Pension & Benefits News Control of fixed rates of return did not subject GIC provider to liability as fiduciary
Thursday, December 27, 2018

Control of fixed rates of return did not subject GIC provider to liability as fiduciary

By Pension and Benefits Editorial Staff

A life insurance company that controlled fixed rates of return and allegedly retained excess compensation under a guaranteed interest product sold to a 401(k) plan was not a fiduciary subject to liability under ERISA, according to a federal trial court in Iowa. The fact that the insurance company announced the rates in advance, allowing the plan and plan participants to reject the investment, forestalled fiduciary liability under ERISA, the court explained.

Fixed rates of return under guaranteed investment contract

Principal Life Insurance Company offers a Principal Fixed Income Option (“PFIO”) to 401(k) plans. The terms of the investment are governed by a group annuity contract and incorporated schedules (i.e., a guaranteed investment contract). PFIO funds are deposited into Principal’s general account, which is invested in bonds and fixed income instruments.

The PFIO is structured as a series of Guaranteed Interest Funds (“GIFs"). Every six months during the class period, Principal creates a new GIF that accepts participants’ deposits into the PFIO for the following six months. For each GIF, Principal declares in advance an applicable Guaranteed Interest Rate (“GIR"). Accordingly, every six months, Principal issues a new PFIO schedule that relates to and governs the new GIF.

The interest rate credited to participants is termed the Composite Crediting Rate (“CCR"). During the class period, Principal established a new CCR every six months (with effective dates of January 1 and July 1) pursuant to a formula stated in the contract.

Participants are guaranteed to earn interest at the CCR for that six-month period. However, if the general account performs at a rate of return above the CCR, Principal retains the resultant “spread,” as profit.

Principal notifies plan sponsors of the new CCR about 30 days in advance of the new effective date. Plan administrators in turn relay the new rate to participants. In the event participants object to the new CCR, they can generally withdraw their money from the PFIO at any time and deposit it in another plan investment option without a contractual financial penalty. Plans are further allowed to terminate their entire interest in the PFIO either by giving Principal 12-month advance notice or by paying a 5% surrender charge to receive their funds immediately.

Participants in a 401(k) plan sponsored by Western Exterminator Company, which allocated funds to a PFIO, filed suit alleging that Principal breached its fiduciary duties by: setting the guaranteed interest rate and/or composite guaranteed rate for its own benefit; manipulating the extent to which the rate was guaranteed; failing to disclose its retention of the spread; and charging an excessive disclosed fee in addition to the undisclosed spread compensation. In addition, the participants charged that Principal engaged in a prohibited transaction by setting the credited rate at an artificially low level to ensure its own profit. Alternatively, the participants alleged that Principal was liable as a nonfiduciary party in interest for the prohibited transaction of receiving excessive compensation from the PFIO and failing to disclose the compensation.

Control over CCR did not establish fiduciary status

The participants argued that the central factor in determining Principal’s fiduciary status was not whether the governing rates were disclosed in advance, but whether the company exercised discretionary authority in making those decisions. The court, however, relying on a long line of precedents, concluded that the “undisputed facts” established that Principal was not acting as a fiduciary with respect to its ability to set the CCR. The court found that Principal was acting pursuant to a contract (PIFO) that was the product of an arms-length bargaining process with the plan sponsor. The court also noted that the plan participants chose whether to make the investment, subject to the terms of the contract. However, the primary focus of the court was on the fact that Principal announced the GIR and CCR in advance and communicated the rates to the plan sponsor. According to the court, the “overwhelming weight of authority indicates that announcing the rate in advance forestalls fiduciary responsibility under ERISA.” Participants who object to the CCR, the court further advised have a “meaningful opportunity” to “vote with their feet” by leaving the PFIO, as there are no contractual fees or penalties (at the participant level) for transferring funds to non-competing funds. The contractual requirement of a short “equity wash” period, during which funds could not be transferred to a competing fund, did not “obviate the meaningfulness” of a participant’s ability to leave to the PIFO. Thus, Principal did not exercise discretionary authority, sufficient to subject it to liability under ERISA, when it set the CCR and the GIR.

Principal did not control own compensation

The participants charged that Principal’s ability to set a new GIR every six months empowered it with authority over its compensation as it retained the spread between the rate paid to participants and the return on the underlying investment portfolio. The court acknowledged that a party with direct contractual authority to establish its fees, or authority to approve or disapprove of transactions from which it collected a fee, would be a fiduciary. However, the court found that Principal did not exercise such control over its compensation. It was “self-evident” to the court that Principal could not control its compensation by merely retaining the spread because its compensation was ultimately based on how many people invested in the PFIO. As Principal could not compel a plan or plan participants to choose its product, ensure that it would manage investments well enough to earn a profit, or otherwise control the market, it could not control its own compensation, the court explained.

Lack of knowledge that compensation was unreasonable precluded nonfiduciary liability for prohibited transaction

Although Principal was not a fiduciary, it could still be liable under ERISA as a nonfiduciary party in interest. The participants argued that Principal was subject to ERISA liability as a nonfiduciary because it had knowledge of all of the facts regarding its compensation. Principal, the participants stressed, determined the deductions it applied to price the PIFO and had the necessary data and information to calculate the spread for each six-month period.

The court, however, noted that the United States Supreme Court has ruled that a nonfiduciary party in interest may be liable under ERISA for a prohibited transaction if it had “actual or constructive knowledge of the circumstances that rendered the transaction unlawful” (Harris Trust & Savings Bank v. Salomon Smith Barney, Inc., US Sup. Ct (2000), 530 U.S. 238). Under this standard, as further clarified by recent precedent, a nonfiduciary party in interest must have not only knowledge of the underlying facts, but knowledge of their potential unlawfulness (Teets v. Great -West Life & Annuity Ins. Co., DC Col (2017), 286 F. Supp. 3d 1192). Accordingly, the participants needed to show that Principal knew or should have known that the transaction violated ERISA. However, the participants failed to present any evidence that Principal knew that its compensation was unreasonable. On the contrary, given that Principal’s duties and methods of calculating its compensation were agreed-upon terms of the contract, the court reasoned that Principal would have no reason to believe its compensation was anything other than reasonable.

SOURCE: Rozo v. Principal Life Insurance Company (DC IA).

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