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Participant Alleges Design Flaw in Proprietary Fund Suit

An alleged “built-in” flaw in fund design has drawn a fiduciary breach suit by a plan participant.

The suit (Birse v. CenturyLink, Inc., D. Colo., No. 1:17-cv-02872, complaint filed 11/30/17) was filed in the U.S. District Court for the District of Colorado by Franklin D. Azar & Associates, a personal injury law firm that claims to specialize in “motor vehicle accidents, defective products, and slip-and-fall accidents.” It’s not the first ERISA suit filed by the firm, which has also filed suit on behalf of at least one relatively modest-sized plan. In fact, on the same day this suit was filed, the firm filed an ERISA excessive fee lawsuit against a union retirement fund.

In the case at hand, plaintiff Bonnie Birse is a participant in the CenturyLink Dollars & Sense 401(k) Plan that, as of Dec. 31, 2016, had 35,785 participants and $3,687,832,382 in assets. She has been a participant in that plan since 2012, and is invested in the 2015 Target Date Fund.

The suit notes that CenturyLink’s investment options consisted of a number of custom funds designed by CIM, a mix of passively and actively managed funds offered as plan investments included an active large cap U.S. stock fund whose stated objective was to “exceed the return of a broad market index of the largest 1,000 companies using an actively managed multi-manager approach.” However, the plaintiff alleged that the fund “consistently under-performed its benchmark index… by two percent or more each year since it was formed in 2012.” (For those who might be thinking that isn’t a big shortfall, the plaintiff cited statistics from the Labor Department that a 1% lower return over a 35-year period makes a 28% difference in retirement assets at the end of a participant’s career).

The suit claims that this underperformance was “virtually guaranteed because it contained a serious design flaw from inception,” a flaw the plaintiff claims was “built-in” by the decision to use six different fund managers with the same mandate (five active and one passive). “The odds of the five active managers outperforming the market in aggregate was highly remote due to the efficiency of the large cap domestic equity market and the difficulty of even one manager outperforming for more than a year,” according to the suit.

Additionally, the suit claims that the use of multiple fund managers tends to make funds perform more like an index fund, which the plaintiff alleges “contradicts the goal of seeking to outperform the benchmark,” noting that “research shows fund performance drops when funds switch from being run by a single manager to two or more,” and that “the more managers a fund has, the worse its performance is compared with a product run by a single portfolio manager.” She concludes that in reducing the “risk” of having a single manager through using multiple managers, “CIM actually reduced the likelihood that the Large Cap Fund would actually outperform its benchmark.”

Not surprisingly, the suit also takes to task the choice of active management over index funds. “The Large Cap Fund charged investment management fees of .41% of net assets annually,” the plaintiff notes, going on by way of comparison that the CenturyLink U.S. stock index fund charged management fees of 0.07% of net assets annually.

The plaintiff claims that, as an investment professional, CenturyLink “knew or should have known that the Large Cap Fund’s design was flawed and underperforming,” and that the plan fiduciaries “breached their duty of prudence by failing to replace or restructure the Large Cap Fund for five years despite its poor design and performance.”

Moreover, the impact was magnified by CenturyLink’s other investment choices, according to the suit. It notes that the large cap fund was one of only three stock funds offered, and the only large cap stock investment option, and comprised 16% of the underlying investments in each of the target date funds offered by the plan, which the suit claims reduced the performance of those funds as well.

Will these unusual claims be successful? We shall see.