In this article we focus on the recent complaint filed against Intel (Anderson v. Intel), challenging the significant allocations to hedge funds and private equity in the Intel plans’ TDFs.
We note that sponsors have generally been reluctant to include alternative/non-traditional investments as separate, explicit investment options in 401(k) fund menus, largely because of challenges with respect to fees and liquidity – both the lack of transparency of, e.g., the hedge fund itself and the difficulty participants may have understanding these investments – and liquidity. But many believe that these investments may have a role in target date fund portfolios.
Our focus in this article is not on whether hedge funds are a good investment, or even whether passive is better than active. Our focus when we consider a case like this is on (1) the standards that apply to the investment of plan assets, the construction of a DC plan fund menu, and the selection and monitoring of DC fund managers, under ERISA’s fiduciary rules, and (2) how plaintiffs are going about proving (or attempting to prove) violations of those standards.
The following discussion is based on the complaint. We assume that some (or many) of plaintiffs’ assertions in the complaint will, in one way or another, be challenged by the Intel defendants, and the “facts” discussed below should be understood in that context.
Intel maintains two defined contribution plans – the 401(k) Savings Plan and the Retirement Contribution Plan – that include default target date funds (TDFs), and (as an investment alternative) balanced funds. These TDFs and balanced funds include significant allocations to “Non-Traditional Investments Accounts” – generally, hedge funds, private equity funds, emerging market funds, and commodities. The primary focus of the complaint is the use of hedge fund and private equity investments in the Intel plans’ TDF and balanced funds.
A feature of the Intel plan’s investment menu is that the TDF and balanced fund investments did not (for most of the relevant period) exist as separate. “Rather, the Intel TDFs and [balanced funds] were allocation models that directed participant savings into various pooled investment funds such as Large Cap, Commodities, Private Equity and Hedge Funds.” This assertion provides the basis for a claim by plaintiffs that required disclosure with respect to “designated investment alternatives” under the Department of Labor’s participant disclosure regulation applied to these various pooled investment funds and not to, e.g., the TDFs. The latter simply consisted of a set of “asset allocation models.” (We will discuss this issue more, below.)
As of December 31, 2015, the 401(k) Savings Plan had approximately $8.5 billion in assets, with $1.2 billion allocated to the Non-Traditional Investments Accounts, and the Retirement Contribution Plan had approximately $6.3 billion in assets, with $2.7 billion allocated to the Non-Traditional Investments Accounts.
Challenge to the Intel plans’ alternatives strategy — three theories
Plaintiffs challenge the Intel plans’ hedge fund/private equity strategy on basis of three broad theories:
1. Hedge funds and private equity are not appropriate investments for a participant choice DC plan
Plaintiffs argue (and cite academic literature) to the effect that hedge funds present six sorts of risk not found in more traditional TDF investments:
Valuation Risk. The complaint quotes the Government Accountability Office’s 2011 report Plans Face Challenges When Investing in Hedge Funds and Private Equity: “[b]ecause many hedge funds may own [securities traded infrequently or in low volume] and derivatives whose valuation can be complex and subjective, a retirement plan official may not be able to obtain timely information on the value of assets owned by a hedge fund. Further, hedge fund managers may decline to disclose information on asset holdings and the net value of individual assets largely because the release of such information could compromise their trading strategy.”
Investment Risk. The complaint emphasizes the effect of leverage in hedge fund investing, that can (quoting GAO again) “magnify profits, but can also magnify losses to the fund if the market goes against the fund’s expectations.”
Lack of Liquidity. Hedge funds “often require an initial ‘lock-up’ period where investors must commit their money for one-to-two years or more.”
High Fees. The complaint states that “Managers are typically paid under a ‘2 and 20’ formula, meaning that the manager gets 2% of the assets under management and 20% of the profits generated by the fund’s investments.”
Lack of Transparency. The complaint quotes 2006 testimony of Randall Dodd (Director of the Financial Policy Forum) before the ERISA Advisory Council: “[t]he investment strategies of hedge funds are often not well known, or are so lacking in transparency – even to their own investors […]– that the investors cannot adequately assess the hedge fund investment’s contribution to their overall portfolio risk.”
Operational Risks. Quoting Dodd (again) to the effect that reduced regulation of hedge funds makes them “especially prone to financial fraud.”
Plaintiffs argue that, given their lack of transparency,a significant allocation of 401(k) plan TDF assets to hedge funds makes implementation of traditional modern portfolio theory asset allocation principles challenging at best. And their sophistication – involving the use of leverage, shorting, and derivatives, and pursuing directional, or distressed, or event-driven strategies – generally puts them beyond the understanding of many plan participants.
Plaintiffs also make amore general argument that most hedge funds do not add value, producing copious data purporting to show that they have underperformed “traditional” investments (stocks and bonds).
Plaintiffs’ discussion of similar issues with respect to private equity investments is less fully developed, focusing on their high fees and lack of transparency (again) and on the problem of valuing private equity investments.
To be clear: this element of plaintiffs’ case represents a challenge not just to Intel’s strategy but to any significant use of alternatives in any plan’s TDF. A court’s ruling in favor of plaintiffs on this ground would be tantamount to a ban on the significant use of hedge funds or private equity in any TDF, at least until the above-listed “defects” are fixed.
2. Intel plans’ TDF and balanced fund fees were unreasonably high
The complaint surveys data from a number of different sources, comparing the fees on the Intel plans’ TDFs with:
The TDF market broadly – “In 2014, the 12 Intel TDFs in the 401(k) Savings Plan had expense ratios between 1.07 and 1.09%, which exceeded the category average of 0.46% by more than 130%.”
“[A]ctively-managed and passively-managed investment alternatives with comparable investment styles and with similar or superior performance” – “the fees for the Intel Funds in the 401(k) Savings were considerably higher – up to 940 % more expensive.”
The cheapest available share class (“the share class large investors like the Plans are most likely to invest in”) – where “[e]very single TDF provider charges, on average, less than the Intel TDFs.”
3. The Intel plans’ TDFs and balanced funds significantly underperformed the market
The plaintiffs provide data purporting to show that the ten-year returns of the Intel TDFs, compared to the group of 13 mutual funds with 10 years of such data, place the Intel Plans’ TDFs in the 83rd percentile, underperforming the weighted average return of this peer group for every TDF “vintage” other than retirees by 20%-25%. Plaintiffs go on to argue that this underperformance holds even when adjusted for risk.
Failure to use an adequate process
It is a commonplace that ERISA prudence is about process and that courts will not apply a rear-view-mirror analysis to fiduciary investment decisions. In many cases, sponsor fiduciaries’ best defense has been to produce evidence that they used a thorough and prudent process in arriving at their decision.
With respect to this issue, the complaint simply makes the broad arguments outlined above and then asserts that no fiduciary aware of these issues and using a prudent process would have allocated as much TDF assets to alternatives as Intel had. Will this sort of “no prudent fiduciary would have done this” claim, in the absence of any specific factual allegations about the inadequacy of the Intel fiduciaries’ process, survive a defendant’s motion to dismiss?
Failure to adequately disclose fees and risks
In addition to challenging the prudence of the Intel plans’ alternatives strategy, plaintiffs claim that disclosure with respect to that strategy was inadequate and misleading. In this regard, plaintiffs claim, first, that plan disclosures did not adequately identify “the risks associated with the Intel Funds’ significant allocations to hedge funds and private equity funds.”
And second, that Intel’s fund disclosures focused on the wrong “entity.” As noted at the beginning, it is plaintiffs’ theory that the “designated investment alternatives” (to which disclosure obligations under DOL’s ERISA section 404(a)(4) regulation applies) were not, e.g., the TDF and balanced fund, but rather were the underlying hedge fund and private equity investment accounts. Therefore, disclosure of risks and, critically, fees should have been made with respect to those accounts (e.g., the allegedly very high fees on hedge fund investments) rather than with respect to the TDFs and balanced funds.
This latter claim, and the theory on which it is based, looks like a stretch, but it does point out an ambiguity – an area of un-clarity – in the 404(a)(4) regulation. In these sorts of arrangements, where the participant simply elects an allocation formula for underlying funds, what is the “designated investment alternative?” Is it the formula or the underlying funds? A ruling by a court in favor of plaintiffs on this issue (that is, that the “designated investment alternative” is the underlying funds) would force a reconsideration by many sponsors of how they structure their target date funds specifically, and any fund-of-funds investment option more generally.
More general observations
Keeping in mind what we said at the beginning – that we are writing about ERISA regulation, not about what is the best investment strategy – a couple practical considerations force themselves into the analysis.
Will fiduciaries be punished for innovation if the innovation underperforms traditional investment strategy? The qualified default investment alternative (QDIA) regulation requires that, to be a QDIA, a TDF must apply “generally accepted investment theories.” It’s not clear (at the margins at least) what a generally accepted investment theory is, but it does seem rational that what is and is not “generally accepted” will change over time.
Plaintiffs make a point of the (alleged) fact that “Peer target date funds do not allocate to speculative asset classes in any percentage close to the allocations of the Intel TDFs.” Although the complaint does not explicitly connect these dots, this is in effect an argument that the Intel TDFs have deviated from generally accepted investment theories and therefore do not qualify as QDIAs.
That deviation would not be a problem if it had paid off. Plaintiffs argue (with copious data), however, that it did not. Will courts (or even DOL) use the “generally accepted investment theories” standard to apply, in effect, a rear-view-mirror test to innovations?
In this regard, we also note that, while they are not used significantly in 401(k) plan target date fund portfolios, alternatives, including hedge funds and private equity, are an element of broader institutional investor portfolio strategy.
The extraordinary performance of US equities presents a challenge to ERISA’s diversification principle. In that regard, sponsor fiduciaries responsible for fund menu construction, in 2019, face a fairly extraordinary situation.
The complaint states that “The Investment Committee purportedly chose to invest in hedge funds in an attempt to achieve at least three goals: to increase diversification of plan assets; to decrease the volatility of the plan’s investment performance; and to enhance the plan’s performance overall,” (citing Intel’s 401K Global Diversified Fund Fact Sheet).
Between December 31, 2008, and today, the S&P 500 CAGR (Cumulative Annual Growth Rate) (with reinvested dividends) has been 14.2%. Generally, and with the possible exception (on a risk-adjusted basis) of US investment grade fixed income, a passive S&P 500 investment strategy has outperformed (significantly in many cases) nearly all diversification strategies, including those implemented by Intel.
The Intel complaint – like many plaintiffs’ 401(k) fee lawsuits – cites academic literature purporting to show that active management, and implicitly, nearly all diversification strategies, do not add value and compares results in the Intel plan with results under S&P 500 index-based comparators.
These conditions put plan fiduciaries in a difficult position. Should they diversify out of US large cap equities plus, e.g., a low-cost investment grade bond fund? Or should they simply focus on fees and a passive, low-cost S&P 500 investment strategy.
Some guidance from DOL on this issue would be helpful but is unlikely. Support from the courts would also be helpful. And yet, in the 401(k) fee case Putnam Investments, LLC v. Brotherston (as to which there is currently a petition for Supreme Court review), the First Circuit Court of Appeals stated that: “any fiduciary of a plan such as the Plan in this case can easily insulate itself [against ERISA fiduciary litigation] by selecting well-established, low-fee and diversified market index funds.”
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We have only focused on the prudence and disclosure claims in the complaint, as they are most likely to be relevant to the broadest group of plan sponsors. There are a number of other issues presented in the case that we have left out.
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The Intel complaint focuses on one particular issue current in considerations of TDF investment strategies – the viability of the inclusion of significant allocations to alternatives in a TDF. Oversimplifying, plaintiffs’ case challenges this strategy as (1) unusual (other sponsors’ TDFs have not adopted it), (2) inappropriate for TDF/401(k) participant choice investment structures, (3) overpriced, and (4) underperforming. It will be interesting to see Intel’s response on these issues.
The outcome in Intel may have a significant effect on (specifically) the use of alternatives in TDFs and (conceivably and more generally) the ongoing viability of diversification strategies in these plans.
We will continue to follow this issue.