401(k) Plan Participants Challenge Principal’s Management of TDFs

The lawsuit alleges Principal used proprietary investment vehicles, rather than other investment vehicles, and share classes with higher fees for the underlying TDF investments, to produce more income for itself and its subsidiaries.

A participant in the Starkey Laboratories, Inc. Employee Retirement Plan and two participants in the Fleetcor Technologies, Inc. 401(k) Savings Plan have filed a lawsuit challenging the management of Principal LifeTime Hybrid Collective Investment Funds (CITs)—target-date funds (TDFs) offered in their plans—on behalf of themselves and other similarly situated retirement plan participants.

The Employee Retirement Income Security Act (ERISA) lawsuit was filed against Principal Global Investors Trust Company, Delaware Charter Guarantee & Trust Company d/b/a Principal Trust Company, Principal Management Corporation, and Principal Global Investors, LLC and alleges they breached their fiduciary duties under ERISA to the detriment of plan participants.

In a statement to PLANSPONSOR, Principal says, “We disagree with the allegations in this lawsuit and will vigorously contest them.”

The complaint points out the two main differences between CITs and mutual funds, one of which is that, while ERISA explicitly excludes mutual fund managers from the definition of a fiduciary to the extent they are managing assets of a plan covered by ERISA, the trustees (and any sub-advisers they employ) of CITs are ERISA fiduciaries, according to Department of Labor (DOL) Advisory Opinion 2005-09A. The complaint notes that the defendants acknowledged in both the Declaration of Trust and sales literature for the Principal CITs they were all fiduciaries with respect to the management of the Principal CITs, and their fiduciary duties included the selection and monitoring of investment options and investment managers.

According to the complaint, as of the end of 2017, the Principal CITs consisted of 12 trusts: 11 options with a target date ranging from 2010 to 2060 (2010, 2015, 2020, etc.), and an option called Principal LifeTime Hybrid Income Fund designed for investors “who have reached their investment time horizon.” The CITs’ assets are invested in other pooled investment products, which according to the Declaration of Trust can be mutual funds, CITs, andannuity separate accounts, among other options. Through the end of 2017, the fees of each Principal CIT consisted of four components: a trustee fee of .04%, set by the Declaration of Trust; operating expenses, which are deducted from the trust; the service fee, which varies based upon the share class selected in the participation agreement, and ranges from 0 bps to 110 bps; and the “fees charged by the underlying investments in the Principal CIT.” The plaintiffs argue that because the Principal CIT investors bear the expense of the underlying investment options, the defendants’ decisions regarding which underlying investment options to use directly determined the amount of fees paid by Principal CIT investors as well as the recipient of those fees.

The plaintiffs allege fiduciary breaches regarding the selection and monitoring of the Principal CITs’ underlying investment options. They do not challenge either the decision to use passive investments or index funds, but say the fiduciary breaches relate to which underlying investments were used—a determination that fell squarely within the scope of the defendants’ fiduciary duties.

The plaintiffs argue that the marketplace for index funds is highly competitive. For most major market indices, one or more companies offer an index fund product that can track the index with a high degree of accuracy, while charging very low fees. This is particularly true for large investors such as the Principal CITs (which at all relevant times had over $2 billion invested in index fund investments), that can leverage their billions in investable assets to negotiate lower fees than what is available to the vast majority of investors.

However, they say the defendants did not invest in any of the competitive index fund offerings in the marketplace, choosing instead to profit themselves and their affiliates by investing exclusively in Principal’s proprietary index funds, despite fees that were five to 15 times higher than marketplace alternatives that tracked the exact same index.

“Not only were the Principal index fund products far more expensive, they were also of significantly lower quality. Compared to marketplace alternatives, Principal’s index funds deviated further from the benchmark index, and consistently had the worst performance even on a pre-fee basis,” the complaint says.

The plaintiffs asset that, “Given the high fees and history of poor performance of Principal’s index funds, a prudent fiduciary of a multi-billion dollar suite of target-date funds acting in the best interest of the trust beneficiaries would have removed these proprietary index funds from the Principal CITs at the beginning of the relevant period and replaced them with more competitive marketplace alternatives. Defendants’ failure to do so has cost participants millions in investment losses compared to what they would have earned had Defendants acted in accordance with their fiduciary duties.”

In their complaint, the plaintiffs contrasted Principal’s conduct to that of other, similarly situated fiduciaries. “Fiduciaries of numerous other target-date collective investment trusts offered by companies such as Charles Schwab, JPMorgan, AllianceBernstein, and Great-West all invested in non-proprietary index funds as underlying holdings, despite the fact that each of these financial services companies offers their own indexing products or services in the marketplace. No fiduciaries of other target-date collective investment trusts (outside of fiduciaries affiliated with Principal) used Principal’s index funds as underlying holdings,” they contend.

The plaintiffs allege the defendants also intentionally selected higher-fee versions of proprietary actively-managed funds to increase fee revenue, at the expense of trust participants and beneficiaries, saying they were permitted to invest in different investment vehicles which contained identical investments, but varied significantly in terms of costs. Principal also offered different share classes of each of these different vehicles, with the primary difference being the costs associated with each share class.

Citing Tibble v. Edison Int’l, plaintiffs say the defendants “cannot ignore the power the trust wields to obtain favorable investment products, particularly when those products are substantially identical—other than their lower cost—to products the trustee has already selected.”

As an example, the complaint notes that the Principal CITs have had more than $1 billion invested in Institutional shares of the Principal Diversified International mutual fund, which charged annual expenses of 0.85% as of the end of 2017. Yet, the plaintiffs contend the defendants could have instead selected the exact same investment in annuity separate account form, the lowest-cost share class of which charged fees of only 0.39% per year. The complaint says this pattern of failing to leverage the assets and negotiating power of the Principal CITs to demand the lowest-cost vehicle and share class was not limited to the Diversified International Fund—for eleven of the thirteen investments held by the Principal CITs, Defendants failed to use the least expensive vehicle, failed to use the least expensive share class, or both.

“These imprudent investment decisions were not the result of mere negligence or oversight. Defendants’ wrongdoing consistently earned themselves and their Principal affiliates additional investment management fees and provided a larger asset base to make Principal’s index fund and mutual fund products more competitive in the marketplace,” rather than considering the best interest of participants, the lawsuit contends.

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