Limit lawsuit risk by staying apprised of the current 401(k) legal setting
As fiduciaries, plan sponsors should keep aware of the current legal setting around 401(k) plans. If applicable, sponsors should take steps to avoid the risk of facing similar lawsuits. A recent case deals with using the lowest cost index fund available. On August 8th, former 401(k) plan participants filed a lawsuit aimed at both the retirement committee of the plan sponsor, Community Health Systems, Inc., and the target date provider, Principal Global Investors, LLC, among other Principal entities.
This lawsuit highlights the need for plan sponsors to review their passive index funds on a regular basis. Index funds are typically offered in a defined contribution portfolio to track an index benchmark at a low cost. The suit claims that the plan should have used less expensive index funds. Specifically, the plan allegedly used Principal index funds in both the target date series and as standalone options when there were cheaper options that followed the same benchmark with less tracking error.
Example: Passive Fund A tracks the S&P 500 Index and charges 20 bps. Passive Fund B also tracks the S&P 500 but charges only 5 basis points. Plan sponsors would need a very good reason to keep Fund A in their lineups over Fund B. These reasons do exist however, and some examples are listed below:
- Fund B may offset costs using securities lending, whereby it loans individual stocks to other businesses when they are not immediately needed for trading. Fiduciaries should understand that securities lending may lead to increased liquidity risks in tail risk scenarios.
- Recordkeeping fees may be contingent on having the recordkeeper’s proprietary funds in the investment lineup. If recordkeeping costs are passed on to participants, then switching may not be in their best interests. However, R&M has not found this linkage of investment and recordkeeping fees to be as common for passive funds as it is for more expensive active mandates.
- Fund A may track the S&P 500 better than Fund B. Examining tracking error is an important step for fiduciaries when looking at passive funds.
R&M plan sponsor takeaways – Plan sponsors should be aware of similar passive investment options to those in this lawsuit, as well as others that R&M is monitoring, in their own investment lineups. While lawsuits criticizing the performance and fees of active managers are difficult to adjudicate, this lawsuit’s focus on passive index funds provides a more clear-cut challenge. Index funds have fewer points of differentiation than their active counterparts, so investment fees are especially important. Sponsors should be proactive and conclude that the passive investment options they offer are appropriately priced compared to other index funds that follow the same benchmark.