Litigation reform – investment ”underperformance”

This is the third article in our series on the issues ERISA fiduciary litigation presents for plan sponsors – litigation over alleged “underperformance” of funds in a participant-directed defined contribution plan fund menu, and, increasingly, alleged “underperformance” of the plan’s target date fund. Remarks we made in our earlier article on the preliminary issues applicable to ERISA fiduciary litigation – who gets sued and why and the importance of and rules with respect to the motion to dismiss – will also apply to this litigation with respect to alleged fund underperformance.

The ERISA prudence duty with respect to fund performance

In these cases, plaintiffs are claiming the plan fiduciaries imprudently included a particular fund in the plan fund menu and that both the basis for that imprudence claim and for the damages the fiduciaries owe is the subsequent “underperformance” of that fund vs. (alleged) “comparator” funds.

What exactly is the test in these cases? Axiomatically, ERISA prudence is about process, so the ultimate question is, did the plan’s fiduciaries use a prudent process in arriving at the decision to include a particular fund in the fund menu.

But since (as in the fee litigation we have discussed) plaintiffs don’t typically have access to the facts with respect to that process, courts have generally allowed plaintiffs to focus on a more objective issue: whether, at the time a fund is selected for a fund menu, and at the time of, e.g., quarterly or annual reviews, investment in it was (or could be considered) prudent, as part of a participant selected portfolio of funds. This shifts the argument from process (what the committee did) to substance (was the fund a “bad” fund).

Plaintiffs’ complaints

There is, embedded in the above test, a critical “timing” issue. Most courts would, if pressed, agree that the question about whether a particular fiduciary decision was prudent depends on the facts and circumstances at the time it was made and not in retrospect, that is, not in view of the subsequent (alleged) underperformance of that fund. But some courts seem to (implicitly) ignore this distinction.

Plaintiffs will sometimes raise issues that do bear on prudence-at-the-time-a-decision-was-made, arguing that, e.g., the “newness”/lack of track record of a particular fund or turnover in fund management are “facts” that a prudent fiduciary should have considered. But they typically give over most of their complaint to a detailed analysis of (and pages of data on) how the plan’s fund subsequently did, featuring a retrospective comparison of that fund’s performance against some (allegedly) comparable benchmark/comparator funds.

Taking that approach, it’s easy for a plaintiffs’ lawyer to reverse-engineer a case: (1) find a fund that underperformed over the last 1-5 years; (2) find a plan that has included that fund in its fund menu; (3) find some negative press about that fund (at the time the fund was selected by the plan, or during the period the plan held it), that plan fiduciaries “should have been aware of.” And hit “print complaint.”

Perhaps the best illustration of this sort of case involves targeting a plan’s target date fund. And, indeed, underperformance litigation has largely targeted TDFs, because that is (as they say) “where the money is.”

The BlackRock TDF litigation

Beginning in 2022, participants and former participants in some of the largest 401(k) plans in the US sued plan fiduciaries claiming that the use of one of the largest target date funds, the BlackRock LifePath Funds, was imprudent, because those funds “underperformed” alleged “comparators.”

Most (but not all) courts have dismissed these claims. A good example is the February 7, 2023, decision by the US District Court for the Western District of Washington, in Beldock v. Microsoft, holding that plaintiffs’ “allegation of imprudence based on performance relative to comparators” was insufficient to state a claim under ERISA. The Beldock court found that:

[A] complaint must allege “factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.” Where there are “two possible explanations, only one of which can be true and only one of which results in liability,” Plaintiffs “cannot offer allegations that are ‘merely consistent with’ their favored explanation but are also consistent with the alternative explanation.” Indeed, “[s]omething more is needed, such as facts tending to exclude the possibility that the alternative explanation is true, . . . in order to render plaintiffs’ allegations plausible within the meaning of [the Supreme Court’s decisions in] Iqbal and Twombly.”

“Underperformance” vs. which comparator

There is, in all underperformance cases, a critical issue that is particularly acute in TDF litigation – sorting out (retrospectively) the difference between:

(1) Underperformance that might conceivably be the result of a bad fiduciary process/bad fiduciary decision (let’s call that negative “alpha”), from

(2) Underperformance that is the necessary result of a perfectly legitimate (that is, perfectly prudent) asset allocation decision (let’s call that negative “beta”).

A very simple example: a plan that selects a “value fund” that does worse than any other value funds might conceivably have made a bad decision. A plan that selects a value fund that does worse than the S&P 500 (during a large cap bull market) has not made a bad decision, per se – it has made a perfectly rational decision to offer a fund in the fund menu that, given subsequent market performance, didn’t work out.

This issue typically gets litigated in underperformance cases as an argument over whether the plaintiffs have selected an appropriate comparator (in their retrospective analysis) for the plan fund.

“Underperformance” vs. asset allocation and glide path

This issue is particularly acute (as we said) for TDF litigation for a couple of reasons. First, because as the default plan investment, courts are tempted to analyze the plan’s TDF not as one investment among many (e.g., not as choice between a value fund and growth fund, both of which are offered in the plan fund menu), but as the primary fund for a large number (sometime the majority) of plan participants.

And second, because the addition of a (sometimes unique) glidepath complicates comparison of the performance of one TDF with another.

Some courts have been good at sorting out these issues. Thus, in Beldock, the court noted:

As Defendants point out, there are some key differences between the BlackRock TDFs and the Comparator TDFs [offered by plaintiffs in the complaint]. … For example, the BlackRock TDFs are a “to retirement” suite, while the Comparator TDFs are “through retirement” suites; the BlackRock TDFs and two of the Comparator TDFs invest only in passively managed funds while the remaining two invest in actively managed funds; the TDFs allocate their assets differently among bonds and equities; and the TDFs invest in different categories of bonds and equities. … In addition, the BlackRock TDFs have a “Gold” analyst rating from Morningstar, while only two of the four Comparator TDFs have a “Gold” rating.

Not all courts agree …

Not all courts, however, have been as skeptical of comparisons between TDFs that differ in their design: In a November 20, 2024, decision, the Sixth Circuit Court of Appeals, in Johnson, et al. v. Parker-Hannifin Corporation, et al., reversed and remanded a decision by the lower court dismissing plaintiffs’ claims “that Parker-Hannifin breached its fiduciary duties by imprudently retaining the Northern Trust Focus Funds [the plan’s TDF], imprudently providing participants with higher-cost shares, and failing to monitor its agents in their fiduciary duties.”

The Sixth Circuit’s decision included a finding that plaintiffs had adequately alleged that defendants had imprudently retained a suite of target date funds (the Northern Trust Focus Funds) in the 401(k) plan’s fund menu, based in part on the alleged underperformance of those funds relative to the “S&P target date fund benchmark.”

The court in this case seemed unaware of the variables (noted above and discussed in Beldock) among target date funds, how they are constructed and the complexeffect that glidepath and asset allocation have on performance. Quoting the dissent in Johnson v. Parker-Hannifin:

The complaint offers no details about [the S&P target-date benchmark]. … [A]s the district court recognized, the benchmark is not a “fund” that administrators can select for retirement plans. … And the complaint includes no details about the benchmark’s hypothetical contents. Another court suggested that it represents a hypothetical composite of target-date funds with different strategies and risk profiles.

Two fundamental problems with “underperformance” litigation

Non-TDF cases typically follow a similar pattern – voluminous retrospective comparison of the allegedly “imprudent fund” with other better performing funds plus some other fact that might lead an investor not to invest in a fund. There are, however, two fundamental problems with these sorts of claims that many courts overlook.

First, there is something inherently problematic in the retrospective performance analysis that plaintiffs rely on. That sort of data might be relevant to a determination of damages, but some courts are willing to consider it in determining imprudence, even though all of the challenged decisions are made before any of the “comparative underperformance” data has “happened.” Another version of this same point: in nearly all cases, the challenged funds are investing in publicly traded securities with respect to which the market is setting the fair market value, and under ERISA that value is necessarily “prudent” at that price. And, of course, if that price subsequently goes down, the plan will only be able sell the fund after the “underperformance” has happened.

Second, there is an issue of what is sometimes called “objective prudence” and sometimes “loss causation.” That sounds complicated, but it is basically the principle that, even where a fiduciary did not have a prudent process – say, the fiduciary just used a dartboard to pick funds – if that process nevertheless resulted in a prudent choice, there is no ERISA prudence violation. Most courts recognize that principle in one of those guises (“objective prudence” or “loss causation”).

The foregoing naturally leads to the question: what is the standard here/what is a prudent choice? Is the test “is it possible that some prudent fiduciary might have invested in this fund?” or is it “is there some other fiduciary somewhere in the world that might have considered this investment imprudent?”

On what basis can you drag a sponsor fiduciary into court?

And all of that leads us back to the question we began this series with: what is the minimum that a complaint must allege on an underperformance claim to survive a motion to dismiss?

It would be “nice” if the courts would give us some coherent guidance on this issue that recognized that – in a liquid market – underperformance is a problematic concept and a dubious basis for a court case. The Supreme Court did just that in a company stock case – Fifth Third Bancorp et al. v. Dudenhoeffer – in which it said:

Where a stock is publicly traded, allegations that a fiduciary should have recognized on the basis of publicly available information that the market was overvaluing or undervaluing the stock are generally implausible and thus insufficient to state a claim.

Does that same principle apply to a fund of publicly traded stocks? At this point all we can say is: “good question.”

It’s unclear whether, in the absence of a Supreme Court decision that resolves all of these difficult questions, anything can be done about these issues through, e.g., agency guidance or legislation.

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We will continue to follow this issue.