Compliance April 23, 2019

Revenue Sharing, Soft Fees Questioned in Latest ERISA Suit

Beyond the issue of excessive compensation, the lawsuit questions the collection of “float interest” and asks whether BTG International permitted a provider to create a “captive market for 401(k) rollovers.”

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A new complaint filed in the U.S. District Court for the Eastern District of Pennsylvania accuses BTG International of breaching the Employee Retirement Income Security Act (ERISA) in the operation of a profit sharing 401(k) plan.

The plaintiff, seeking class-action status on behalf of similarly situated participants in the BTG International Inc. Profit Sharing 40l(k) Plan, alleges company officials allowed the plan’s recordkeeper, John Hancock, to receive excessive and unreasonable compensation through a variety of undisclosed channels. In addition to the BTG company, the complaint directly states its allegations against the plan’s named fiduciaries—three top executives.

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The text of the complaint details alleged fiduciary breaches relating to “direct hard dollar fees paid by the plan to John Hancock; indirect soft dollar fees paid to John Hancock by non-John Hancock managed sub-advised accounts added and maintained in the plan to generate fees to John Hancock; fees collected directly by John Hancock from John Hancock-managed sub-advised accounts, added and maintained in the plan to generate fees to John Hancock; and float interest, access to a captive market for 401(k) rollover materials to plan participants, and other forms of indirect compensation.”

“In order to provide for these revenue streams, defendants larded the plan with excessively expensive sub-advised accounts—to the exclusion of superior alternatives—which in turn paid John Hancock out of the excessive fees they collected from plan investments,” the complaint states. “In fact, since the plan is a group annuity 401(k) product, defendants offered only investment options primarily offered by John Hancock to the exclusion of all other options.”

The complaint stipulates that the plaintiff is bringing this action “by and through their undersigned attorneys based upon their personal knowledge and information obtained through counsel’s investigation.” According to the complaint, the plaintiff “anticipates that discovery will uncover further substantial support for the allegations.”

One salient feature of this lawsuit is that the lead plaintiff moved his personal 401(k) fund from the plan in September of 2016. The complaint argues he nevertheless “remains a plan participant under ERISA since he was a participant during the times of the alleged breaches of fiduciary duty; may be eligible to receive benefits though the plan; and maintains a colorable claim for such benefits.” He participated in the plan from May of 2013 until September of 2016, the complaint says.

According to the complaint, during the class period, of the plan’s more than 100 investment options, 53 of them “appear to be managed by John Hancock, with the remainder paying revenue sharing to John Hancock.” The plan’s most recent Form 5500 filing with the U.S. Department of Labor states that at the end of the 2017 plan year the plan had 810 participants with account balances. At all relevant periods, the compliant says, John Hancock served, and continues to serve, as the plan’s recordkeeper.

Here the complaint presents the attorneys’ and plaintiff’s view of the recordkeeping market: “The recordkeeper of a defined contribution plan, like the plan, maintains participant account balances, provides a website and telephone number for plan participants to monitor and control their plan accounts, and provides various other services to the plan. These services are highly commoditized, with little or nothing distinguishing the services provided by one recordkeeper over another.”

The suit continues: “For providing various services, third-party plan administrators, recordkeepers, consultants, investment managers, and other vendors in the 40l(k) industries have developed a variety of pricing and fee structures. At best, these fee structures are complicated and confusing when disclosed to plan participants. At worst, they are excessive, undisclosed, and illegal.”

According to the complaint, BTG and the individual defendants “failed to have a prudent process for evaluating the amount and reasonableness of this compensation. Instead of evaluating the cost of these services in the marketplace, BTG and the individual defendants permitted John Hancock to administer and do the recordkeeping for the plan without meaningful market competition.”

The complaint alleges that defendants did nothing “to limit or curtail John Hancock’s growing compensation, rather, John Hancock was allowed to generate ever higher fees despite costs which were either stable or falling. Failing to do so constituted a breach of the duties of prudence in violation of 29 U.S.C. §1104(a) and cost the plan millions of dollars in excessive fees charged directly by John Hancock or collected by John Hancock from the plan’s investment options through revenue sharing.”

The text of the complaint goes into some detail about the handling of the plan’s Form 5500 annual filings, and how the plan may be tracking revenue sharing payments.

“Defendants negligently prepared and/or intentionally misstated their form 5500s with the Department of Labor each year from 2012 to the present,” the complaint states. “From 2012 through 2016, the plan’s Form 5500 state the John Hancock received no direct or indirect compensation whatsoever for its services. The defendants are obligated as fiduciaries to accurately report this compensation. It wasn’t until 2017 the Plan’s Form 5500 reported that John Hancock received a total of $318 in direct compensation for its services and no indirect compensation whatsoever. Again, it is believed … that this information was not reported accurately. The defendants, as fiduciaries, should have questioned, on behalf of the members of the plan, the amount of compensation John Hancock actually received. Failure to do so is a clear breach of their fiduciary duties. … While the hard dollar fees above appear modest or misstated, it must be the case that the vast majority of John Hancock’s compensation came in the form of revenue sharing. Industry commentators and analysts consider revenue sharing as the ‘big secret of the retirement industry.’”

The lawsuit suggests that, to “severely reduce, or eliminate hard dollar payments altogether, a plan’s fiduciaries and/or a service provider like John Hancock may agree to set a fund’s asset-based fee (its expense ratio) at a level high enough: (A) to cover the Fund’s services and profit; and (B) to provide excess revenue sharing more than sufficient to cover all other plan services and more. This causes a plan’s recordkeeping fees to appear deceptively low in disclosures to plan participants and government regulators.”

From here, the complaint argues plan fiduciaries have limited their selection of funds to only those funds which provide sufficient revenue sharing, thus foregoing superior investment alternatives and selecting or maintaining inferior investment options based upon revenue-sharing relationships.

“These alternatives include different share classes of the identical sub-advised account that charged lower fees because they do not pay revenue sharing, institutional products by the same fund managers which offer materially identical services for even lower cost, or superior alternatives offered by different managers who are unwilling to pay revenue sharing to the plan recordkeeper,” the complaint says.

The full text of the complaint is available here.

The Markets April 23, 2019

Monitoring DC Plan Fund Menus Important for Participant Outcomes

It is important for plan fiduciaries to know what to consider for placing a fund on watch or replacing it.

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A Morningstar report, “Change Is a Great Thing,” finds that monitoring defined contribution (DC) plan fund menus can improve performance, although more research on why this effect occurs is warranted.

The report cites previous research which found that institutional investment managers hired to replace terminated underperforming managers perform much better before they are hired, but this outperformance disappears after they are selected.

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Morningstar researchers used a large data set of plan holdings from three different recordkeepers between January 2010 and November 2018, to investigate the monitoring value provided by plan sponsors. For each plan, a list of available funds is available at some interval, typically quarterly. They employ a matching criterion to determine when a fund is replaced within the same investment factor style based on its Morningstar Category over time. The analysis results in a sample of 3,478 replacements across 678 DC plans. They find that on average replacement funds had better historical performance and lower expense ratios, along with more-favorable comprehensive metrics such as the Morningstar

Rating for funds (the “star rating”) and the Morningstar Quantitative Rating for funds, than the funds they replaced. The largest performance difference in the replacement and replaced funds is the five-year historical returns, suggesting this historical reference period is the one that carries the most weight among plan sponsors.

They also found that the future performance of the replacement fund is better than the fund being replaced at both the future one-year and three-year time periods, and that these differences are statistically significant. The outperformance persists even after controlling for expense ratios, momentum, style exposures, and other metrics commonly used by plan sponsors to evaluate funds such as the star rating and quantitative rating.

“Our findings suggest that monitoring plan menus can have a positive impact on performance,” the researchers conclude.

Jim Licato, vice president of product management at Morningstar in Chicago, and co-author of the report, tells PLANSPONSOR, “We have found, and believe it is very important, for someone to be keeping an eye on retirement plan investments—whether an investment committee or investment adviser—and make necessary changes. We found not doing so is a disservice to participants.”

He says that the prior studies did not include as robust a data set as the Morningstar analysis and that may be the reason it found different results than prior research. However, he adds, “We still have not dug through the detail about why exactly replacement funds are overperforming. It will require further research as it remains elusive as to why.

“What we can say,” Licato continues, “is that prior to replacement, plan sponsors were looking at a number of areas—past performance, expense ratios, Morningstar ratings, etc.—and all improved with the replacement fund.”

Considerations for fund replacement

Other than declining returns, Mike Goss, EVP and co-founder, Fiduciary Investment Advisors in Windsor, Connecticut, says one big factor in considering a fund for replacement for his firm is a fund manager change—whether a lead portfolio manager or a key member of that team. When this happens a fund may be put on watch because generally the manager is ultimately responsible for the funds track record and which securities to own. A fund manager change could change the fund’s track record or style, he explains.

Other factors in considering a fund for placement on a watch list or for considering a fund change is the change in ownership of the investment firm. “It’s a potential change that could lead to poor results,” Goss says. Those tasked with monitoring a DC plan’s investment menu also want to watch out for a fund style change or drift—for example, from value to growth—and for a strange in strategy or fund turnover—for example, some funds own stocks for a long time and some trade frequently. “Both can be good strategies, but if a fund changes strategy it should cause a plan fiduciary to ask why,” he says. “Plan sponsors select funds based on a certain process, style or philosophy. Any change would be a red flag.”

According to Licato, fund expenses should also be monitored to make sure they are in line with what similar funds are charging.

He says when a fund is put on a watch list, it can remain on the watch list for one quarter or a few quarters. Those monitoring the DC plan fund menu will look to see whether what triggered putting the fund on the watch list has been improved or gotten worse. If it’s gotten worse, the fund should be replaced. “There is no set number of funds that need to be replaced or put on watch. It’s more about fund monitoring and staying on top of things,” he adds.

According to Goss, his firm’s rule is that a fund cannot be on watch more than year. “There’s no law or necessary best practice, but we think a year is enough time to make a quality assessment to either maintain the fund in the DC plan investment menu or change it,” he says.

Goss warns that DC plan fiduciaries should never try to time the market. “That’s no reason to add or delete a fund. Hopefully, if they’re doing very good due diligence when they select a fund to include on the investment menu, they should not have a significant turnover of funds. We very rarely turn funds over,” he says. Goss adds that one of the things fiduciaries can outsource through a 3(38) investment manager is the ability to have the manager select, monitor and replace funds.

Licato points out that fund turnover can be disruptive for recordkeepers and participants—the paperwork and moving of assets is never a good thing from an administrative standpoint. However, he says, if a plan fiduciary is contemplating not removing a fund because it will be disruptive, it is not looking at the best interest of participants. “If it will benefit participants, do it.”

He adds that the main lesson from Morningstar’s analysis is, “Don’t’ set the investment menu on cruise control and not look at it for years. During that time there could be many red flags.”

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