Compliance July 3, 2017

Money Market Returns Challenged In Latest ERISA Suit

The suit, Barrett vs. Pioneer Natural Resources, was filed in the U.S. District Court for the District of Colorado and calls out the firm’s offering of both stable value and money market funds.
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Employees of Pioneer Natural Resources have filed an Employee Retirement Income Security Act (ERISA) lawsuit against their employer, alleging a variety of fiduciary breaches in the management of its 401(k) plan.

A close look at the complaint offers plan officials some important—if unwelcome—insight about just how widespread ERISA-based litigation has become and how difficult it can be to avoid a challenge once the plan has gained the attention of the plaintiffs’ bar. Perhaps most notably, in this suit the plan sponsor is called out for failing to remove a money market fund option that had low returns when a stable value fund was also already available in the plan, and yet other suits have been filed arguing essentially the exact opposite, that a given plan should have offered a money market fund option in place of a stable value fund.

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The suit, Barrett vs. Pioneer Natural Resources, was filed in the U.S. District Court for the District of Colorado, and it names as defendants not only the company and the 401(k) committee, but also a number of the energy company’s HR and finance executives. The plan in question is a $500 million 401(k) program.

The list of fiduciary breaches alleged goes as follows: “Failing to offer institutional class shares for mutual funds, which resulted in the participants paying excessive costs to invest in the funds; failing to make sure that plan fees were reasonable; and failing to remove the poorly performing money market fund when the better-performing stable value fund was already available, causing losses to plan participants who maintained excessively high cash balances in money market funds rather than the stable value fund, which offered higher returns and the same risk level.”

Given the impermissibility of relying on hindsight in judging investment performance in the context of ERISA breaches, this last claim may be particularly difficult for plaintiffs to succeed on. Indeed, in a similar lawsuit filed against Fidelity regarding money market fund performance relative to other options available to retirement plan clients, the district court was unsympathetic to plaintiffs, dismissing their challenge on summary judgement for failure to establish a breach of either loyalty or prudence.

The claims regarding the purchase of inappropriate share classes may be harder to defend: “Despite having plan assets worth hundreds of millions of dollars, the Pioneer defendants routinely selected the higher-priced Investor share class of mutual funds, instead of the lower-cost Institutional/Admiral share classes of those same mutual funds which were readily available to the plan.”

Most helpful for readers thinking about their own litigation exposure, the text of the suit examines in detail steps the plan sponsor went through to start using the cheaper share classes for some investments. The sponsor clearly communicated its fee-saving activities to plan participants and even told them directly that all plan expenses, “no matter how small, were important.” Yet the Pioneer defendants, after making some share-class changes, continued to offer higher-cost Investment class shares for nine Vanguard funds.

NEXT: Failure to consider CITs also alleged 

Plaintiffs forward similar allegations regarding the plans’ failure to utilize the fee efficiency of collective investment trusts (CITs), as follows: “Vanguard offers five different low-cost collective trust funds to qualified retirement plans, including Target Retirement Trust Select, Target Retirement Trust Plus, and Target Retirement Trust I–III. These target-date funds are managed by the same investment adviser as those mutual funds, but have far lower fees than the Vanguard target-date mutual funds offered as investment options by the plan. The plan offered the higher-cost mutual fund version of the Vanguard Target Retirement Funds, even though much lower-cost collective trust Vanguard Target Retirement Funds were available to the plan.”

The suit further suggests 10 of the 12 Vanguard CITs the plan could have accessed have been available since 2007. Exacerbating the problem, plaintiffs suggest, “the Pioneer Defendants had no annual review or other process in place to fulfill their continuing obligation to monitor and control plan investment options, or, in the alternative, failed to follow their own processes.”

Plaintiffs allege additional fiduciary breaches relating to the plan’s recordkeeping fees. “Between 2012 and 2015, plan participation increased 11.9% from 3,939 in 2012 to 4,410 and assets increased by 40.5% from $355,855,632 to $500,187,132. However, the plan’s direct compensation paid to Vanguard increased by 106% from $141,924 to $291,794.” Plaintiffs argue this arrangement is at best irrational and at worst flatly conflicted.

The text continues: “Vanguard received additional annual fees through revenue sharing from at least 10 mutual funds offered as past or present plan choices. In a revenue-sharing arrangement, a mutual fund or other investment vehicle directs a portion of the expense ratio—the asset-based fees it charges to investors—to the 401(k) plan's recordkeeper putatively for providing recordkeeping and administrative services for the mutual fund … Prudent fiduciaries monitor the total amount of revenue sharing a recordkeeper receives to ensure that the recordkeeper is not receiving unreasonable compensation. A prudent fiduciary ensures that the recordkeeper rebates to the plan all revenue-sharing payments that exceed a reasonable, flat per participant recordkeeping fee that can be obtained from the recordkeeping market through competitive bids.”

Because revenue-sharing payments are asset based in this plan, plaintiffs argue, “they bear no relation to a reasonable recordkeeping fee and can provide excessive compensation … The mutual funds paid Vanguard annual revenue-sharing fees based on a percentage of the total plan assets invested in the fund, which were ultimately paid by plan participants who invest in those funds. For example, the Oppenheimer Developing Markets Fund charged 0.87% annually to plan participants to invest in the fund. Oppenheimer then paid Vanguard .25% in marketing, distribution and other fees to be part of the plan investment options. Had the Pioneer Defendants negotiated a rebate by Vanguard of those fees, plan participants investing in the Oppenheimer funds would have earned .25% more per year on their investment.”

Finally, regarding the money market versus stable value question, plaintiffs argue the following: “Offering both the Vanguard Retirement Trust V and the Vanguard Federal Money Market funds as short-term reserve investment options in the Plan provided no benefit to the plan participants, but instead confused and misled the plan participants by leading them to believe there was a material difference in the funds. As a result, many plan participants who were eligible to invest in the Vanguard Retirement Trust stable value fund instead invested in the Vanguard Federal Money Market fund, which cost them an annual investment return of almost 2%.”

Pioneer has not yet responded to a request for comment. The full text of the complaint is available here.

The Markets June 30, 2017

A Deeper Look into the Long-Horizon of DB Plans

A study by Willis Towers Watson argues that long-term horizon investing can generate as much as a 1.5% premium per year.
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A recent study by Willis Towers Watson (WTW) suggests that a long-horizon investor can stand to gain a net premium return of up to 1.5% annually depending on the asset manager’s size, strategy and governance. The research revolves around the idea that long-horizon investing offers significant opportunities for return, while downplaying drags on return. It identified eight building blocks or strategies for long-horizon investing.

These building blocks were applied to two hypothetical defined benefit (DB) pension plans. The smaller one, with $1 billion in assets, focused on lowering costs and avoiding mistakes by reducing manager turnover and avoiding chasing performance, while moving parts of its passive exposure into smart beta strategies. The net benefit of these strategies was potentially an annual increase in investment returns of about .5% per year. The larger scheme, with $100 billion in assets under management, had the governance and financial resources to employ all strategies and achieved a potential increase in returns of 1.5%.

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“Most investors, if not all, would agree that those who are able to take a long-term view have a competitive edge over others,” says paper co-author Liang Yin. “I would summarize that competitive edge as the ability or skillset to identify long-term opportunities and the willingness or mind-set to maintain position in the face of short-term performance volatility.”

The report suggests creating portfolios that actively invest in companies that are focused on the long term as opposed to their short-term peers. It points to research by McKinsey Global Institute indicating that between 2001 and 2014, the revenue of companies with long-term outlooks grew on average 47% more than that of other firms, and with less volatility. WTW also recommends thematic investing and capturing systematic mispricing through alternative weighting schemes, or liability driven investing (LDI) glidepaths. It points to research concluding that “various mispricing effects via smart betas adds more than 1.5% per year relative to the cap-weighted index over decades of data.”

Matt Peron, head of global equity investing with Northern Trust Asset Management, tells PLANSPONSOR that alternative weighting schemes may pose less risk in long-horizon investing as opposed to thematic investing, however.

“You can pick factors that have long cycle lengths and higher return premiums such as value, and you can put that to your advantage,” Peron explains. “With factor-based investing, you have a rich, empirical data set going back to the early 1900s and you see fairly consistent patterns of return profiles of these factors. Thematic investing changes every decade. And you have to pick the right theme every time.”

WTW found that overall, return-seeking strategies were more suitable for larger plans with the resources and expertise to execute them effectively.

NEXT: Using a longer-term return analysis when firing managers

WTW notes that smaller funds can benefit from a shift in mindset by lowering transaction costs and avoiding buying high while selling low, as well as forced sales. Evading these actions can enhance returns at a “much lower governance cost than seeking return enhancements.”

The report cited a study of 3,400 plan sponsors that looked at their selection and termination of investment management firms from 1994 to 2003. The researchers used this data to compare post-hiring returns with returns that would have been delivered by fired managers.

It found that, although managers that would be hired outperformed the managers that would be fired by 4.6% over one year and 9.5% over three years, “a strong signal that plans were chasing past performance,” returns of managers fired due to poor three-year performance experienced a rebound. This led to a cost of 1% three years post manager change. In terms of long-term investing, plan sponsors can benefit from focusing on performance in the long-run as opposed to short-term shifts.

Citing similar research, Peron said it showed “Plan sponsors would hire and fire on a three-year cycle. People tend to hire at the top and fire at the bottom because they look at the three-year horizon. In my view, that’s the wrong measuring frequency to be looking at.”

Yin adds, “Considerable evidence suggests that investors, both individual and institutional, engage in buying high and selling low and as a result they give up substantial returns. This past-performance-chasing behavior is fundamentally incompatible with a long-horizon mind-set.”

NEXT: The Complexities of Long-Term Investing 

WTW points out that not all building blocks are independent of each other and some are even contradictory. For example, it points to the “liquidity provision” and the “illiquidity premium.”

With the liquidity provision, DB plans can hold a certain amount of cash in reserve and use it at times when other investors need cash and are willing to sell shares below market value, thereby making a positive return on investment. WTW says “Long-horizon investors have the potential to earn additional returns of 1% pa [per annum] by providing liquidity when it is most needed.”

When investors accept illiquidity, however, they stand to gain by locking capital up as long as they can tolerate. WTW notes, “The illiquidity risk premium (IRP) is worth 0.5% to 2% annually—and even higher returns might be available to very long-horizon investors.” Illiquidity risk is not having liquid assets on hand when an opportunity to buy low presents itself.

Still, a paper by the World Economic Forum reports there are key constraints to long-term investing when it comes to DB plans. Challenges among these plans include differentiation in liabilities, risk appetites, and decision-making processes—all of which can enhance or hinder the plan’s ability to engage in these strategies or building blocks. Moreover, all this comes at a price some may not be willing to stomach.

WTW says “Capturing the benefits of long-horizon investing is likely to require a major shift of mindset and significantly expanded skill-sets by asset owners and asset managers. The cost of strengthening governance capability to address these requirements could be significant, depending on the starting place.”

Thus, it is essential to engage in due diligence and evaluate cost as well as potential return when looking at asset managers focused on long-horizon investing. The results, however, could be substantial.

“In fact, it is reasonable to assume the long-horizon premium exists precisely because it is so hard to capture,” says Yin. “However, a return uplift of 0.5 to 1.5%, particularly in today’s low-yield environment, can be extremely rewarding.”  

He concludes, “To put it in context, 0.5% return enhancement equals $5 million in incremental wealth creation, per year, for a $1 billion fund. For a $100 billion asset owner, a return uplift of 1.5%, if achieved, would translate to $1.5 billion additional wealth creation every year.”

The research paper from Willis Towers Watson may be downloaded from here.

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