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Appellate Court Backs Freedom Funds Fee Suit Dismissal


A federal appellate court has backed the dismissal of an excessive fee suit, rejecting the notion that offering actively managed funds—even those with disappointing performance—by itself doesn’t support allegations of a fiduciary breach.

Interestingly enough, it’s the first such appellate court ruling since the Supreme Court weighed in in the case of Hughes v. Northwestern University, which held that motions to dismiss in fee-and-expense cases under ERISA had to employ a “context-specific inquiry” that gives “due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise.” Two dismissed cases on appeal that had been pending in the Ninth Circuit have been resurrected in the wake of the Hughes decision. 

This Case

The participant-plaintiff in this case was a participant in a defined contribution plan sponsored by a predecessor of CommonSpirit Health. As has routinely been alleged in these cases, she claimed that the plan fiduciaries breached their duty of prudence by offering actively managed investment options rather than lower-cost, better-performing index options. In fact, it was alleged[i] that at least 76% of the plan’s assets were invested in the actively managed option. She also alleged that the plan fiduciaries permitted the plan to pay excessive recordkeeping and management fees. Those claims had been dismissed as insufficient to state a claim by the district court.

More specifically, Judge David L. Bunning of the U.S. District Court for the Eastern District of Kentucky dismissed the comparison of performance between active and passive management benchmarks, citing a recent case which concluded that, “actively managed funds and passively managed index funds are not ideal comparators: they have different aims, different risks, and different potential rewards that cater to different investors.” In fact, he went on to note that “offering funds with different management approaches and varying levels of risk is one way to diversity the portfolio of available investments,” explaining that “…a plan fiduciary does not necessarily act unreasonably merely by including an actively managed fund that happens to perform worse or cost more than any given passively managed fund. Any other conclusion would in effect prohibit plan managers from offering investment options a plaintiff views as inferior, something which courts have repeatedly held is not the law under ERISA.”

The Appeal

A three-judge panel of the Sixth Circuit (Yosaun Smith v. CommonSpirit Health, et al., case number 21-5964, in the U.S. Court of Appeals for the Sixth Circuit) unanimously affirmed that determination, writing that whether an ERISA fee-and-expense claim is plausible “depends on a host of considerations, including common sense and the strength of competing explanations for the defendant’s conduct.” Actively managed funds “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,” the court noted. Rather, they noted, in order to be deemed sufficient, those claims of imprudence “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.”

It’s not that the higher fees[ii] weren’t to be an item of consideration—but the court wasn’t willing to accept as an article of faith that there weren’t other ameliorating factors. “Over time, management fees, like taxes, are not trivial features of investment performance,” the court noted.

The appellate panel also noted that the plan serves more than 105,000 people and manages more than $3 billion in assets, offers 28 different funds, including several index funds with management fees as low as 0.02% and several actively managed funds with management fees as high as 0.82%. Among those are the actively managed Fidelity Freedom Funds, which were the default investment option, and a target of the suit.

Active ‘Management’

“Smith as an initial matter has not plausibly pleaded that this ERISA plan acted imprudently merely by offering actively managed funds in its mix of investment options,” according to the court. “She alleges that “investors should be very skeptical of an actively managed fund’s ability to consistently outperform its index” and that the Freedom Funds “chase[] returns by taking levels of risk that render [them] unsuitable for the average retirement investor,” the decision acknowledges. “But 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—sometimes through high-growth investment strategies, sometimes through highly defensive investment strategies. It is possible indeed that denying employees the option of actively managed funds, especially for those eager to undertake more or less risk, would itself be imprudent. Keep in mind that Smith could still choose an index fund investment for her 401(k), as CommonSpirit offered many such options.”

In fact, “We know of no case that says a plan fiduciary violates its duty of prudence by offering actively managed funds to its employees as opposed to offering only passively managed funds,” they write. “Several cases in truth suggest the opposite.” That said, the court cautioned that ERISA “does not allow fiduciaries merely to offer a broad range of options and call it a day.”

However, the court stated that the plaintiff “…mainly compares the Fidelity Freedom Funds’ performance to the Fidelity Freedom Index Funds’ performance for a five-year period, noting that the Freedom Funds trailed the Index Funds by as much as 0.63 percentage points per year. 

“We accept that pointing to an alternative course of action, say another fund the plan might have invested in, will often be necessary to show a fund acted imprudently (and to prove damages),” the court wrote. “But that factual allegation is not by itself sufficient. In addition, these claims require evidence that an investment was imprudent.”

Meaningful Benchmark

“That a fund’s underperformance, as compared to a ‘meaningful benchmark,’ may offer a building block for a claim of imprudence is one thing,” the court explained. “But it is quite another to say that it suffices alone, especially if the different performance rates between the funds may be explained by a ‘different investment strategy.’” Indeed, the court commented: “A retirement plan acts wisely, not imprudently, when it offers distinct funds to deal with different objectives for different investors.”

The court acknowledged that the plaintiff here was concerned that “…the imperatives of pleading a process-based defect put her in a deep hole given the difficulty of gaining information about how her plan chose each investment.” But while acknowledging the point, the court went on to point out that “…it is Congress, not the courts, that established a cause of action premised on a duty of prudence, and at all events the difficulties are not insurmountable. ERISA’s extensive disclosure requirements ease the burdens. Under the statute, a retirement plan must disclose a range of information about costs and performance, including the administrative expenses it charges to participants and investment-related information explaining the characteristics of the plan’s investment options. Plus, publicly available performance information about an investment may show sufficiently dismal performance that this reality, when combined with ‘allegations about methods,’ will successfully allege that a prudent fiduciary would have acted differently.”

As for the recordkeeping fees, the court held that Smith fails to provide the kind of context that could move this claim “from possibility to plausibility” because she hadn’t “pleaded that the services that CommonSpirit’s fee covers are equivalent to those provided by the plans comprising the average in the industry publication that she cites.” While the lower fees paid by smaller plans are often cited as evidence that a larger plan should be able to command an even better price, the judges here commented that those smaller plans might well “offer fewer services and tools to plan participants.” Indeed, they noted that “Smith has failed “to allege that the fees were excessive relative to the services rendered,” and she “…also allege[s] no facts concerning other factors relevant to determining whether a fee is excessive under the circumstances.”

The ruling concludes with, in the words of the court, “…a few loose ends to tie.” These were claims that CommonSpirit “acted disloyally in addition to imprudently by investing in Fidelity Freedom Funds,” but the court said that was raised too late—and that, even if it hadn’t been, “she failed to plead facts suggesting “the fiduciary’s operative motive was to further its own interests,” as required to show a breach of the fiduciary duty of loyalty.” Lastly, though plaintiff Smith requested an opportunity to amend the suit, she apparently did so “in a form that we do not allow under Civil Rule 15, as a short footnote in her brief in opposition to CommonSpirit’s motion to dismiss.” And so, they didn’t—and affirmed the judgment of the district court in dismissing the suit.

What This Means

As this winds up being the first appellate court decision in the wake of the Hughes decision, there is a natural tendency to try to glean what it means for the future. It is likely too soon to do so—but it seems worth acknowledging that this case, along with a couple of other recent decisions, have not accepted at face value the mere assertion that certain aspects are imprudent per se. The court here acknowledged that there are rational reasons for selecting active management that may well justify higher fees, that there are factors beyond plan size that warrant consideration in evaluating the reasonableness of fees, and that there are factors beyond fees that are part of a prudent evaluation process—all of which support the “context-specific” inquiry that the Supreme Court backed in Hughes

Here’s hoping. 

[i] The plaintiff here was represented by Miller Shah LLP, Goldenberg Schneider LPA, and Capozzi Adler PC.

[ii] “...just as compounding can dramatically increase the value of a mutual-fund investment over time, so the costs of that investment can dramatically eat into that investment over time.”