BY: Chris Tobe, CFA October 26, 2012
401k fee disclosure has a big loophole in one of the largest asset classes. Stable value, or
guaranteed funds, typically constitute 10-40% of assets in most 401(k) plans and have varied
and complex structures which complicate fee disclosure. Billions of dollars in what I call spread
based fees remain undisclosed under the new DOL fee disclosure rules.
Last month I saw my wife’s statement from Lincoln. It showed the stable value or fixed
product with 0% in fees, when I know they may make as much as 2% or 200 basis points (bps)
in spread profits based on my nearly 7 years experience as an officer of insurance companies. I
was recently quoted in the Wall Street Journal’s Marketwatch “These excessive profits, even if
called spread, act like fees and are used like fees,”
Insurance companies are manipulating loopholes for excessive profits. While they may
disclose some fees, it may only tell 25% of the story as they make the majority of their profit on
the spread. Even if the DOL continues to ignore this loophole I believe their hidden spread
fees will probably put them in danger of class action lawsuits. In addition they continue to pay
commissions out of the hidden spread which drive even more sales.
Currently if the insurance lobby gets their way these higher risk and higher fee bundled
products will appear to have lower fees (and higher returns) compared to a diversified
low risk low fee product, like the Vanguard Stable Value collective trust. In this scenario
an advisor with an insurance license can get a kickback in commissions for a product he can
show is DOL approved with higher yields and no fees.
We need to look more closely at the loophole that the insurance companies are using. “ The
preamble to the participant-level disclosure regulation provides that designated investment
alternatives with fixed returns are those that provide a fixed or stated rate of return to the
participant, for a stated duration, and with respect to which investment risks are borne by an
entity other than the participant (e.g., insurance company). 75 FR 64910”.
I believe insurance companies are twisting and manipulating this rule.
I believe that the intent is to exempt a traditional GIC which functions like a bank CD, 3% rate
for 3 years that is sold in a competitive bidding environment. For example Vanguard in their
stable value plan has had a 20% allocation to a diversified basket of traditional GIC’s. When
they purchase a GIC which is never over 5% of their total holding they go to 5 or more insurance companies and get bids to get the highest rate for a GIC of say 3 years. This process
eliminates the excessive fees and the diversification eliminates excessive risk. Vanguard
discloses a management fee, but does not add any additional fees for the internal spread of insurance company.
Insurance company General Account products are usually part of a bundled arrangement.
There is no competitive bidding so they essentially set their own rates and their own profits
without any disclosure. Historically they have been allowed to vary their rates at the will of
the insurance company depending on their thirst for profit. However, I think in their attempt to
manipulate this loophole they will try to keep rates more constant to appear to fit the exemption
which states fixed or stated rate of return. The other qualification for the exemption is a
stated maturity or duration, and none of the insurance products I have seen do this and should
be eliminated from exemption based on that alone.
The insurance industry and its lobbyists have this spin on the loophole. “For general account
products or fixed income products, the Department of Labor (DOL) acknowledges that for a
product with a stated rate of return and term, it is not pertinent to have some type of expense
ratio related because the real driver of income is the rate being offered” I have never heard
this directly from the DOL, but neither have I heard them deny it. Again I think this applies to
diversified product in a competitive bidding situation, not in a captive bundled product.
One of the reasons this loophole exists is because the vast majority of the largest plans
abandoned insurance products for their liability, risks and excessive hidden fees 10 to 20 years
ago. To understand this I think it is helpful to split the $4.5 trillion 401(k) market.
The top $3 trillion (68% of assets) is large fortune 500 type plans account for only 1% of the
plans and for the most part do not use single entity general account products iv However the
bottom $1.5 trillion is spread over 650,000 plans (99%) ranging from small Dr’s offices to midsize
manufacturers. The battleground for fee disclosure will be in bundled insurance company
products in small to midsized plans.
The financial crisis allowed some room for growth of these products to some larger firms as
reported in the Wall Street Journal in May 2010. Amid the shortage of wrap insurance, though,
some firms are seizing an opportunity to reintroduce older types of stable-value products that
are backed by a single insurer and carry considerable risks. OneAmerica Financial Partners
Inc.’s American United Life Insurance Co., for example, last month launched a stable-value
product backed by its own general-account assets. In such products, investors are taking on the
risk that this single issuer could go belly up.
In 2008 Federal Reserve Chairman Ben Bernanke said that “workers whose 401(k) plans had
purchased $40 billion of insurance from AIG against the risk that their stable-value funds
would decline in value would have seen that insurance disappear.”
Many investment professionals believe that a plan sponsor is taking a severe fiduciary risk by having a single contract with any one entity such as AIG. The only counter to this relies on assuming that the
single insurance company backing the stable value option is too big to fail and has an implied government guarantee which is problematic on its face.
The National Association of Government Defined Contribution Administrators,
Inc. (NAGDCA) in September 2010 created a brochure with this characterization of general
account stable value that got beyond the high risks and right to fee disclosure. “Due to the fact
that the plan sponsor does not own the underlying investments, the portfolio holdings,
performance, risk, and management fees are generally not disclosed. This limits the ability of
plan sponsors to compare returns with other SVFs [stable-value funds]. It also makes it nearly
impossible for plan sponsors to know the fees (which can be increased without disclosure) paid
by participants in these funds—a critical component of a fiduciary’s responsibility. It is hard
to comprehend why the DOL lets these products escape disclosure.
1. High hidden stable-value spread fees are subsidizing administrative costs.
Revenue from general and separate account stable value options have typically
subsidized administration costs, making some participants pay higher
administration costs than those in mutual funds, and making products appear
competitive in requests for proposal that look at per head administrative costs.
2. Fees and commissions are not being fully disclosed. Insurance companies are
still fighting not to disclose any spread profits. These excessive profits, even if called spread,
act like fees and are used like fees. Commission kickbacks to consultants with insurance
licenses are common in plans with general and separate account stable value.
3. The structure creates a higher level of fiduciary duty for vendors and risks for plans. Since
general and separate account stable-value assets are on the balance sheet of the insurance
company, this creates an inherent conflict between the fiduciary care of pension investors and
company shareholders. If the firm needed more income they could get it by lowering rates paid
to plans since they are in captive non-bid bundled arrangements.
Most stable value products (IPG) provided in bundled insurance company products do not fit
this exemption in my opinion since its fixed rate is variable and the duration is variable. If the
DOL continues to listen to the insurance lobby higher risk and higher fee bundled products will
appear to have lower fees (and higher returns) compared to a diversified low risk low fee product like the Vanguard Stable Value collective trust.