Stable Value Pick-up Trucks

By Jeb Graham CEBS, CIMA® of CapTrust Financial Advisors, an independent consulting/advisory practice focused on the institutional retirement plan market, serving corporate, closely held, non-profit and governmental organizations. You may contact Jeb at 813.218.5008 or jeb.graham@captrustadv.com.

Think for a minute about how auto insurance works. The cost of insurance is based upon an assessment of potential risk. Seems fair enough. Suppose it were different. What if people got tax breaks for buying auto insurance through their employer, and the employer controlled the selection of insurance companies? Suppose certain insurance companies, unbeknownst to the insured party, assessed to drivers of pick-up trucks rates three times that of any other type of vehicle…even though there was no apparent logic for the pricing differential? Would the employers have an obligation to understand the pricing? Would the insurance company be liable for inequity, despite fine print disclosure?

Questionable Equity

Switch gears from car insurance to 401k investments. Are some 401k plan participants getting the short end of stable value? Most participants in a stable value fund or guaranteed account are there for a reason. They have a short time horizon…a need to minimize volatility and avoid short term market risk. It is a logical assumption that the investment expenses in a stable value/guaranteed fund would be less than managing a bond or stock portfolio.

Why then might some 401k plans have stable value/guaranteed funds with higher expense ratios? For the same reason that an equity fund might have higher total expense ratios...a revenue sharing component used to offset plan expenses. This is certainly legal, and in many cases beneficial to plan participants, as this additional revenue sharing can lead to an expanded investment menu. Depending on the plan size, a 75 bp expense on a stable value may not be unreasonable.

* Guarantees are based on the claims paying ability of the issuing company.

Stable value funds and guaranteed contracts are structured differently and have different disclosure formats than mutual funds. Whereas expenses in a mutual fund are fixed, and stated in a prospectus, expenses in many so-called "fixed" accounts are not fixed, rather they can be quite fluid. The underlying investment structure can be either a commingled pool of assets managed toward an objective of asset preservation in the short term or the general asset pool of an insurance company, managed toward a much longer time frame. In either case, there is considerable pricing flexibility in setting the cost for each entity having a slice of the overall pie.

* Mutual funds are sold by prospectus. Please consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained by calling your financial advisor. Read it carefully before you invest.

A potential problem?

Consider this hypothetical example of a 401k plan with $75 million in assets, of which 20% of the assets (including lifestyle allocations) is in the fixed account. The investment menu is comprised of institutional share class mutual funds along with several index funds, with expense ratios ranging from 25 - 60 bps. The lifestyle allocations are made up of funds on the underlying menu and do not constitute additional fund options. The only fund that has any revenue sharing component is the fixed account with an expense ratio of 70 bps, of which 60 bps is used to offset recordkeeping costs.

Is there something that stands out here? Yes…the investment option with the highest expense ratio is the fixed account. One can certainly argue that 70 bps. is not an unreasonable expense for even the most conservative investment. This arrangement is certainly within the bounds of the law, but it is likely that the investment committee with oversight responsibility for this plan did not look at the situation from this angle.

The estimated revenue sharing offset in the above example is $90,000 ($75 mm X .2 X 60 bp). Assuming a $30,000 average participant account balance, this might offset about half of the total recordkeeping costs for 2,500 participants. The remaining cost could either be paid by the company, or spread among all participants as an annual per head cost of $36.

The real issue here is the disproportionate spread of the plan's recordkeeping expenses among plan participants. Applying the well known 80/20 rule here, 20% of the participants are paying 80% of the expenses. It is also likely that the 20% is comprised of very few of the plan's "highly compensated" employees as designated by ERISA.

To date, this issue has been under the radar screen of the broader topic of fee analysis. But you can look for this to become a hot topic.

What do we feel is the solution?

In a word…transparency. In an effort to simplify comparison shopping between bundled service providers/investment platforms as revenue sharing became more complex, we believe the industry moved toward an "all-in" pricing format in which nothing was itemized. This author's opinion is that although bundled service models will continue to be the norm, the industry will shift back in the direction of itemized services with all pricing points and revenue sharing being fully disclosed.

This material is distributed solely for information purposes and is not a solicitation of an offer to buy any security or instrument or to participate in any trading strategy. The views contained herein are the opinions of the author. It is not intended as legal or tax advice. CapTrust Advisors, LLC is a Registered Investment Advisor with the SEC. CapTrust is not a legal or tax advisor.

Other articles by Jeb Graham: Looking Under the Hood of Your 401k to Understand the Real Costs, Does Your Organization's Retirement Plan Measure Up? and The Importance of Legal Counsel Review.

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