Sixth Circuit upholds dismissal of plaintiff’s claim based on use of actively managed TDF
On June 8, 2022, the Sixth Circuit Court of Appeals affirmed the dismissal of plaintiff’s claim, in Smith v. CommonSpirit Health, et al., that the fiduciary of the CommonSpirit Health 401(k) plan “breached its duty of prudence by offering several actively managed investment funds when index funds available on the market offered higher returns and lower fees.” The case is another in a series of post-Hughes v. Northwestern University 401(k) fiduciary prudence cases, this one raising the issues of both fees and performance.
In this article we review the court’s decision on this issue.
Factual background
CommonSpirit Health is one of the largest US healthcare providers. Its 401(k) plan covers 105,000 participants and has over $3 billion in assets. Plaintiff Smith is (or was) a participant in that plan.
A focus of plaintiff’s claims in this case was the selection by the plan’s fiduciary for the plans default investment of the actively managed Fidelity Freedom Funds target date fund suite.
Plaintiff claimed that the plan’s fiduciary breached its duty of prudence in selecting and retaining the Fidelity Freedom Funds TDF because there were index funds available that “offered higher returns and lower fees.” To support this claim, plaintiff compared the performance of the Fidelity Freedom Funds TDF with the performance of the Fidelity Freedom Index Funds, a TDF that includes only (lower cost) index funds. Plaintiff also alleged that the Fidelity Freedom Funds TDF “trailed related index funds in their rates of return over three- and five-year periods.”
Legal background – types of claims
In 401(k) fee litigation, plaintiffs often claim that it is a breach of ERISA’s prudence standard for a fiduciary to select a higher fee fund when there is an “identical” – or “nearly identical” or “similar” – lower-fee fund available. Plaintiffs have had the most success with this argument where the fund selected uses a retail share class and there was a lower-priced institutional share class, in (literally) the same investment pool, available. (See, e.g., Tibble v. Edison.) They have had less success trying to stretch this argument to cover, e.g., use of an (allegedly) higher-priced mutual fund rather than an (allegedly) lower-priced collective trust or separate account, or (as here, and at the extreme) a (higher-priced) active strategy rather than a (lower-priced) passive strategy for the same asset class.
More recently litigation has emerged over the alleged “underperformance” of fiduciary fund menu choices, (see, e.g., our article 401(k) Fiduciary Litigation – “Underperformance” – Current Issues (December 2021)). These cases have also turned on the comparison of the selected fund with, e.g., other funds in the same asset class.
Both types of claim – fee and underperformance claims – raise the issue, what is the appropriate comparator? And that is a significant focus of the Sixth Circuit’s decision in Smith v. CommonSpirit.
Hughes v. Northwestern
In its January 2022 decision in Hughes v. Northwestern University, the Supreme Court held that in these sorts of cases courts must apply a “context-specific inquiry” into a fiduciary’s decision, taking into account the sponsor fiduciary’s “duty to monitor all plan investments and remove any imprudent ones.”
In characterizing the analysis the courts should use, the Supreme Court stated:
“Because the content of the duty of prudence turns on ‘the circumstances . . . prevailing’ at the time the fiduciary acts, … the appropriate inquiry will necessarily be context specific.” [Citing Fifth Third Bancorp v. Dudenhoeffer] At times, the circumstances facing an ERISA fiduciary will implicate difficult tradeoffs, and courts must give due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise.
We are now, post-Hughes v. Northwestern, in a period where lower courts (in this case, the Sixth Circuit) are trying to figure out just how this very general language should be applied to specific claims.
The court’s holding
In this case, the Sixth Circuit upheld a lower court decision dismissing plaintiff’s claim on these issues, finding that:
There is nothing imprudent about actively managed funds per se: “such investments represent a common fixture of retirement plans, and there is nothing wrong with permitting employees to choose them in hopes of realizing above-average returns over the course of the long lifespan of a retirement account. … Offering actively managed funds in addition to passively managed funds [is] merely a reasonable response to customer behavior.”
Simply pointing (retrospectively) to underperformance is not enough to state a claim: “Nor does a showing of imprudence come down to simply pointing to a fund with better performance …. [T]hese claims require evidence that an investment was imprudent from the moment the administrator selected it, that the investment became imprudent over time, or that the investment was otherwise clearly unsuitable for the goals of the fund based on ongoing performance.” This is an important point often not given enough weight by courts: it’s easy, in retrospect, to find one fund outperforming another. But ERISA only requires that the fiduciary’s decision be appropriate at the time it is made, not in hindsight.
It is generally not appropriate (in attempting to show imprudence) to compare the performance of actively managed funds to index funds because they have different goals and strategies: In this case, plaintiff (adversely) compared fees and performance of the (actively managed) Fidelity Freedom Funds to the (passively managed) Fidelity Index Funds, arguing that they were “sponsored by the same company, managed by the same team, and use a similar allocation of investment types.” The court rejected this argument, finding that these two fund suites had different objectives and strategies.
No “red flags”: The possible existence of “red flags” has also been a feature of underperformance cases. In this case, plaintiff pointed to “the discretion that fund managers had in choosing investments, net outflows from these funds to other investments, and outside analysts’ critical evaluations of the funds.” In rejecting this argument, the court noted that “[a]lthough investments in Fidelity Freedom Funds decreased in recent years, they still remain more than twice as popular as the Freedom Index Funds. …. Morningstar gave the Freedom Funds and the Index Funds a “Silver” rating and rated the Freedom Funds’ management team and process as ‘above average’ or better.… Nothing in [the submitted] reports suggests that the Freedom Funds’ reputation was bad enough when viewed in the market as a whole that a prudent plan administrator should never have included them in the offerings or should have precipitously dumped them. We would need significantly more serious signs of distress to allow an imprudence claim to proceed.”
Other courts have reached different conclusions
We note that other courts have reached different conclusions. Indeed, in In Re Linkedin ERISA Litigation (2021), the United States District Court for the Northern District of California reached the opposite conclusion (from that of the Sixth Circuit in Smith v. CommonSpirit) on nearly identical facts. That case also involved a challenge to the prudence of the selection of the Fidelity Freedom Funds TDF (both on fee and underperformance grounds), in which plaintiffs compared the performance of the Fidelity Freedom Funds TDF to the Fidelity Freedom Index Funds TDF. In that case, the court found that “the Index Suite is a ‘perfect comparator’ for the Active Suite because the two share the same investment management firm, management team, and a nearly identical glide path.”
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This is an evolving area of the law. As we have discussed, the issue of when a case can be dismissed on motion, pre-discovery, is critical. In many of these cases, after the denial of a motion to dismiss, the defendants settle rather than confront the cost (in dollars, management time, and (conceivably) reputation) of discovery.
We will continue to follow these issues.
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