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Stable Value Funds: A Disclosure Dilemma

Spread profits earned by insurance companies on general account stable value funds still remain hidden to plan sponsors.

W. Scott Simon, 12/06/2012

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.

I wrote about stable value funds in my October column. In brief, a stable value fund issued by an insurance company provides investors with a guaranteed return (backed by the financial soundness--the general account--of the insurance company itself or by assets set aside in a separate account unreachable by the general creditors of the insurance company) and smoothed income flow. These features are not free, however. They require investors to bear an increased (and little understood) assumption of risk and higher fees.

Another kind of stable value fund is issued by a bank or trust company in the form of a collective investment trust provided by an asset manager. The focus this month will be on stable value funds that are general account products issued by insurance companies.  

This column will delve into a particular issue involving these funds--which really aren't funds but rather a fixed interest option offered in the form of a group annuity contract distributed by a life insurance company. The issue involved has taken on new importance for participants in retirement plans such as 401(k) plans and 457(b) plans with the Department of Labor's (DOL) implementation of the disclosure regulations under the Employee Retirement Income Security Act of 1974 (ERISA) earlier this year. To wit, the DOL's 408(b)(2) regulation requires service providers to retirement plans to make certain disclosures of costs--and provide descriptions of the services rendered in exchange for such costs--to plan sponsors. In turn, the 404(a)(5) regulation requires plan sponsors to make certain disclosures to participants of the charges made to their plan accounts over the previous calendar quarter.

Incomplete Fee Disclosures?
Stable value funds are not registered investment products under the Investment Company Act of 1940, nor do they need to be registered with the U.S. Securities and Exchange Commission. That's why these funds aren't subject to the rules for the reporting of underlying portfolio holdings and fee disclosures, both of which are required of mutual funds. This (legal) lack of transparency, however, cuts against efforts made by the DOL to promote new cost disclosures concerning the investment options offered to participants in retirement plans.

The management fee of a stable value fund--that is, its annual expense ratio such as 90 basis points--is discernible because it's disclosed, for example, in the fine print of product advertisements. In some cases, though, a stable value fund doesn't charge an annual expense ratio. In those cases, the issuing insurance company has decided to work for free. OK, that's not true. (Note that stable value funds will always earn a spread (explained below) and some of them will also impose an annual expense ratio.)

What is true is that in cases where a stable value fund doesn't charge an annual expense ratio, the insurance company providing it nonetheless extracts a significant amount of revenue. That revenue--known as a "spread"--is derived from the difference between what an insurance company can earn on the fixed-income portfolio (i.e., the assets of the stable value fund itself) that it invests in and the percentage rate "guarantee" it pays out to those invested in the stable value fund, such as participants in retirement plans.

The spread profits earned by an insurance company on a stable value fund can be thought of as a kind of slush fund (i.e., with hidden and undisclosed revenue) from which other expenses that are incurred by it as the record-keeper of a retirement plan (such as administrative costs) are deducted. For example, suppose that an insurance company enters a bidding process to provide a retirement plan with a bundled solution as the plan record-keeper and investment provider. It may low-ball the record-keeping administrative costs it proposes to charge a plan sponsor, especially if a juicy stable value fund is already in the plan.

In reality, though, the spread on the proposed stable value fund would fully subsidize those administrative costs and any other costs incurred by the insurance company many, many times over. So spread profits are really far more than a slush fund; they are that high. Indeed, it's hard to see how any self-respecting insurance company would make less than 100 basis points on a spread and more likely would make 200 points. In a mid-sized retirement plan of, say, $200 million where at least one-quarter of plan assets can be invested in a stable value fund, a spread profit equates to $500,000 to $1 million. Fiduciaries of, as well as advisors to, plans with assets of, say, $20 million to $500 million in the mid-market should be aware of these often-misunderstood and undisclosed, yet hefty, costs of stable value funds in retirement plans. Plans with assets of, say, greater than $500 million, and therefore having a greater knowledge base (contra are Braden v. Wal-Mart, et al.), generally don't allow general account stable value funds as a plan investment option because they figured out years ago that they pose unnecessarily higher risks and costs to plan participants.

What's good for insurance companies is that they need not disclose their spread profits to plan sponsors or plan participants. At least that's their interpretation of the DOL regulations and, to date, the DOL has not told them any differently. The DOL excuses investment products that have a stated rate of return and a stated definite term for which that return will be guaranteed from having to itemize their expenses. Insurance companies reason that because the DOL says that guaranteed rate investment products are not portfolios from which expenses (such as record-keeping costs and revenue-sharing) can be deducted, then they need not disclose them.

This assumes, of course, that stable value funds are actually guaranteed rate products. But some believe that they aren't any such animal because their stated guaranteed rates and length of maturities are highly variable given that the insurance companies themselves determine them. One company describes that process this way: "The XX Fixed Annuity and the fixed accounts of variable annuities have interest rates that are determined and declared periodically by a XX executive committee. Most XX contracts have quarterly 'new money' rates and quarterly portfolio rates set at the discretion of that committee, taking into account all issues important to the contract owners and the company. Some fixed annuities have interest rates based on an external index."

But what about the obvious question in all of this: If the costs that underlie a stable value fund are not assessed against plan participants (but instead subsidized against the spread profits), then what's the big deal? The returns earned by participants aren't being affected, so why should anyone care?

Well, in the first place, plan sponsors have to care. They are required under ERISA section 404(a) to determine whether a cost imposed in exchange for a service is "reasonable." That's impossible to determine, of course, if a cost--the spread profit in this case--is not disclosed to the sponsors.

In the second place, the returns of plan participants are still impacted. Even though returns earned by participants aren't being affected--as reflected in a stated annual expense ratio--by a stable value fund, when an insurance company is calculating what amount of guarantee to offer on a fund and its term, it must take into consideration the costs of record-keeping and other administrative services as well as any revenue-sharing expenses and broker compensation. This could indeed impact the amount of a stable value fund's guarantee and its term to the detriment of plan participants.

A person unfamiliar with the moving parts of stable value funds (which unfortunately includes many plan fiduciaries) looking at all this on paper would have to assume that since there's no cost imposed or revenue derived from a stable value fund, there must be no services being provided by the insurance companies. But they are clearly providing services so they must be working for free. Well, we know that's not true.

What is true is that insurance companies in the role of a record-keeper offering general account stable value funds as part of a bundled product solution just do not want to disclose their significant spread profits--which are always there. Stable value funds are a very important profit center for the insurance companies that offer them. Indeed, some insurance companies in the retirement plan industry generate at least half of their total profits from stable value funds. There's nothing wrong with profits, but when such enormous sums are involved in the fiduciary-rich environment of ERISA, at the very least plan sponsors should know the amount of those sums, and where they flow from and where they flow to.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understandingis the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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