Costco’s Use of Actively Managed Funds in 401(k) Plan Lineup Called Out in Lawsuit

A participant in the Costco 401(k) Retirement Plan has filed a lawsuit against the company, its board of directors and benefits committee alleging violations of the Employee Retirement Income Security Act (ERISA).

The lawsuit says the fiduciaries of the plan breached their ERISA duties by authorizing the plan to pay unreasonably high fees for recordkeeping; failing to objectively and adequately review the plan’s investment portfolio with due care to ensure that each investment option was prudent, in terms of cost; and maintaining certain funds in the plan despite the availability of identical or similar investment options with lower costs and/or better performance histories.

“The plan generally chose more costly ‘actively managed funds’ rather than ‘index funds’ that offered equal or better performance at substantially lower cost. Additionally, the administrative fees charged to plan participants were consistently greater than the fees of most comparable 401(k) plans, when fees are calculated as cost per participant or when fees are calculated as a percent of total assets,” the complaint states.

Costco told PLANSPONSOR it has no comment on the lawsuit at this time.

At the end of 2018, the plan had approximately 174,403 participants and approximately $15,464,315,721 in assets. At different times, the plan offered about 42 different investment choices to its participants, the lawsuit notes.

The complaint alleges the defendants did not have a viable methodology for monitoring the expenses of the funds in the plan, failed to have an independent system of review in place to ensure that the plan participants were charged appropriate and reasonable fees for the plan’s investment options, and failed to leverage the size of the plan to negotiate lower expense ratios for certain investment options maintained and/or added to the plan during the class period.

The plan’s investment platform contained 16 active mutual funds, 14 collective trusts and 12 index mutual funds. In a chart, the complaint compares the plan’s funds to those from Vanguard, which the lawsuit says are comparable, to show fees exceed those of the Vanguard funds by up to 3,400%.

The lawsuit suggests that a “plan fiduciary must pay close attention to the recordkeeping fees being paid by the plan. A prudent fiduciary tracks the recordkeeper’s expenses by demanding documents that summarize and contextualize the recordkeeper’s compensation, such as fee transparencies, fee analyses, fee summaries, relationship pricing analyses, cost-competitiveness analyses, and multi-practice and standalone pricing reports.”

In addition, it suggests that “to make an informed evaluation as to whether a recordkeeper or other service provider is receiving no more than a reasonable fee for the services provided to a plan, a prudent fiduciary must identify all fees, including direct compensation and revenue sharing being paid to the plan’s recordkeeper. To the extent that a plan’s investments pay asset-based revenue sharing to the recordkeeper, prudent fiduciaries monitor the amount of the payments to ensure that the recordkeeper’s total compensation from all sources does not exceed reasonable levels and require that any revenue-sharing payments that exceed a reasonable level be returned to the plan and its participants.”

The defendants in the case are accused of failing to undertake any of these steps because, among other things, there is no evidence that they negotiated lower recordkeeping costs.

According to the complaint, the total amount of recordkeeping fees paid throughout the class period on a per participant basis was unreasonable. From 2014 to 2018, recordkeeping costs paid to T. Rowe Price, as disclosed on Forms 5500, rose 500% from around $1 million per year in 2014, to $6 million per year in 2018, while the number of participants only went up 21%. “Although these costs on the surface are already unreasonable, these costs could actually be higher due to revenue-sharing arrangements and indirect compensation,” the complaint states.

The plaintiff contends that the defendants did not use a competitive bid process for recordkeeping services for a substantial period of time. And, although T. Rowe Price is not a defendant in the lawsuit, it is accused of receiving multiple income streams for recordkeeping from the plan and for selecting mutual funds that paid excessive revenue-sharing fees.

Citing a study from S&P Dow Jones Indices, the complaint says, “While higher-cost mutual funds may outperform a less-expensive option, such as a passively managed index fund, over the short term, they rarely do so over a longer term.” The lawsuit cites another study that said, “long-term data suggests that actively managed funds lagged their passive counterparts across nearly all asset classes, especially over the 10-year period from 2004 to 2014.”

Plan fiduciaries are accused of retaining several actively managed funds as plan investment options despite the fact that these funds charged grossly excessive fees compared with comparable or superior alternatives, and despite ample evidence available to a reasonable fiduciary that these funds had become imprudent due to their higher costs relative to the same or similar investments available.

The lawsuit says this fiduciary failure decreased participant compounding returns and reduced the available amount participants will have at retirement. “During the class period, the plan lost millions of dollars by offering investment options that had similar or identical characteristics to other lower-priced investment options,” the complaint states. It contends that a “reasonable investigation would have revealed the existence of these lower-cost alternatives.” Again, a chart is provided to demonstrate that the expense ratios of the plan’s investment options were more expensive by significant multiples of comparable passively managed funds in the same investment style.

To avoid an argument by defendants that the plaintiff had actual knowledge that could lead to his claims being barred by ERISA statute of limitations, the lawsuit says the plaintiff had no knowledge of the defendants’ process for selecting investments and monitoring them to ensure they remained prudent or of how the fees charged to and paid by the plan participants compared to any other funds. Nor, the lawsuit says, did the plaintiff know about the availability of lower-cost and better-performing investment options that the defendants did not offer because they provided no comparative information to allow the plaintiff to evaluate and compare investment options.