In the latest episode of Plan Talk, Retirement Director Ben Rizzuto discusses the implications of two recent fiduciary breach cases. The first case highlights the issue of equity funds being too highly correlated and fixed income options too limited within retirement plans. The second case, filed against the Retail Employees Superannuation Trust in Australia, questions whether plan sponsors have a fiduciary responsibility to consider how environmental, social and governance (ESG) factors such as climate change may impact participant assets.
Plan Talk: New Fiduciary Allegations Arise around Failure to Diversify and ESG Investing - Ben Rizzuto, CRPS®
Ben Rizzuto: Hello, I’m Ben Rizzuto, and you’re listening to the Knowledge Labs Podcast Channel from Janus Henderson Investors.
In many parts of our lives, there is a constant barrage of stimuli. Our iPhones buzz and beep constantly letting us know of a new email, a new text or a new post on one of the several social media platforms we are part of.
We turn on the television. A new season of our favorite series drops on Netflix that must be binged as soon as possible. Plus, once we’ve completed that we are offered several different series that can help to quench our continual thirst for entertainment.
Within the retirement plan industry there are so many issues that consistently beg our attention. The SECURE Act, regulatory updates, new plan design features, as well as ever-evolving needs of participants. Plus, there is our ever-present fiduciary duty and the consistent litigation that ensnares plan sponsors.
If you read the full text of these lawsuits, you will many times see the phrase “Prayer for Relief.” This is the request or prayer made to the court by plaintiffs for specific relief or damages to which they feel entitled based on the alleged fiduciary breaches.
These cases are becoming so numerous and so frequent that it’s become hard to keep up with all the plan sponsors who have been sued, the allegations, and where cases are in the process of arguments, appeals, remands or dismissals. Because of this, I am sure plan sponsors are praying for relief as well.
We are all looking for a little relief from this barrage. The thing is, we can turn off the notifications from the apps on our phones. Heck, we could be so bold as to turn off our phones or our TVs all together. But when you’re a plan sponsor, you unfortunately can’t turn off your fiduciary duties.
While that may be the case, we can always try to better prepare ourselves and be better aware of the allegations that other plans are being sued over. Today we have two cases that are relatively new and bring about alleged fiduciary breaches, which I think could be issues that many plans out there could be sued for.
The first case hit the wires just before Christmas. The Fleming versus Rollins case has several of the common themes that we’ve seen in past lawsuits, in that the plaintiffs claimed fiduciary breaches going back to 2014 based on imprudent investments, use of expensive share classes and excessive fees.
Another item that comes up in the case is that the plaintiffs name the plan’s advisor by name in the complaint. While this isn’t totally new, it is something we are seeing more and more. Not only could this trend lead to legal issues for advisors, but there is the reputational fallout that could occur as well.
In reading through the complaint, I found some interesting additions that investment committee members would do well to make sure they are educated on. For example, the research of Eugene Fama and Ken French was referenced with regards to return expectations over time. There is a discussion of standard deviation and the idea that “if a fund lost 37% in 2008, it wouldn’t need a 37% return to break even, but [rather] almost 60% (37/63).”
An interesting analogy was used to explain this. The complaint noted that the plan sponsor ensured that participants’ contributions were repeatedly bet on a horse with a 600-pound jockey versus betting on a horse with a 60-pound jockey.
Now, many of you may be saying that’s common knowledge, but as we know, it’s sometime these quote-unquote “common” items that need to be covered occasionally to make sure investment committee members truly understand how their investment decisions can impact participant portfolios.
Failure to Diversify
Along with those items, the main issue that I think all of us need to be aware of is that this plan sponsor has been sued for a lack of diversification in its plan menu. This complaint was built as follows:
First, it was noted that the plan offered 12 mutual funds. So, here’s the first question: What’s the right number of funds? Most studies will show the average number of funds at around 20, but ERISAPedia did some research last year that looked at over 40,000 plan menus. The average from that study was 16.2 funds, but we did see that the fatter part of the bell curve went down to 11 funds and up to 20 funds.
Along with that, we’ve seen research that says that too many choices lead to participant inertia. However, recent research from Morningstar showed larger menus with up to 30 funds lead to better default investment acceptance and better returns for self-directed participants. The point is that there isn’t one right answer; it depends on your plan and it depends on your participants.
From there, the complaint says that defendants further failed to diversify the investments of the plan to minimize the risk of large losses. This was exhibited by showing that over all applicable periods, the plans’ equity funds had a 90% average correlation to each other with no provisions made available to participants to less-correlated foreign bond, real estate or commodity funds. So, the first issue is that the equity options within the core menu were all highly correlated to each other.
Furthermore, in 2014, the plan’s investment choices did not include low correlation investments such as short-term government bonds, global bonds, emerging markets, emerging markets bonds or commodities. In fact, defendants offered participants just one fixed income mutual fund.
Not only did participants only have one fixed income option in 2014, but also in 2015 after one total return bond fund was replaced with another. The complaint points out that, yet again, participants had no other low correlation bonds to choose from – such as short-term, long-term or international bonds – or other low-correlation investment choices such as REITs or emerging market.
So not only were the 11 equity funds highly correlated, but participants only had one fixed income option with which to quote-unquote “diversify” their portfolio.
Overall, the complaint points out that it is the plan sponsor who selects and monitors investment options. And even though they in this case had over 20,000 options to choose from, they gave employees a limited menu to choose from.
Using that horse and jockey analogy from earlier, it’s as if not only has the plan sponsor put out a horse with a 600-pound jockey riding it, but they haven’t given the jockey a saddle, stirrups or all the tools necessary for success.
This “failure to diversify” claim is one we haven’t seen before, and I think it will be incredibly noteworthy to see where this case goes. Along with that, I think it provides plan sponsors with a few action items for their next investment committee meeting.
First, I would encourage them to look at the equity portion of their core menu to see what correlations look like across the all equity options but also among equity options. Higher correlations between funds are likely in many cases, but it could uncover areas where changes or additions might make sense. Also, if the overall correlation is high, it should lead to a second item: How are participants able to diversify? This should center around the fixed income portion of the plan menu. Here we should consider questions like:
- How many fixed income options are we offering?
- Are there options that can provide inflation protection?
- Are there options that will provide income?
- Are there options that offer short-, medium- and long-term bond exposure?
- And, most importantly, is now a good time to rationalize the options we are giving participants?
The discussion and decisions around those questions should of course be documented and saved within meeting minutes. Within the Fleming versus Rollins case, it will be interesting to see what sort of processes were in place and how their investment decisions were documented. If they don’t exist, the plaintiffs’ “prayer for relief” could turn into a significant amount of money.
Mark McVeigh v Retail Employees Superannuation Party
Next, I’d like to discuss a case that you may have missed because it is from Australia. The case is that of McVeigh versus Retail Employees Superannuation Trust, otherwise known as REST.
REST is one of the largest funds by membership in Australia, with around 2 million members, primarily those working in the retail industry, and over AUS$57 billion in funds under management.
Under the Corporations Act 2001, superfund beneficiaries are entitled to request information that they need to make an informed decision about the management and financial condition of the fund.
The plaintiff in this case requested information from REST regarding its knowledge of Climate Change Business Risks and its actions responding to those Climate Change Business Risks.
To put it more simply, he wondered how the fund was ensuring his savings were future-proofed against rising world temperatures. More fully, how could REST better ensure that climate change and the possible natural disasters that could stem from it would not lead to increased risk and possible losses within the fund’s investments?
The suit stemmed from the allegation that REST failed to disclose the requested information and that REST has violated the Superannuation Industry Supervision Act of 1993 that requires trustees to act with care, skill and diligence, and to perform their duties and exercise their powers in the best interests of their beneficiaries.
More specifically, within the complaint, lawyers for the participant lay out a couple of interesting ideas. First, within the Australian system, participants are subject to a “preservation age.” In this case, it is 60 years, meaning that the participant wouldn’t be able to access his superannuation assets until January 2055.
Second, the complaint lays out several widely held ideas about climate change and its affects on global temperatures, precipitation [and] sea levels, as well as the fact that Australia and other countries have recognized the existence of climate change and the likelihood of the physical impacts.
These physical impacts will increasingly continue to pose material risks to the financial position of many of REST’s investments and thus REST participants. The case is set to go to court in July 2020, so it will be interesting to see what happens.
Now, you may be saying, “This is Australia, why should I care?” One reason is the fact that the number of climate-related case filings has jumped over the last several years. The Sabin Center for Climate Change Law at Columbia University keeps track of these cases and notes that in 2019 there were 107 in total, with 96 in the United States. Now, most of these were not ERISA cases, but it does signal a growing trend.
Plus, there continues to be greater interest in ESG investing from plans and participants here in the United States. In fact, Callan’s 2019 ESG Survey showed that there was a 91% increase in respondents that have incorporated ESG factors into investment decisions since 2013.
Along with that, the question that the case against REST brings up is, do plan sponsors have a fiduciary responsibility to consider how these factors may impact participant assets? And if we believe that there is a fiduciary duty, how do we make sure we are meeting this duty consistently? What’s interesting and difficult within this idea is how to quantify the possible impact that climate change could have on assets in the future. This is something that plans and the ESG community will wrestle with over the coming years, and it could be something that affects every plan.
So, if you think about those two cases, there are two questions that we need to consider: Are we providing our participants with enough options to diversify? And, how can we better ensure that global warming and climate change don’t affect participants’ retirement savings negatively?
Based on these cases and those two questions, I would suggest looking at the correlations of investments in your plan menu as well as the other investment options that are available besides equity funds. Also, regarding climate change and ESG funds, one item to consider is how asset managers within the plan menu utilize ESG within their investment process. This is an easier first step than completing an adverse impact study on all the funds in your plan menu, which includes a number of variables and assumptions.
Those are difficult questions, and there may be no way to answer them with absolute certainty, but these are the questions that help us develop and ensure that the processes we have set up for our investment committee to follow are sufficiently rigorous.
These questions and issues are big and difficult, and they might lead many to look to the heavens, throw up their hands and ask for a sign from above to help them find an answer.
Who knows if those prayers for relief will be answered?
But remember, the relief you can gain as an investment committee comes from the processes that are set up and continually followed. Those processes, while demanding, will help us be able to sleep a little better at night.
If you’d like more information on these cases and other fiduciary topics, you can check out the Janus Henderson Blog or our Top DC Trends and Developments Guide. And as always, I’d love for you to subscribe to this podcast via iTunes or Spotify so you get the latest episode when it is available.
Until then, I’m Ben Rizzuto and thanks for listening to Plan Talk from Janus Henderson Investors.