Sixth Circuit, in decision for plaintiffs, uses generic S&P TDF benchmark to determine underperformance/imprudence

On November 20, 2024, 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, 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.”

In this article we are going to focus on that issue: the court’s crediting an allegation of underperformance based on a comparison to what the court characterized as an “industry standard” benchmark. We conclude with some observations about the utility of custom benchmarks to prevent (or at least present an alternative to) the this sort of comparison.

Imprudent selection of Northern Focus Funds for the plan fund menu

The (allegedly) underperforming Northern Trust Focus Funds are “a suite of target date funds that ‘were collective investment trusts, not mutual funds, comprised primarily of index or passive strategies.’”

Plaintiffs allege three reasons why the selection and retention of the Northern Focus Funds was imprudent: (1) The funds had a “short and untested track record.” (2) The funds “had ‘major changes in asset holdings, extremely high turnover,’—as high as a 90% turnover rate—'and substantial transaction costs.’” (3) The funds underperformed “compared to the S&P target date fund benchmark and alternative target date funds.”

Untested track record:The court rejected plaintiffs’ first argument, that it was imprudent to select the Funds because of their “untested track record,” finding that while the Funds were arguably “untested” when launched in 2009, for the period to which this litigation relates (beginning 2015) the Funds did have a track record.

Unreasonable turnover:The court, however, accepted plaintiffs’ argument that there had been unreasonably high turnover in the Funds, supporting their imprudence claim. The court reached that conclusion even though the high turnover (it appears) occurred before 2015, explaining that “A jury could find that, in 2015, a prudent administrative process weighing the retention of a fund would take into account any underperformance and turnover, even if it occurred before the fund was added to the Plan in 2014.”

The court found that these allegations of unreasonably high turnover, “combined” or “taken together” with plaintiffs’ allegations with respect to the Funds’ underperformance, were sufficient for plaintiffs’ ERISA imprudence claim to survive a motion to dismiss. And it was on the basis of those findings that the court reversed and remanded the lower court’s finding for defendants on this count.

Measuring underperformance

Let’s now turn to that last issue – plaintiffs’ allegation that the Northern Funds underperformed, supporting plaintiffs’ imprudence claim.

Plaintiffs argued that “that a prudent fiduciary would have removed the Focus Funds based on its underperformance compared to the S&P target date fund benchmark and alternative target date funds.” The court’s analysis of this issue, however, focuses only on a comparison of the Funds’ performance with the “S&P target date fund benchmark.” In a footnote the court states that “Because we hold that the S&P target date fund benchmark is a meaningful comparator, we need not determine whether the alternative target date funds are also meaningful benchmarks.”

The court’s argument for why this S&P benchmark was a “meaningful comparator” to the Northern target date funds is curious:

Because tracking an industry-recognized index is the “investment goal” of a passively managed target date fund such as the Focus Funds, a relevant market index is inherently a meaningful benchmark. … Contrary to the dissent’s assertion, … we thus break no “new ground” by holding that Johnson sufficiently pleaded that the Focus Funds were “attempting to mimic” the S&P target date fund, making it a meaningful benchmark.

Essentially, the court is saying that because the plan’s TDF is composed of index funds, using a market index is an appropriate benchmark.

In a footnote, the court distinguished its decision in Smith v. CommonSpirit Health, et al. (June 2022) as follows:

This is different from CommonSpirit, in which we rejected the use of a passive fund as a benchmark for an active fund. … For an active fund, a “portfolio manager actively makes investment decisions and initiates buying and selling of securities in an effort to maximize return.” Evaluating performance of these funds is more complex, as the fund’s strategy may differ significantly from that of an index or passive fund. … And because an active fund is not trying to mimic an index, managers have more flexibility to adjust asset allocation based on market conditions or their outlook. … Therefore, year-to-year comparisons between active funds and indices or passive funds can be more inconsistent.

The court seemed unaware of the complexity of target date funds

All of this seems to misunderstand how a target date fund is constructed and the complexeffect that glide path and asset allocation have on performance – even where the challenged fund’s glidepath and asset allocation structure are indisputably within the range of prudence.

Moreover, there is little discussion of what that S&P benchmark is or how it is constructed (that is, what glide path/asset allocation strategy it uses). Quoting the dissent:

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.

An argument for custom benchmarks?

The Sixth Circuit’s decision on this critical issue of what is a meaningful benchmark is disturbing.

As we discussed in our article on the BlackRock target date fund litigation, comparing target date fund performance is particularly difficult and problematic because of the multitude of variables that may affect it. Differing glidepaths. Differing asset allocation strategies. And differing asset classes. Choices with respect to which, while rational and prudent by themselves, may result in “underperformance” vs. an alleged “comparator” (with a different glidepath, asset allocation strategy, and different asset classes). In Johnson v. Parker-Hannifin, the court utterly failed to address these issues – it is not even clear the court knew that they exist.

In this regard, the provision in a plan’s Investment Policy Statement of a custom benchmark, reflecting the plan’s specific target date fund glidepath/asset allocation strategy, may be a defense to the sort of approach taken by the Sixth Circuit in this case (using a generic and opaque “industry standard” TDF benchmark).

In Bracalente v. Cisco Systems, Inc. (a BlackRock TDF case), plaintiffs challenged the use of this sort of custom benchmark, claiming that it was “simply a reflection of the TDF portfolio,” which they contended was “akin to looking in a mirror.” The use of such a custom benchmark, however, was explicitly provided for in the Cisco plan’s IPS. And in Bracalente the court rejected plaintiffs’ challenge to it, holding that, in this regard, “[a]lthough Plaintiffs would have preferred a different IPS, courts must give due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise.’”

Sponsors may want to consider this approach to the challenge of benchmarking target date funds and threats of litigation with respect to it.

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We will continue to follow this issue.