On November 30, 2017, a participant in the CenturyLink 401(k) plan filed a complaint with the United States District Court for the District of Colorado claiming that the inclusion of a multi-manager large cap fund in the plan’s fund menu was per se imprudent.
In this article we review the complaint and some of the issues it raises.
Summarizing, based on the complaint: CenturyLink (a telecommunications company) sponsors a 401(k) plan that provides a fund menu that includes “a total of 12 target date funds, three bond funds, a money market fund, three domestic stock funds, two international funds and a CenturyLink Company Stock Fund.” A subsidiary of CenturyLink, CenturyLink Investment Management (CIM), is the plan’s “investment fiduciary” and one of the defendants in the case.
The plan’s Active Large Cap Fund (Large Cap Fund) includes a “mix of passively and actively managed funds” (one passive and five active managers) and uses an “actively managed multi-manager approach” with the objective of exceeding the performance of the Russell 1000 Stock Index.
According to the complaint:
CIM designed the Large Cap Fund using a multiple manager approach “in order to provide exposure to different styles of portfolio management,” “increased resources” and “a broader range of investment ideas.” “Multiple managers also reduce the risks associated with a single manager,” giving the Large Cap Fund “a higher likelihood of meeting its objective.” The managers of the Large Cap Fund “seek to add returns above the benchmark through actively selecting stocks and favoring investment styles they believe will outperform the benchmark over long periods of time.”
Plaintiff claims that the Large Cap Fund was defective as designed and that its inclusion in the plan’s fund menu was, by definition, imprudent:
CIM designed, and offered, a defective Large Cap Fund investment option to CenturyLink plan participants, by structuring it to allocate invested capital to six different managers with the same large cap domestic equity mandate. CIM, as an experienced investment advisor, knew or should have known the design of the Large Cap Fund was defective and that the Large Cap Fund objectives could not be realized by using multiple investment managers with the same mandate.
It’s important to the viability of this claim that the proof of this defect is not based on a hindsight consideration of performance. Plaintiff is claiming, in effect, that the use of any large cap fund designed this way is imprudent as such. Thus, the (alleged) fact that the Large Cap Fund over the last five years underperformed its benchmark by 2.11% would only be relevant to damages.
Plaintiff’s theory is that, because of the efficiency of the large cap market, any actively managed large cap multi-manager fund design in which the different fund managers are all operating under the same mandate will, at best, simply reproduce results that are more efficiently achieved by investing in a stock index fund.
Quoting the complaint:
Because of the highly efficient nature of the large cap domestic equity market, companies are generally fairly valued and excess returns are hard to produce over time. Furthermore, the [Large Cap Fund’s] five active managers would inevitably take competing positions and cancel out each other’s strategy. Effectively, the fund managers will be trading stocks among themselves as one manager overweights a stock that another manager chooses to underweight.
The harm caused to participants by this (allegedly) defective design was exacerbated by the fact that, according to the complaint, the Large Cap Fund was (1) the only large cap stock investment option and (2) also made up 16% of the target date funds.
Plaintiff also repeated what is by now a generic 401(k) plaintiffs’ argument against large cap active management: That “[l]ess than one percent of large-cap managers consistently outperformed their benchmarks over a five year period.” And she challenged basic multi-manager theory: “[r]esearch shows fund performance drops when funds switch from being run by a single manager to two or more. The more managers a fund has, the worse its performance is compared with a product run by a single portfolio manager.”
The plaintiff did not provide any citation for this research or facts supporting these claims. And many serious investment professionals would dispute them.
Further, the plaintiff claimed that “there are three primary investment strategies: over or underweighting certain sectors, over or underweighting individual companies within sectors, or both.” With such a limited set of choices, “it is a virtual certainty that the strategies [of the fund’s managers] would conflict and offset each other. This would tend to cancel the effect of active management over time.” Again, plaintiff provides no citation or facts supporting these assertions.
Are these viable claims under ERISA?
In it’s 2016 decision in White v. Chevron, the United States District Court for the Northern District of California described the standard for pleading an ERISA prudence claim as follows: “the complaint must allege facts sufficient to give rise to a ‘reasonable inference’ that the Plan fiduciaries engaged in conduct constituting a breach of fiduciary duty.”
The only facts (relevant to her ERISA claim) about the CenturyLink plan’s Large Cap Fund that plaintiff alleges are (1) that there were five different active managers operating under the same mandate but using different styles and (2) that the fund significantly underperformed its benchmark. She doesn’t allege any facts about, e.g., what those different styles were and how (specifically) they tended to, e.g., “cancel out each other’s strategy.”
As in other ERISA prudence litigation, the plaintiff references research that purports to prove the efficient market hypothesis. But, despite the claims of some plaintiffs in 401(k) plan fee litigation, no court has found, as a matter of law, that including an actively managed fund in a 401(k) plan fund menu is per se imprudent or, even, creates a presumption of imprudence. Indeed, despite these plaintiffs’ claims, it’s hard to imagine a court adopting such a standard.
Certainly, at some point, the CenturyLink plaintiff will have to prove more of a factual link between the use of multiple managers and the Large Cap Fund’s underperformance. The critical question at this stage of the litigation is: are plaintiff’s general assertions enough to survive a defendants’ motion to dismiss?
Finally, we would expect that, when we get defendants’ answer (and their motion to dismiss), the picture the plaintiff has painted in her complaint will become a lot more nuanced. First, plaintiff’s view of available investment strategies – “over or underweighting certain sectors, over or underweighting individual companies within sectors” – seems drastically limited. Second, there are a variety of large cap investment strategies, e.g., “smart beta,” that do consider market efficiency as part of their “style.” And third, there are, e.g., defensive active equity management strategies that may be both prudent and underperform a large cap index during a strong market such as the one in US large cap over the last five years.
We will continue to follow this issue.