Did Principal Overcharge?

Parsing the Numbers
A 401(k) plan sponsor, American Chemicals & Equipment, is suing Principal for overcharging with its target-date funds.

That such a suit exists is not breaking news. Dozens of claims have been filed in recent years against fund companies, Principal included. Most of the cases come from the 401(k) marketplace. The extra legal protection afforded to fund owners via ERISA law (which governs employee pensions), plus the public nature of 401(k) plans, has encouraged tort lawyers to solicit clients to file for damages. So far, nearly all such actions have been either settled or dismissed by the courts.

While I suspect that this one will be, too, the argument is worth noting because it highlights an issue with fund of fund accounting. Principal’s LifeTime target-date funds, as with most in the industry, are structured as funds of funds, meaning that each target-date fund holds various underlying funds. (Market leaders Fidelity, Vanguard, and T. Rowe Price use the same approach.) However, Principal differs from many by farming out the management of the underlying funds to outside parties. Principal retains control at the top level of each target-date fund, determining the fund's asset allocation. It then hires managers to subadvise the underlying funds.

For this service, Principal charges almost nothing. Of the 0.72% per year that LifeTime 2020 Institutional Fund levies in annual expenses, 0.68% is officially billed as a subadvisory fee. That leaves a mere 0.04% for Principal for creating the fund's allocation, and for hiring, monitoring, and firing the outside managers. As Principal also must pay operational and shareholder-servicing costs from that 0.04%, the company appears to be running its target-date funds at a loss.

Of course, that is not what really happens. The plaintiffs did the math (the required figures are readily available in the funds’ prospectus) and determined that most of the official subadvisory fees do not, in fact, go to the funds’ subadvisors. They are instead retained by Principal. According to the claim, Principal collected $120 million in subadvisory fees (called “acquired fund fees” in Principal’s documents) in 2012, passed along $40 million of that to the outside managers, and kept $80 million for itself. The lawsuit says that is too much money, giving Principal an “unreasonably lucrative profit margin."

I don’t think the profit-margin argument will work. For one, Principal’s target-date economics are not different than other fund companies’. They are merely more transparent. Because Principal hires subadvisors for its funds, it must publish in the prospectus what it pays those subadvisors, thereby affording outsiders the opportunity to distinguish between revenues funneled to the underlying funds and those devoted to the top layer. We can’t do that with giants Fidelity, Vanguard, or T. Rowe Price, each of which officially charge zero at the top layer. (All their target-date management fees come from the receipts of their underlying funds.) The economic reality for those three families, however, is quite the opposite of the accounting convention and in line with Principal's. Most target-date revenues flow to the companies' bottom lines, rather than to pay the costs of holding the underling funds. 

Second, per the Supreme Court, Jones v. Harris Associates (2010), a plaintiff faces a very steep challenge in proving that a fund company breached its fiduciary duty by overcharging. The fee must be so “disproportionately large it bears no reasonable relationship to the services rendered.” To my knowledge, no fund company yet has ever failed that lenient test. Principal is unlikely to become the first. It is not, in fact, a particularly high-cost provider of target-date funds. Management fees on the Lifetime funds are not only below those of the industry’s equal-weighted average, but also slightly below those of the Fidelity Freedom and T. Rowe Price Target Retirement series.

The case may not end up establishing new legal ground, but it's useful for illustrating the inconsistencies of target-date expense reporting. How fund companies categorize the two layers of management fees is entirely arbitrary. Their accounting choice, though, will affect the expense ratio as reported in a fund’s annual or semiannual report. That is because shareholder reports for funds of funds (not just target-date funds, but all funds of funds) show only the top layer of expenses and not the costs of running the underlying funds. In contrast, the expense ratio reported in a prospectus contains both costs. Thus, Morningstar’s report on Principal’s Lifetime 2020 Institutional shares reads as follows:

 

The solution: Use the prospectus calculation for all funds of funds. It has the disadvantage of being a prospective calculation, based on a forecast, as opposed to an actual figure, as is the case with the annual-report ratio. However, the prospectus calculation has the far greater advantage of being comparable and useful. With fund of fund expenses, as with so many other things, it's better to be approximately right than to be precisely wrong.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.