Monday, October 02, 2006

Schlichter, Bogard & Denton 401(K) ERISA Suit vs International Paper

Plaintiff law firm Schlichter,Bogard & Denton has filed ERSIA breach of fiduciary duty suits against at least 7 Fortune 500 employers; Lockheed Martin, General Dynamics, United Technologies Corp, Bechtel Group, Caterpillar Inc, Exelon and International Paper. These plans collectively have more than 400,000 employees in their 401(k) plans.

We took a closer look at the International Paper (IP) complaint to understand the specific claims and to highlight possible exposures for other Plans. The IP plans had about $4.3 billion in assets and $666 million in IP stock ending 2005 according to their 10-K filing.

Overall, the complaint charges breach of fiduciary duty for allowing excessive fees and incomplete disclosures to Plan participants. The relevance of these suits to the rest of us is that the alleged breaches pertain to fairly common industry practices such as; master trust account structures, revenue sharing and generalized fee and performance benchmarking.

Master Trust Structure Understates Disclosed Fees
Master trust structures are widely used in the 401(k) industry to provide multiple employers or related groups with a common trust to facilitate uniform administration of the assets of multiple plans and multiple investment managers. According to the complaint, this structure understates Plan expenses reflected in information available to participants. For instance, certain master trust specific expenses, while being taken out of fund net asset values are not explicitly detailed in Plan regulatory filings. These expenses are included in Master Trust filings, though these are presumably not readily available to plan participants.

Unapplied and Undisclosed Revenue Sharing Arrangements
Revenue sharing arrangements (compensation transfers usually from asset managers to service providers) are commonly employed in the industry and can fund a substantial percentage of a plan's expenses. These arrangements are lightly disclosed and relatively unregulated by the DOL or SEC and were not addressed since they werent common practice when ERISA was drafted. The complaint charges that established revenue sharing arrangements were not utilized to offset hard-dollar plan costs – effectively making plan participants pay an unnecessary premium for services. In addition, the revenue sharing arrangements were not disclosed to Plan participants.

Revenue sharing arrangements are common in the industry and, like any tool, can be properly used or abused. These arrangements have been getting better disclosure at the sponsor level, though participant level disclosure probably lags. In the small 401(k) market, plans are largely “price-takers”. These Plans have less recourse in accepting revenue sharing arrangements and may be less informed and/or limit disclosure. A $4 billion Plan, on the other hand, can avoid undesirable revenue sharing arrangements and many generally practice better disclosure. According to the 2005/2006 Deloitte & Touche 401(k) Benchmarking Study, Plans with assets >$1Billion (mega plans) are more likely to fully disclose plan administration costs without any revenue-sharing or investment revenue offsets as well as disclose revenue-sharing arrangements and investment offsets (75 percent and 79 percent, respectively) compared to the national sample (63 percent and 67 percent, respectively). Revenue sharing arrangements in this segment that exceed costs of service are more likely to result in a fee credit (19%) than in the average. Avoiding the capture of available revenue sharing on behalf of plan partcipants could be a big fiduciary issue for IP. This case also point out the need for additional regulatory or legal clarity around common revenue sharing practices that impact many plans.

Misleading Fee Benchmarks
IP Plan fiduciaries allegedly compared their Plan investment expenses ratios to a Morningstar average including retail share classes (which include the impact of sales commissions/deferred charges etc). Use of the Morningstar Overall Fee Average is a favorite “head fake” used regularly in the asset management business to put distance between their fees and a peer mean.

Though this comparison may not be an example of discerning fiduciary benchmarking, the level of fund expenses, which were not disclosed in the complaint, should be substantially below this average, even after considering that they support some level of non-sponsor paid service provision in 401(k) plans. According to the Deloitte and Touche study, average fund expense ratios for mega plans should be 38% to 50% percent lower than in other segments.


Misleading Performance Benchmarks
The complaint states that “the performance and quality of the Plans investment options is, and has been quite poor”. Though no performance details were provided, the complaint argues that several fund benchmark changes, an incorrectly benchmarked S&P500 fund and an improperly scaled risk return exhibit provide evidence of Plan self-promotion and misleading performance.

Though actual performance data is critical to judging the merit of these charges, they don’t appear especially flagrant given practical imprecision in comparative performance analysis. The complaint seems very literal and naive in its assertions about what constitutes maket indicies and the absolute correlation of performance indicies to actual holdings. For instance, the complaint alleges the combination of an 80% MSCI EAFE and 20% S&P EMI EPAC (extended market index in the Euro Pacific region) is not a valid “market benchmark”. Only the facts can determine whether this composite matches the implemented investment strategy but composite benchmarks generally signal more sophisticated not less relevant benchmarking. The complaint alleges that benchmarking a large cap fund which held undisclosed securities “with risk levels incompatible with large cap investing” to the S&P 500 was misleading. Though this may be "literally" inappropriate, it is normative practice. Look at Growth Fund of America, a US large cap fund that includes 12% cash and 19% international equity. The complaints benchmarking example would probably require an extreme set of facts to be considered "misleading" beyond currently accepted fund categorizations.

Excessive Fees for the Employee Stock fund
This portion of the complaint reads like a “stock drop” suit where underperformance and participant risks are enumerated. However, in the end, the fiduciary violation charged is excessive management fees for what they regard as a “low cost” ( ie no-one manages the investments) option. Though the expenses weren’t detailed, unitized employer stock funds are expensive to manage because; the asset pool size is limited, daily pool liquidity must be managed, they often require one-off record keeping systems and processes and also represent legal exposure for the trustee/administrator. For this, firms levy higher investment management fees than comparable generic investment pools.

The IP complaint addresses several areas of industry practice which have developed beyond specifc regulatory or legal standards. The DOL has strenghtened fee disclosure requirements effective in 2008. Under the new Schedule C requirements Plans will have to provide more information about third-party financial relationships. Plans will have to identify all service providers that receive $5,000 or more from plan assets. At this point, Plan sponsors should focus on understanding and memorializing any revenue sharing arrangements. Request all service providers document their fee and revenue arrangements. Reviewing and documenting external fee comparables would be prudenta s well. Sponsors might also review participant disclosures and plan/trust documents to ensure comprehensive disclosure of all relevant fees and arrangements. To the extent employer stock is held in the Plan, review your goveranance and fiduciary monitoring protocol with ERISA counsel.

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