TDF fiduciary hygiene: an appropriate IPS; customized benchmarks; and thorough committee minutes
On May 20, 2024, the United States District Court for the Northern District of California (San Jose Division) dismissed plaintiffs’ complaint in Bracalente v. Cisco Systems, Inc., holding that defendant Cisco did not violate ERISA’s prudence requirement in selecting (and retaining) a suite of BlackRock target date funds (TDFs) as the Cisco 401(k) plan’s qualified default investment alternative (QDIA), notwithstanding that (as plaintiffs alleged) “the BlackRock TDFs had either the worst or second worst three- and five-year returns of the group of Comparator TDFs.” (This case is part of the series of lawsuits targeting sponsors that use BlackRock TDFs.)
In this article, we very briefly review the court’s decision, highlighting three issues of practical significance for sponsor fiduciaries – the importance of:
An appropriate investment policy statement (IPS) crafted (in part, at least) with a view towards possible litigation.
Where appropriate, explicit custom benchmarks, especially for the plan’s QDIA-TDFs.
Adequate committee minutes reflecting review of fund performance and conforming to the standards adopted in the IPS.
A brief summary of the case
Plaintiffs are participants in Cisco’s participant directed 401(k) plan. Per agreement of the parties, Cisco is the sole defendant and is being sued in its capacity as an ERISA fiduciary.
As in other BlackRock TDF lawsuits, plaintiffs claim that defendant violated ERISA’s fiduciary prudence requirement by selecting (and retaining) BlackRock TDFs, given their underperformance vs. “the four other largest TDF series, which include the Vanguard Target Retirement funds, T. Rowe Price Retirement funds, American Funds Target Date Retirement funds, and Fidelity Freedom Index funds.”
As noted, plaintiffs claimed that “the BlackRock TDFs had either the worst or second worst three- and five-year returns” vs. this group of comparators. The court found, however, that these comparators could not (without further factual allegations) “serve as meaningful benchmarks” because “two [of the] comparators are composed of actively managed funds (contrast the BlackRock TDFs, which are composed of passively managed funds), and the other two employ a ‘through retirement’ glide path strategy (contrast the BlackRock TDFs, which employ a ‘to retirement’ glide path strategy).”
The court further rejected plaintiffs’ claims that: (1) defendant fiduciary had “violated” the IPS; (2) the use by the fiduciary of a custom benchmark that was (plaintiff claimed) inappropriate and imprudent; and (3) committee minutes failed to demonstrate adequate review of the TDFs’ performance.
In what follows we briefly review the significance for sponsors of the court’s discussion of these three issues.
An appropriately crafted IPS
Plaintiffs claim that “The IPS becomes a binding plan document when plan fiduciaries adopt an IPS, and prevailing standards dictate that plan fiduciaries have certain responsibilities with respect to the IPS, including that they do not violate the guidance set forth in an IPS.” The court, in its analysis, appears to adopt this standard.
To illustrate: The Cisco IPS provided that “The primary objective of each investment option is to meet (for passive funds) or exceed (for active funds) the results of a representative benchmark for the option, such as a broad market index.” (Emphasis added.) Plaintiffs argued that the plan’s TDFs were “active funds,” because – notwithstanding that the “the underlying structure of the BlackRock TDFs … undisputedly consist entirely of passive funds” – “no series [of the plan’s TDFs] is truly passively managed, as every target-date manager makes active decisions in building a glide path and selecting asset classes, sometimes tactically based on market outlooks.” Thus, the BlackRock TDFs should have been held to an “exceeds benchmark” standard.
The court found that "the apparent misclassification of the BlackRock TDFs [did not demonstrate] an imprudent process because the IPS explicitly states that the Committee ‘may or may not judge that the investment manager(s) is likely to meet its objectives in the future, and therefore may or may not invoke any further action in regard to the reviewed manager.’”
The lesson here for sponsors: Cisco was able to win on this issue because of the flexibility it had built into its IPS, giving the committee discretion as to what to do if a fund did not meet a target.
There is sometimes a tendency to make an IPS more aspirational than practical. The rule should always be: The IPS should reflect committee practice, and committee practice should reflect the IPS. The IPS should be reviewed by counsel, with a view to a future court finding it to be “a binding plan document … dictat[ing] that plan fiduciaries have certain responsibilities with respect to the IPS, including that they do not violate the guidance set forth in an IPS.”
Customized glide paths
The problem with nearly all “imprudence based on underperformance” lawsuits is that plaintiffs argue from post hoc results (that are easily cherry picked) that an ex ante decision – e.g., to include a particular fund in the fund menu – was imprudent. Typically, however, that ex ante decision was perfectly rational. In the BlackRock TDF cases, it can be argued that nearly all the difference in performance of BlackRock TDFs vs. comparator TDFs can be explained by perfectly rational/prudent investment/asset allocation decisions: in the BlackRock funds, a preference for passive over active investments and for a “to” rather than a “through” glidepath and that neither of those preferences are in any way imprudent.
One way to address this issue – in the TDF context – is to use a custom benchmark that embodies those investment/asset allocation decisions. Which is what Cisco did here. In plaintiffs’ words:
Plaintiffs allege that Cisco improperly relied on performance comparisons of the BlackRock TDFs to their custom benchmarks. The custom benchmark is a “weighted mix of the benchmarks of the underlying portfolio funds” whose purpose is “to reflect the funds’ asset allocation shifts over time by reweighting the component indices quarterly to match the weighting of the BlackRock TDF portfolio.” In other words, the custom benchmark is “simply a reflection of the TDF portfolio,” which Plaintiffs contend is “akin to looking in a mirror.”
This approach was (in fact) explicitly provided for in the IPS. And 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.’”
And the court rejected the use of plaintiffs’ four comparator TDFs on just the basis noted: two of the four used actively manage underlying funds, and the other two used a “through” rather than a “to” glidepath.
Minutes that reflect fiduciary requirements
Plaintiffs also alleged that the committee did not consider the issue of BlackRock TDF performance:
Plaintiffs allege that Cisco failed to establish a prudent investment monitoring process …. In support, Plaintiffs allege that, “[a]lthough the Committee met periodically, it failed to meet quarterly during the Class Period,” and the minutes of the Committee’s first meeting on October 13, 2016 “reflect no discussion of the performance of the BlackRock TDFs, even though the BlackRock TDFs were obviously the Plan’s most important investment.”
The court agreed with plaintiffs that, although “meeting minutes need not – and almost always do not – contain ‘a verbatim transcript of all the issues considered by fiduciaries’” [citation omitted], “the Court must consider the allegations and meeting minutes in the light most favorable to Plaintiffs.” In this regard, it found, that while the omission of a discussion of performance in the October 13, 2016, meeting was significant, it was remedied in this case by “the February [2017] meeting minutes, which specifically reflect a review of the BlackRock TDFs and the Committee’s determination that they remain ‘a prudent investment choice for the Cisco 401(k) participants.’”
For the foreseeable future, plaintiffs lawyers will be on the hunt for sponsors that include “underperforming funds” in the plan fund menu. Committees may address this issue by explicitly recording/summarizing in their minutes any discussion of fund performance, especially with respect to funds that are “underperforming.”
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We expect challenges to the prudence of fund selection/fund menu construction to be with us for the foreseeable future. For that reason, sponsor fiduciaries will want to consider how they can best present the case for the prudence of their decisions. With respect to challenges to TDFs, the content of the IPS, an explicit, customized benchmark, and thorough minutes on the committee’s review of performance may in many cases be critical to the outcome.
We will continue to follow this issue.