Stable Value Funds in the Litigation Crosshairs

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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On Jan. 29, Deborah Bishop-Bristol filed a class action lawsuit against the Massachusetts Mutual Life Insurance Company (MassMutual) in the United States District Court, District of Connecticut, on behalf of the Arthur J. Gallagher & Company 401(k) Savings and Thrift Plan (as well as all other employee pension benefit plans governed by the Employee Income Security Act of 1974, as amended (ERISA) similarly situated). The complaint is here.

I'd like to sidestep the common legal and factual questions often raised in complaints of this nature, such as whether MassMutual a) is a fiduciary to the plan, b) is a party in interest with respect to the plan, c) breached its fiduciary duties in failing to comply with ERISA, d) breached ERISA's prohibited transaction rules, and e) received and retained money that constituted plan assets.

I'd like to focus instead on the complaint's allegations detailing the process by which MassMutual earns revenue from the stable value fund (SVF) (termed SVA in the complaint) that it provides as an investment option in the Gallagher 401(k) plan. This process is similar to those followed by other SVF issuers.

Issuers market their SVFs to plan sponsors as investment options that provide a guaranteed return and smoothed income flow. In furtherance of this, issuers use reassuring (and brilliant) marketing language such as "stable," "value," "fund," "guarantee," and "guaranteed" in their promotional activities. Plan participants who are looking for returns higher than money market funds and/or less volatile returns may find these words comforting and, hence, be attracted to SVFs. Some plan sponsors that know little more about SVFs than associating them with this soothing marketing language will consent to allowing an SVF to be placed on their plan's investment menu.

At the outset, it should be understood that an SVF is not a registered investment product under the Investment Company Act of 1940 ('40 Act) nor does it need to be registered with the U.S. Securities and Exchange Commission. As a result, SVFs aren't subject to the rules for reporting underlying portfolio holdings and fee disclosures, both of which are required of '40 Act mutual funds. Nor do the fee disclosure regulations (e.g., 408(b)(2)) promulgated by the U.S. Department of Labor in 2012 require the fees of an SVF to be disclosed. Nonetheless, the nub of the allegations in the lawsuit is that MassMutual is an ERISA fiduciary earning unreasonable compensation on ERISA assets undisclosed to plan sponsors and plan participants.

In particular, the complaint alleges that MassMutual markets SVFs to sponsors of retirement plans such as 401(k) plans like the one in this case (as well as to ERISA-governed Internal Revenue Code section 401(a) and 403(b) retirement plans). Each SVF utilizes group annuity contracts (GACs) that are issued by MassMutual and managed through the insurance company's general investment account (GIA) and guaranteed separate accounts (GSA) holding the GIA.

MassMutual takes the contributions that participants in the Gallagher 401(k) plan make to the SVF and deposits them in the GIA where they are held, pooled, and invested by MassMutual (along with its other financial assets), reporting them as "invested assets."

With all the money invested in SVFs that are on retirement plan investment menus pouring into the MassMutual GIA, it's not surprising that, over time, MassMutual has gained (in the language of the complaint) "investment experience" with the invested assets in its GIA. Based on that experience, MassMutual computes an internal rate of return (IRR).

In setting and resetting up or down its gross crediting rate, MassMutual takes into consideration the investment experience of the invested assets in its GIA; this rate will therefore rise or fall based on that investment experience. The complaint alleges that the gross crediting rate can be set and reset by MassMutual as frequently as on a daily basis.

The gross crediting rate doesn't reflect deductions taken by MassMutual for its administrative, marketing, and record-keeping expenses. MassMutual also determines the guaranteed crediting rate (which in some SVFs can be as low as 0%), which is the interest rate it sets and resets up or down for each subsequent crediting period, such as every quarter or two quarters. This guaranteed rate reflects MassMutual's deduction of the expenses noted previously, and this net number is what's actually "guaranteed" and paid out to plan participants invested in an insurance company's SVF. MassMutual sets the guaranteed crediting rate well below the IRR it earns on the money invested in the SVF.

Although not alleged in this case, an SVF such as MassMutual's is usually invested in a diversified portfolio of intermediate-term (i.e., 3-5 years) corporate and government fixed-income investments as well as a smattering of stocks. This makes clear that SVFs aren't cash equivalent alternatives as often depicted in marketing materials (as well as in popular articles in the media). As a result, the returns of SVFs cannot be compared on an apples-to-apples basis to those of money market funds, since the two kinds of investment vehicles hold different investments with consequently different risk profiles.

Spread Profits In addition to what it charges for its administrative, marketing, and record-keeping expenses (which are deducted from the gross crediting rate), MassMutual pays itself a "spread profit," which covers investment management and administrative expenses as well as expenses for risk and profit.

The spread profit for a given crediting period is the difference between what MassMutual actually earns on money invested by plan participants--the IRR--and what it pays out to them--the guaranteed crediting rate--for that crediting period. The spread profit reduces the investment returns on MassMutual's GACs. MassMutual makes no disclosure of its spread profit to either plan sponsors or plan participants. MassMutual's SVFs don't specify or require any formula or methodology for determining crediting rates, nor does MassMutual disclose any actual formula or methodology for use in determining crediting rates.

$236 Million Made by an SVF in 2014 The complaint alleges that MassMutual earned approximately 460 basis points (bps) on the invested assets in its GIA for 2014. MassMutual's average return on its GIA, a GIA and one of its SVFs (over a three-year period that included 2014) was 182 bps. The difference of approximately 278 bps (i.e., 460 bps less 182 bps) was MassMutual's undisclosed spread profit averaged annually over that period.

Note that the spread profit of 278 bps doesn't include the amount that was paid to MassMutual for its administrative, marketing, and record-keeping services (i.e., the extent to which the gross crediting rate was reduced) noted previously. MassMutual has reported in its public filings that its GIA held approximately $8.5 billion. Doing the math shows that it earned approximately $236 million--in one year alone--in undisclosed spread profit on all the plans (actually, on the plan participants) in which the SVF in the case at hand was offered as a plan investment option.

Mind you, that spread profit has been flowing to MassMutual even in a historically low interest rate environment in which investors (including plan participants) have been receiving a pittance in interest income at the same time that MassMutual (as well as many other SVF providers) has made a substantial profit. MassMutual would answer this by saying that it simply earns the spread (say, 250 bps) between what it earns on the money invested by plan participants (say, 300 bps) and what it pays out to them (say, 50 bps). Just like a bank.

Sometimes issuers of SVFs will disclose an expense ratio of, say, 45 bps or 80 bps. This may throw off plan sponsors and make them think that an SVF with an expense ratio of, say, 45 bps isn't so bad. But any such disclosed expense ratio is simply a portion of the undisclosed profit spread. For example, suppose that an insurance company earns a gross return of 500 bps on its portfolio and out of that, pays 200 bps to plan participants, leaving 300 bps of undisclosed spread profit. Further suppose that the insurance company decides to disclose an expense ratio of 45 bps. That disclosed 45 bps comes out of the undisclosed spread profit of 300 bps, leaving 255 bps of undisclosed spread profit.

Providing a peek at some of an SVF's undisclosed spread profit through a disclosed expense ratio is sometimes a way for SVF issuers to counter the disbelief registered by some that an SVF can be offered for "free" with no expense ratio. A disclosed expense ratio in such cases is arguably nothing more than the number that an SVF issuer thinks will best help maximize an SVF's sales and revenue; it's just a made up number.

In next month's column, I'll provide some more observations about this case.

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