W. Scott Simon
To recap the case, some current and former employees of the Massachusetts Mutual Life Insurance Company (MassMutual) sued MassMutual and other defendants for breach of fiduciary duty. MassMutual sponsors a defined contribution plan known as the Thrift Plan, which it offers to its eligible employees. The Thrift Plan has nearly 15,000 participants and holds almost $1.5 billion in assets.
Plaintiffs’ complaint sets forth seven counts, including the selection of unreasonably priced and imprudent investment options, entering into prohibited transactions, the failure to administer the plan in accordance with the governing plan documents, and the failure to monitor fiduciaries.
My discussion last month focused on the failure to administer the plan in accordance with the governing plan documents and the selection of unreasonably priced and imprudent investment options.
In this month’s column, I thought it might be of interest to discuss certain allegations in some specific paragraphs of the complaint, to wit:
Paragraph “85. The Fixed Interest Account [i.e., the stable value fund (SVF) investment option offered by the Thrift Plan that was discussed in last month’s column] not only subjected the Plan and its participants to excessive and undiversified risk, it also benefited Defendants by providing: (1) hundreds of millions of dollars of assets under management against which Defendants could assess fees; (2) Defendants with over $500 million dollars in working capital for their general account from MassMutual employees’ retirement savings; and (3) additional revenue through spread or other earnings hidden from participants.”
The second allegation–“$500 million working capital”–in paragraph 85 is quite interesting when viewed through the prism of self-dealing. That is, it’s alleged that MassMutual takes the money of its own employees and uses it as working capital for its own business purposes. That seems like a mighty neat trick, but it could also result in a self-dealing charge if it is seen as using the retirement assets of plan participants for MassMutual’s own business use.
Under ERISA, sponsors of retirement plans must be cognizant of, when making certain decisions, which “hat” they are wearing–their business hat, which will favor shareholders of the sponsor, or their fiduciary hat, which must “exclusively” and “solely” favor plan participants. So although using the assets of plan participants as working capital for MassMutual might be good for MassMutual, it won’t be permitted if it’s determined that MassMutual is engaged in self-dealing activities, those not for the exclusive purpose and in the sole interests of plan participants.
It’s interesting to see that the third allegation–“keeping spread or other earnings hidden”–in paragraph 85 was included, because it’s seldom raised as an issue in litigation, much less widely understood by plan fiduciaries responsible for millions of dollars of assets invested by plan participants.
What are “spread” earnings? Paragraph 89 explains: “… MassMutual also retains, as additional revenue, the difference between what the investments in the general account [in which MassMutual’s proprietary SVF is invested] actually earn versus what is credited to the [Thrift] Plan. This is commonly referred to as spread earnings.” Paragraph 89 further alleges: “Spread earnings can be significant, reaching multiples of the 115–175 basis points fee… These earnings, in addition to the layers of fees, are never disclosed to participants.”
To be clear, then, plaintiffs are alleging that the plan fiduciaries responsible for MassMutual’s proprietary SVF have decided to (a) charge annual fees on the SVF ranging from 115-175 basis points, (b) retain the SVF’s spread earnings as revenue each year, and (c) not disclose such fees or earnings to plan participants.
The annual 115-175 basis points is derived from a risk fee (i.e., a mortality and expense charge) of 85 basis points and a record-keeping fee ranging from 30 to 90 basis points (paragraph 88). Plaintiffs alleged that the SVF is the largest investment option in the Thrift Plan, representing as much as 40% of its assets (paragraph 82). If true, this equates to investing about $600 million of the Thrift Plan’s $1.5 billion asset base in the SVF. 115-175 basis points generates an annual fee of $6.9-$10.5 million for MassMutual.
The spread earnings retained as revenue by MassMutual every year are the difference between what the investments in the SVF (invested in the MassMutual general account) earned, which could be, say, 3%-6%, and what was credited to the retirement plan, which could be, say, 1%-2%. The hypothetical example presented here produces spread revenue ranging from a minimum of 1% to a maximum of 5%. Since $600 million of the Thrift Plan’s $1.5 billion in assets is invested in the SVF, that generates spread revenue ranging, hypothetically, from $6 million (1%) to $30 million (5%). No doubt it’s the possibility of these kinds of numbers that led plaintiffs to allege: “Spread earnings can be significant [i.e., $6-$30 million in my hypothetical], reaching multiples of the 115–175 basis points fee [i.e., $6.9-$10.5 million].” (Paragraph 89.)
By way of note: Our registered investment advisory firm recently became the investment advisor to a multi-hundred million dollar retirement plan and found that about 45% of plan assets–over $100 million–were invested in an SVF. We had estimated that the incumbent insurance company was making 1%-2% (or $1.2-$2.4 million) annually in spread profits off the SVF. I can now see that our estimate may have been far too low. Whatever the actual amount, though, it’s critical to understand that the actual annual spread revenue on an SVF flies completely under the radar.
There’s no doubt that MassMutual will argue in its defense that any spread revenue (such as my hypothetical amounts of $6-$30 million per year) is simply profit to it that should not be shared with its own plan participants invested in the MassMutual SVF. It will also argue that this spread revenue should not be seen in any way as a cost to those participants. These two assertions taken together would simply mean that MassMutual sees no need to disclose its spread revenue. In fact, insurance companies offering an SVF never do make such disclosures. Indeed, they hide their spread revenue numbers so well it’s unlikely that the National Security Agency could uncover them.
The contention made by MassMutual (or any other insurance company) that the spread revenue it retains is simply profit may (or may not) have merit. In any event, it would seem that such vast amounts of money flowing directly into a service provider’s coffers should be clearly disclosed to plan fiduciaries. (Presumably, this disclosure was made to fiduciaries at MassMutual.) It will be interesting–if discovery in the case proceeds that far–to see if any such disclosure was made to all plan fiduciaries or only to the MassMutual CEO who allegedly had the sole power to set the interest crediting rate (i.e., “what was credited to the retirement plan”) for the SVF at six-month intervals (paragraph 55), set the SVF fees charged to the Thrift Plan, and mandate that the SVF be invested in the MassMutual general account (paragraph 10).
Aside from whether or not any fees were disclosed by MassMutual, the amount of such charges, if proven to be correct, takes one aback somewhat considering that this case involves MassMutual’s defined contribution plan for its very own employees. It always amazes me how entities that are in the retirement plan business–especially those that provide “bundled” plan services to plan sponsors (i.e., record-keeping, custodial/trustee, investment as well as other services)–actually run their very own retirement plan.
Indeed, when a retirement plan has 40% of its assets invested in one investment option (as alleged in the MassMutual case) or 45% of its assets actually invested in one investment option (the plan involving our RIA discussed previously)–and in both situations, that investment option is one and the same (an insurance company’s proprietary SVF)–is anyone seriously to believe that that’s a fortuitous occurrence? Not very likely.
Rather, in cases like this, it’s very likely that some subset of the insurance company’s crack salespeople pushed their SVF onto unsuspecting plan participants. All the while, insurance companies such as MassMutual can be secure in the knowledge that they are not–and never will be–fiduciaries, which frees them to sell just about anything, as is suggested from what they allegedly sold their very own employees.
Plaintiffs allege in paragraph 84 that the MassMutual SVF caused the Thrift Plan to be exposed to imprudent and undiversified risk, for which the plan was not compensated. This allegation is important to bring because the SVF allegedly comprises as much as 40% of the Thrift Plan’s asset value (paragraph 82), which makes it particularly risky. Investing in an SVF is, in my view, often akin to investing in a single stock or bond.
Related to the preceding “imprudent and undiversified risk” allegation is the allegation concerning the nature of the “guarantee” made by MassMutual (or any insurance company or any other service provider for that matter) in paragraph 90: “…[d]efendants’ representation that the [SVF’s] promised interest rate along with the accrued principal is ‘guaranteed’ is false and fraudulent. Such false promises misleads participants into believing that their retirement savings are safe under all circumstances, when they are actually subject to the risks of MassMutual’s business operations and solvency.” Further, paragraph 91: “Although MassMutual purports to ‘guarantee’ an investment in the [SVF] against loss, that guarantee is backed only by the assets held in MassMutual’s general account and is subject to MassMutual’s general creditors.”
These allegations mean, in short, that if MassMutual goes bankrupt, plan participants invested in the MassMutual SVF could very well lose everything. This gets us back to risk. Fiduciaries (indeed, all investors for that matter) should be concerned not only with the chances of a risk but also with the consequences of a risk. (It’s the chances of a risk that are almost always discussed to the near exclusion of the consequences of a risk, however.) Consider the purchase of fire insurance for a home. We buy fire insurance not because the chances that our home will burn down are high (in fact, such chances are statistically remote). Rather, we buy fire insurance because the consequences of the risk that our home will burn down–loss of precious and irreplaceable limbs (and/or even lives) as well as the loss of precious and irreplaceable possessions–are so catastrophic that they are barely imaginable.
Another Executive Life–an insurance company that went bankrupt in the early 1990s with many people who were invested in an SVF (invested primarily in guaranteed investment contracts)–losing everything may (or may not) be an event with a low chance of repeating itself. (I wrote about Executive Life in my October 2012 column.) Even if it’s judged to be low probability, though, what should really concern plan fiduciaries is not so much the chance of a bad thing happening (e.g., the few instances when an Executive Life occurs), but rather the consequences of a bad thing happening (e.g., many people losing everything when an Executive Life–or an Enron–does occur).
The business temptation for entities such as MassMutual to use their own proprietary mutual funds must be overwhelming, and yet acting on this temptation, at its core, appears to be thoroughly conflicted, fiduciary-wise. Adding in primarily (undisclosed) high-cost investment options such as the MassMutual SVF to the mix in the Thrift Plan makes it even worse.
If it’s borne out that MassMutual is willing to operate in this manner, then what would it charge other retirement plans? It’s likely that it wouldn’t charge quite as much because of (at least some) limitations on its compensation due to market competition. But MassMutual’s own employees who participate in the Thrift Plan are at the mercy of MassMutual. It would be interesting to know how MassMutual employees would feel about working for an employer that, if the allegations have merit, may be maximizing return to its shareholders at their own expense.