will debate in basically every case.” 

Despite this vagueness, Boyko noted some features that can make funds an easy target for a lawsuit that advisers should keep in mind.

He notes that some funds can be tested based on their strategy rather than timing. If a fund says, for example, that it protects investors from an economic downturn, and then does significantly worse than the market average during a recession, then there is hardly a need to debate a specific number of years a fiduciary should wait before removing the investment. The hypothetical fund “didn’t do what it was supposed to do, and sometimes you can tell that very quickly.”

Aronowitz and Boyko both agree, however, that it can be difficult to predict which cases proceed past the motion to dismiss stage. “We think it’s a crapshoot,” Aronowitz says. “The same set of facts can go either way, depending on which judge you have.”

Boyko says, “If you find a pattern” to which cases beat motions to dismiss, and which ones do not, “Please let me know.” He adds that there is a “certain level of inconsistency in what cases are dismissed and which ones aren’t,” but complaints challenging funds that are brand new, that have a long period of underperformance, or that represent a conflict of interest for the fiduciaries are more likely to survive a motion to dismiss.