Plan Sponsors Should Follow IPS

Help Participants Live Happily Ever After—Follow Your IPS.

What good is an investment policy statement (IPS) if the plan sponsor doesn’t follow it? That question is at the center of a class action lawsuit filed against the fiduciaries of The Walt Disney Company’s defined benefit and deferred compensation plans for employees, alleging breach of fiduciary duty by the plan sponsor.

The basis of the lawsuit is the failure of plan sponsors to monitor and remove an undiversified and poor performing fund from the Disney plan’s investment menu. Not only did this failure violate ERISA rules around fiduciary duty, it also ran afoul of the plan’s own investment policy statement.

This recent case highlights the diligence plan sponsors and fiduciaries must bring to following the investment policy statement and monitoring funds for excessive risk, even those handsome “Prince Charming” funds that have a track record of superior performance.

The fund in question is The Sequoia Fund, a long-standing equity growth fund that had a reputation for prudent management and a penchant for delivering returns while taking less risk. Warren Buffett had recommended The Sequoia Fund to investors in his partnership when he dissolved it in 1969 to focus on Berkshire Hathaway. The fund has returned 13.5% on an average annual basis since July 1970 (as of 6/30/2016), while the S&P 500 Index gained 10.7% annually over the same time.

The Fund was also closed to new investors for over 25 years, from 1982 to 2008. That’s an unusually long period for a mutual fund, especially during the explosive growth years for the mutual funds during the late 1990s. But the manager’s decision to keep the fund closed for so long demonstrated a commitment to prudent management that earned The Sequoia Fund many admirers and fans in the notoriously fickle fund business.

Over the years, the Sequoia Fund was known to concentrate assets in a handful of stocks. But it was the fund’s allocation to one stock—Canadian pharmaceutical company Valeant—that hurt investor returns in recent years and created a current headache for the Disney plan fiduciaries.

Valeant was a once high-flying company with an impressive track record for equity performance. During a four-year stretch earlier this decade, Valeant’s stock soared over eight-fold, from $32 per share in August 2011 to over $263 in August 2015. These strong returns certainly helped shareholders of The Sequoia Fund during this time.

But the fund managers continued to load up on Valeant stock in the portfolio, despite numerous warning signs that the company wasn’t all it promised to be. At one point, over 30% of The Sequoia Fund’s assets were invested in Valeant stock.

Valeant stock began its precipitous fall in September 2015, losing more than half of its value by year-end. Still, Sequoia Fund managers held on to their position and even added to it. It took until May this year for Sequoia to sell half of its stake in Valeant. By that time, the stock price had declined by 88%.

Lawyers for the Disney plan participants claim the plan fiduciaries should have seen Sequoia’s concentrated position in Valeant as a warning sign. Plan sponsors had a fiduciary duty to monitor The Sequoia Fund, according to the lawsuit. When they saw this high allocation to one stock, they should have recognized that the fund had become less diversified and posed a greater risk to plan participants.

The plan’s investment policy statement also laid out this sentiment in black and white: the plan sponsor “recognizes that an investment in an undiversified fund . . . is subject to greater risk than is an investment in a diversified fund.”

A plan’s investment policy statement is written for a reason: it should help plan participants follow a process of prudence that is in accordance with their responsibilities as plan fiduciaries. But if plan sponsors fail to follow the policies as defined by the IPS, it becomes only as useful as the paper it is printed on.

Maybe plan sponsors were giving The Sequoia Fund the benefit of the doubt, due to the manager’s track record of performance or its reputation in the marketplace.

Still, managers with reputations for prudence and histories of strong performance shouldn’t get a pass when it comes to plan sponsor due diligence. If anything, these funds deserve closer scrutiny because of the potential “halo effect” they get from the marketplace.