Principal sued over target date fund structure

On April 16, 2018, a group of plaintiffs filed suit in the United States District Court for the Southern District of Iowa against a group of Principal affiliates, alleging that they violated their ERISA fiduciary duties of loyalty and prudence.

The complaint is interesting in several respects:

It extends the “identical lower cost investment available from the same provider” claim of, e.g., Tibble v. Edison to “identical” index funds of different providers.

It bases an ERISA disloyalty/imprudence claim on the fiduciary’s choice of a “more expensive” mutual fund, when the “identical” investment is available from the same provider in a less expensive separate account.

It is an ERISA 401(k) plan fee suit brought against a provider rather than, as has been more typical, plan fiduciaries.

Significance for plan sponsors

If plaintiffs are successful, a line of attack in 401(k) plan fee litigation will have opened up that targets providers rather than sponsors. If plaintiffs fail, they may simply bring a case based on the same facts and theory of fiduciary breach against plan sponsors.

It is likely that the plans/sponsors participating in the Principal Collective Investment Trusts are smaller, and that separate individual lawsuits against each of them would not be viable. But the plaintiffs’ lawyers could simply begin looking for large plan sponsors whose plans have similar issues.

Moreover: the lawsuit here is premised (among other things) on the provider being a fiduciary because the investment vehicle is a collective trust. Where the same investment is made using a mutual fund, the provider generally would not be a fiduciary, and a claim against sponsor fiduciaries would become much more likely. In that situation, plaintiffs’ argument that, in judging the prudence of the selection of an index fund, the cost of the fund should be compared with the cost of funds of different providers that track the same index, could easily provide the basis for a lawsuit against sponsor fiduciaries.

In this article we review the complaint.


This is a claim brought on behalf of three participants in two separate and unrelated plans that offered a Principal target date fund consisting of a series of 12 underlying collective investment trusts. The latter were called the Principal LifeTime Hybrid Collective Investment (Trust) Funds (“Principal CITs”).

Plaintiffs are alleging that defendants were fiduciaries with respect to the underlying investments of the Principal CITs and breached their ERISA duties of loyalty and prudence in selecting investments for the Principal CITs in two respects:

First, they selected “higher-cost, poor-performing Principal-affiliated index fund options despite the availability of identical index fund products offered by unaffiliated managers with demonstrably superior ability to track the subject index for fees that were 5 to 15 times lower than those charged by the Principal-affiliated options.” (Emphasis added.)

And, second, they “used higher-cost investment vehicles and share classes of Principal-affiliated investments despite the availability of identical investments that charged lower fees, and would have performed better.”

Plaintiffs are requesting class certification representing “[a]ll participants and beneficiaries of an employee benefit plan qualified under Section 401(a) of the Internal Revenue Code invested in any of the Principal LifeTime Hybrid Collective Investment Funds at any time on or after April 16, 2012.”

Principal as fiduciary: mutual fund vs. collective trust TDFs

Plaintiffs allege that:

Defendants acknowledged in both the Declaration of Trust and sales literature for the Principal CITs [that] 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.

This point (which may or may not be true – we do not have Principal’s answer yet on this issue) is worth noting. These were, as discussed, collective trusts. As plaintiffs note, the issue raised in this case – a breach by fiduciaries of a TDF – generally does not come up with respect to mutual funds. ERISA section 2(21)(B) provides that investment of ERISA plan assets in a mutual fund “shall not by itself cause such investment company or such investment company’s investment adviser or principal underwriter to be deemed to be a fiduciary or a party in interest [under ERISA].”

This special treatment for mutual funds does not extend to collective trusts or separate accounts. When a plan acquires an interest in a collective trust – e.g., when a 401(k) plan participant invests in a collective trust via a TDF – under DOL regulations the plan’s assets “include its investment and an undivided interest in each of the underlying assets” of the collective trust. And fiduciaries with respect to those underlying assets – e.g., the persons making investment management decisions with respect to the collective trust’s assets – are ERISA fiduciaries.

With respect to the critical issue of control over the underlying investments of the Principal CITs, plaintiffs allege that “Defendants constructed each Principal CIT’s investment portfolio, which involved ‘the selection and monitoring of the Target Date Funds’ underlying investment options and investment managers.’” Plaintiffs claim that it is in this respect – the selection of the TDFs underlying investments – that the Principal defendants breached their fiduciary duty.

Proving fees are excessive

Plaintiffs argue in the complaint is that Principal was, with respect to these underlying funds, responsible for “prudently and loyally selecting appropriate investment options, evaluating and monitoring the Principal CITs’ investments on an ongoing basis and removing and replacing those that are no longer appropriate, and taking all necessary steps to ensure that the Plan’s assets are invested prudently and in a low-cost manner.” (Emphasis added.)

As we have discussed in the past, a critical issue for plaintiffs lawyers in 401(k) plan fee litigation is proof: how do you prove that a particular fund’s investment fees are too high? And on this issue, this case, brought against a provider, is no different than the numerous cases brought against plan fiduciaries.

Much of the litigation on this issue (e.g., Tibble v. Edison) has involved a challenge to the share class selected by the fiduciary; thus, in many other cases, plaintiffs have compared the cost of different share classes of the identical investment offered by the identical investment company. In this case, however, plaintiffs are reaching beyond that sort of identical investment/different share class in two respects.

Argument with respect to index funds

According to the complaint, “four index funds have represented 60 to 70 percent of the total assets of each of the Principal CITs.” For this purpose, the Principal fiduciaries invested “exclusively in Principal’s proprietary index funds.” And those Principal index funds carried “fees that were 5 to 15 times higher than marketplace alternatives that tracked the exact same index.” (Formatting in the original.)

Plaintiffs argue the prudence of an index fund investment should be judged by three factors: cost; tracking error; and institutional experience and expertise. And that with respect of each of these factors the Principal funds underperformed the market. The complaint includes extensive data to support this claim.

To be clear about plaintiffs’ strategy: to address the difficult issue of proof, they are arguing that index fund performance is not a matter of judgment but rather of comparing easily measured variables – cost, tracking error and expertise/experience. Thus the performance with respect to those variables between funds of different investment companies that track the same index can be measured. And, in that regard, they argue that the Principal funds selected by the defendants clearly underperformed the market.

Argument with respect to actively managed funds

That sort of argument is generally not available with respect to an actively managed fund, because the performance of an actively managed fund generally depends on the judgment of the fund’s managers.

With respect to the actively managed funds held by the Principal CITs (which we assume generally made up the other 40 to 30 percent of Principal CIT assets), Plaintiffs argue that “Defendants … breached their fiduciary duties by utilizing more expensive versions of Principal-affiliated underlying investments, despite the availability of identical, but lower cost, investment vehicles and share classes.” Specifically, defendants “failed to investigate and utilize lower-cost vehicles, in several instances using Principal-affiliated mutual funds as investments within the Principal CITs despite the availability of lower-cost, but otherwise identical, annuity separate accounts managed by Principal.”

It will be interesting to see how Principal responds on this issue. Plaintiffs assert that:

Defendants cannot argue there was a qualitative difference between the two vehicles [mutual funds and separate accounts]. Defendants’ own sales literature represents that they act as an ERISA fiduciary in their management of annuity separate accounts, that “[s]ubstantial resources have gone into the careful review and ongoing monitoring” of their annuity separate accounts, and that Principal’s annuity separate accounts constitute appropriate investments for an ERISA fiduciary.

There are, nevertheless, substantial differences between the two different investment vehicles.

Moreover, plaintiffs argue that the Principal CITs could have “used their leverage and negotiating power” to, for instance, utilize Z shares of Principal’s lower cost Diversified International annuity separate account. It is an interesting question whether that argument will work, given that many (if not all) of the individual plans investing in the Principal CITs would not have had anything like that sort of leverage and negotiating power.

Suing the provider rather than the sponsor

The viability of plaintiffs’ case will depend in part on whether they can establish that the Principal defendants acted as ERISA fiduciaries in choosing the Principal CITs’ underlying investments. This sort of arrangement may (conceivably) be structured so that it does not involve a discretionary fiduciary decision by the fund manager or an affiliate, although doing so involves some complications.

If the Principal defendants can successfully argue that they were not acting as fiduciaries, they may be able to get this complaint dismissed. But that would not make plaintiffs’ underlying claim – that the funds selected for the Principal CITs were overpriced and that their selection was imprudent – go away. And if Principal is not liable for that selection, then some other fiduciary – in all likelihood a plan fiduciary – may be.

One assumes that most of the sponsors whose plans are participating in the Principal CITs are relatively small. Thus, on these facts, the provider may be a more “inviting target” for class action litigation. But for larger employers, especially where the TDF vehicle is a mutual fund, a suit against sponsor fiduciaries may be more viable.

Thus, while this is a suit against a provider, plan sponsors will want to monitor how it develops.

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We will continue to follow this issue.