Stable Value Funds: A Fiduciary Quandary

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.

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In last month's column, I offered some observations on the complaint filed in the case of Massachusetts Mutual Life Insurance Company v. Arthur J. Gallagher & Company 401(k) Savings and Thrift Plan. That case involved stable value funds (SVF).

In response to that column, I received the following observant email: "I am pleased that you are writing to shed fiduciary light on Stable Value Funds. I ... want to suggest that you need to separate insurance company general account SVFs, from insurance company separate account SVFs and insurance provider contracts from Collective Investment Trust SVA offerings with an insurer wrap to have a meaningful discussion." I have examined these issues and others in two columns on stable value funds published in October 2012 and December 2012.

Another reader posted this comment: "While [spread profits are] interesting, as an investor I am more concerned with assessing the risk-adjusted return of the investment. The problem with SVFs is we don't really know what they own and, therefore, we can't gauge risk. So how can any fiduciary put these products in any plan?"

A very good question. Indeed, given the lack of cost transparency that was examined in last month's column, how is it possible for a plan sponsor to make an informed and prudent decision--which requires a knowing understanding of all relevant material issues--about whether to allow an SVF on their plan investment menu? It remains the case that the total economic impact on plan participants invested in SVFs is unknown since an insurance company's (e.g., MassMutual) crediting rate on an SVF is still controlled and fixed by it, with absolutely no fiduciary duty to plan participants.

By the way, this doesn't help plan sponsors carry out their fiduciary duties prudently. But when low-cost, broadly diversified investment options constitute a retirement plan's investment menu, a plan sponsor cannot help but look like the leading luminary in that prudent afterglow.

Is an SVF Akin to a Single Stock? Nor, as the reader points out, is it possible for a sponsor to have a knowing understanding of the risks involved with an SVF when it has little idea what the heck the bloody thing is invested in. Even with increased risk transparency, though, an SVF, in my opinion, should be viewed as a single stock because it emanates with the (non-fiduciary) "guarantee" of a single issuing insurance company.

Although some may agree that this view is correct when confined to "general account" versions of SVFs, they might view it as incorrect when it comes to other, more transparent versions of SVFs that are available to many larger retirement plans and to smaller plans through collective investment trusts offered by an issuing consortium of, say, Vanguard, Fidelity, T. Rowe, et al.

Even in the latter kind of situation, though, the risk is still unnecessarily large: three "issuers of stock" instead of one. My view doesn't center on the nature of the portfolios involved but rather on the low number of issuers concerned.

Is an SVF Like a Hedge Fund? Alternative investments such as hedge funds are sometimes described as a "compensation structure in search of an investment strategy." It may not be much of a stretch to suggest that this characterization can apply to an SVF: it's arguably created, marketed, and sold--accompanied by brilliant marketing language described in last month's column--to enrich the SVF issuer at the expense (and risk) of participants in retirement plans.

Since MassMutual sets an SVF's gross crediting rate on a daily basis, there's no way for plan sponsors to know in advance what that rate will be. This rate is different than the guaranteed crediting rate that is paid out to plan participants. The gross crediting rate is the mechanism that an insurance company uses to credit an SVF in order to meet the "guarantee" of the SVF (a guarantee that usually changes every three months). So as often as every day, MassMutual decides how much profit to scrape off the gross crediting rate before delivering any return to an SVF.

By the way, this is why there's no way for plan sponsors to know in advance what the trade-off will be between what's paid out to plan participants (100 bps, 200 bps?) and the spread profit (an alleged 278 bps in the MassMutual case) earned by an insurance company, and assess it prudently.

Larger retirement plans are able to negotiate with insurance companies, to a certain extent, the size of the guaranteed payout to plan participants. Logically, then, smaller plans will not get such an advantageous deal. Does this mean that smaller plans are somehow subsidizing larger plans since all this money is pooled together in MassMutual's general investment account (GIA) and even in its guaranteed separate accounts (GSAs) holding the GIA? (In the MassMutual case, each SVF utilizes group annuity contracts that are issued by MassMutual and managed through its general investment account and guaranteed separate accounts holding the GIA.)

Ultimately, the MassMutual case is yet another illustration of a non-fiduciary investment provider attempting to serve two masters in the fiduciary environment of ERISA. There's no doubt that an insurance company will always seek to maximize the risk/return relationship in its GIA. MassMutual, after all, is a mutual company, so its policyholders will be the beneficiaries of this activity, as its goal is to act solely in the best interest of those policyholders. This is as it should be in a capitalistic system.

In reality, of course, there's always a flip-side to this kind of situation, and it's a straightforward one: MassMutual (or any other such SVF provider) has an inherently conflicted relationship with any plan participant that invests in its SVFs. It is simply not possible for MassMutual, by law or by contract, to place the interests of plan participants ahead of its own; on the contrary, it has no other legal choice than to always cut in line ahead of participants.

Although our capitalistic system is largely one where caveat emptor reigns, this is moderated somewhat within the ERISA fiduciary statutory scheme, which is focused on plan participants (and their beneficiaries). In this fiduciary system, plan sponsors must have a knowing understanding of all relevant material issues in order to carry out their duties prudently. But they almost never do--even ones that are responsible for multi-billion dollar 401(k) plans.

This brute reality is rarely acknowledged (much less understood), especially when the various and sundry charms of SFV salespeople mouthing soothing marketing words and armed with an asymmetrical information advantage are brought to bear against helpless plan sponsors--even ones responsible for multi-billion dollar 401(k) plans.

Contrast this inherently conflicted situation of an SVF investment option with, say, a mutual fund investment option in which the fund has a fiduciary duty to the shareholders that invest in the fund. So even though a mutual fund isn't a fiduciary to a retirement plan, it does have fiduciary duties that run to fund shareholders.

A plan sponsor (or any other discretionary fiduciary) who is assessing the prudence of selecting an SVF for a retirement plan needs to think hard about justifying the conflicted, non-fiduciary relationship that exists between an issuer of SVFs and plan participants, in comparison to the non-conflicted fiduciary relationship between the provider of a mutual fund (or even a collective trust) and plan participants. Even if MassMutual legally prevails in this case (as is likely), the issues raised here must still be addressed by any responsible plan sponsors (as well as other discretionary fiduciaries) conscious of their fiduciary duties under ERISA.

All too often allowing an SVF as a retirement plan investment option is exactly the kind of result to be expected when sponsors of retirement plans abdicate their fiduciary duties (either out of inattention or outright ignorance). Such sponsors allow those with no skin in the game--non-fiduciary caveat emptor salespeople with no fidelity to anyone except to the firm for which they work and its shareholders--to, in effect, dictate in many cases the investment options that appear on the menus of retirement plans all over the country. Plan sponsors, however, don't have the luxury of being inattentive or ignorant when operating in the plan participant-centric universe of ERISA. They must be prudent.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.