In order to reduce their risk of fiduciary liability, 401(k) plan sponsors often seek to offer an investment menu that satisfies the requirements of ERISA Section 404(c), which eliminates the risk associated with investment choices by plan participants.
One requirement of the Section 404(c) regulations is to offer a relatively safe investment vehicle, described as an "income producing, low risk, liquid investment." Many plans opt for a stable-value fund — in fact, 67% of 401(k) plans have a stable value fund, according to the Plan Sponsor Council of America.
There are various types of stable-value funds: general-account contracts; separate-account contracts; and synthetic guaranteed investment contracts, or GICs. The fund may also be designated under a plan with a different title, such as a managed income portfolio. There are three salient features to many stable-value funds:
• A stable-value fund generally consists of an underlying portfolio of high-quality, diversified fixed-income securities;
• It generally utilizes a "crediting rate" that takes into account gains and losses over time, and determines what interest will be paid to investors, and at what intervals;
• It often utilizes "wrap insurance," a form of insurance providing that subject to exclusions, investors can recover book value.
These factors affect the manner in which retirement plan advisers will evaluate stable-value funds. First, since stable-value funds are not insured by the FDIC — unlike money market funds — the adviser needs to consider the financial strength of both the provider and the institution providing the wrap. Second, the adviser should ensure that the interest rate being offered is not significantly higher than the intermediate bond rate, which might indicate that the investments are too risky.
This type of analysis is straightforward, but it fails to address an issue that some plaintiffs are raising in lawsuits — namely, that a stable-value fund can be too conservative. However, in February, the Court of Appeals for the First Circuit addressed this issue and concluded that Fidelity did not violate ERISA by adopting a very conservative credited interest rate.
The case arose from actions taken by Fidelity during the 2007-2008 financial crisis. It allocated managed income portfolio investments away from higher-return but higher-risk sectors, such as corporate bonds, mortgage pass-through and asset-based securities, and toward Treasuries and other cash-like or shorter-duration instruments. While these allocations made the managed income portfolio a safer bet and more attractive to wrap providers, it also positioned the MIP less favorably in the event that markets improved. In fact, markets did improve, leading plaintiffs to argue that the added safety Fidelity had built into the stable-value fund was not necessary and competitors whose investments were more aggressive had higher returns.
The appellate court had little difficulty in dismissing claims that Fidelity had breached its duty of loyalty and duty of prudence. It balked at the notion that a fiduciary violates ERISA's duty of loyalty simply by picking too conservative a benchmark for a stable-value fund. Such funds are generally presented as one of the more conservative options for investors who prefer asset preservation to the risk of pursuing greater returns.
"A conservative benchmark for a fund that places principal preservation at its primary goal warns the investor not to expect robust returns, and aligns expectations and results in a manner that is unlikely to harm or disappoint any investor who selects the fund," the court stated.
The court went on to say that Fidelity "offered an investment vehicle for conservative investors in the wake of the 2007-2008 market collapse, it published for its putative investors a cautious and unambitious benchmark, and then it consistently exceeded the benchmark … We cannot say that plans may not offer different types of stable value funds, including those that are intentionally and openly designed to be conservative … With respect to the breach of the duty of prudence claim, the basic problem was that it was relying upon hindsight." With respect to the prudence claim, the court found no authority that a plan fiduciary's choice of portfolio that is fully disclosed to participants can be imprudent by being too conservative.
In short, an investment adviser or consultant, while evaluating a stable-value fund, may believe that the benchmark and portfolio composition selected was too low and conservative. However, the selection of a very conservative benchmark in connection with an intentionally designed conservative investment option is, in general, permissible under ERISA.
Marcia S. Wagner is managing and founding partner of The Wagner Law Group.