What if I told you the position in your retirement portfolio you thought was safe was anything but?
Most of us understand that stocks can lurch violently over the short term. Investors who have not been in a coma for the past two decades understand this is a market feature, not a bug.
While stocks have dramatic swings, investors rely on stable allocations in their portfolio to smooth out the ride. Surprise!
Insurance companies, in their pursuit to combine insurance and investments, play the role of Dr. Frankenstein in this little-known retirement landmine:
The single entity stable value fund.
This was designed for conservative investors who insist on not making any real return on their money over several decades. (Just kidding.)
The purpose of stable value funds is to provide a fixed rate of return to nervous investors. Often individuals are told they can avoid the turbulence of the markets and sleep comfortably with these products. Used properly, they become “smooth bond funds” or fixed annuities.
What investors are not told is the risk is transferred, not eliminated. Under certain conditions, this product could have the potential for a much greater loss than a portfolio that is 100% invested in global stock index funds.
Time to get out the Ambien.
After speaking with Christopher Tobe, a stable value consultant and fee expert, I almost choked on my left over linguine.
These funds are offered in 401(k)/403(b) plans. There are two types of contracts, “single entity” and “synthetic” stable value.
The words synthetic and investment are a horrible combination for individual investors. Surprisingly, “single entity“ is the source of massive hidden liability.
According to Mr. Tobe, “Single entity stable value products, issued only by insurance companies, are the more straightforward of the two. The issuing insurance company guarantees the invested principal amount and pays a specified rate of return (which may adjust periodically) for a certain time period. The issuer buys assets matched to the liability and the underlying assets are then owned and managed by the issuer.”
In other words, the risk of owning the investments was transferred to the financial condition of the insurer, not eliminated.
It gets worse.
With single entity, the contractual guarantees are based solely on the issuer’s claims-paying ability. If you had a single entity stable value fund issued by AIG and the government did not bail them out, you could have been left with nothing — a 100% loss.
WTF? We just went from something that many believe is similar to a C.D. to losing all of your money!
It gets worse.
Under the new Department of Labor (“DOL”) fee disclosure laws, the insurance lobby was able to get an exemption to claim 0% in fees for single entity stable value funds.
This product is advertised as “free.” What is not disclosed is many insurers take your money and earn, say, 4%, while they credit you with 2%. In their conflicted language, they are making a “spread,” not charging you a fee!
Synthetic stable value products are the better choice.
Synthetic stable value funds are structured differently. A contract issued by an insurance company, bank, or other financial institution provides certain guarantees based on a separately-managed underlying portfolio of fixed-income securities owned by the plan.
If you had a synthetic stable value fund issued by AIG your losses probably would have been 0%, or at most 5%, because the synthetic only insures the difference in book and portfolio value. Typically stable value funds use three or four wrappers with the remaining wrappers having step-up provisions to cover an event, such as AIG exiting.
Displaying the nefarious power of the insurance lobby, synthetic products have to disclose fees though the risk of losing of all principal has virtually been eliminated. The spread companies like Vanguard collect on these products are lower. Investors are led to believe these are the higher fee investments. Unbelievable.
Mr. Tobe explains how this deception works: “For example, a diversified stable value fund, like the Vanguard Collective Trusts, will appear to have both a lower yield and higher fees than a general account product issued by AIG or a dozen other insurance companies, which under the new guidelines have 0% in fees. I have estimated that insurance companies make around 2% in spread profit, double to triple that of Vanguard with double to triple the risk as well.”
Say hello to a steaming pile of return-free risk.
These general account products have some sort of floor (1.5% or 1%) before an administration fee. They have this so they can claim they are like a bank C.D., and be exempt from fee disclosure. The guarantee is way out; it is the excuse used to hide fees (spread).
Insurance Companies exaggerate the ability of state insurance to protect investors. States are ill-equipped to deal with wide spread financial mayhem. The Federal Government had to bail out AIG during the financial crisis.
Single entity stable value products are anything but stable. Few would take this risk if they actually read — and understood — the massive, jargon-filled prospectus.
These products are prevalent in 403(b) and 457 plans. They are also in smaller 401(k) plans. Fortune 500 companies avoid single entity funds like the plague.
Why do so many small 401(k), 457 and 403(b) plans hold these misleading and expensive investments?
Insurance companies offer to do plan administration for “free.” They are willing to forego the 0.50% cost in order to make 2.0% on the egregious spreads they miraculously don’t report as fees.
Small businesses and schools are cost conscious. This makes them prey for “free” services.
Non-transparency leads to the exploitation of teachers, small business owners, and others.
Retirement saving is filled with murder holes.
Add single entity stable value funds to the list.
For further reading on how these fees are hidden, check out Christopher Tobe’s research paper and his book Consultants Guide To Stable Value.