Just then, Goldilocks woke up and saw the three bears.  She screamed, “Help!”  And she jumped up and ran out of the room.  Goldilocks ran down the stairs, opened the door, and ran away into the forest.  And she never returned to the home of the three bears.

 

In a previous post, we compared lawsuits against stable value funds for being too risky or too conservative to Goldilocks’ problem of having the porridge be just right—not too hot or too cold.

For stable value funds, it turns out, the porridge cannot be too cold. At least that was the opinion of the First Circuit, which became the first appellate court to rule on stable value funds. The opinion, issued on February 21, 2018, upheld the dismissal of a claim on summary judgment that Fidelity’s stable value fund was too conservative. Ellis v. Fidelity Management Trust Company, No. 17-1693 (1st Cir. 2018).

 

In Ellis, members of Barnes & Noble’s 401(k) plan sued Fidelity for offering a stable value fund called the Managed Income Portfolio (MIP). In the MIP, Fidelity allocated “investments away from higher-return, but higher-risk sectors,” partly in response to the 2008 financial crisis and partly to secure wrap insurance as insurers exited the market. The MIP exceeded its conservative benchmark, but produced lower returns than competitors’ stable value funds. Plaintiffs claimed this violated Fidelity’s duty of loyalty and prudence to plan participants.

 

As for disloyalty, the court “balk[ed] at the notion that a fiduciary violates ERISA’s duty of loyalty simply by picking ‘too conservative’ a benchmark for a stable value fund.” The court found it hard to comprehend how a fund defined by its conservativeness could violate the law by being too conservative. The very nature of the fund “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 admonished the plaintiffs for ignoring “basic and obvious market incentives.” Plaintiffs’ loyalty theory largely centered on the assertion that Fidelity prioritized its interest in securing wrap insurance over the beneficiaries’ interest in higher returns. But by publishing a more conservative benchmark than its peers, Fidelity risked market share as there were “innumerable options available.” In a line helpful in more than just stable value fund cases, the court noted it is not disloyal for a fiduciary to take an action “aimed at furthering an objective [the fiduciary] shared with the beneficiaries,” such as a lower-risk investment option.

 

As for imprudence, the court found the same problems with plaintiffs’ disloyalty claims. The court stated plaintiffs “offer[ed] no authority, and we are aware of none, holding that a plan fiduciary’s choice of benchmark, where such a benchmark is fully disclosed to participants, can be imprudent by virtue of being too conservative.” As a practical matter, it would be hard or impossible to articulate a standard by which to determine if a benchmark is too conservative.

 

What the court did in Ellis essentially gutted the logical core of any argument that a stable value fund is too conservative. Those arguments, the court underscored, impermissibly rely on hindsight. Arguments a fund is “too conservative” arise only when the market performs well and therefore riskier options outperform their more conservative peers. Yet in response to plaintiffs’ best piece of evidence, a colorful email by a Fidelity employee criticizing the MIP’s lower returns as compared to its peers, the court mused “one can only imagine the mirror image e-mails of regret Fidelity’s competitors would have written had the markets collapsed instead of rebounding.”

 

It is not hard to imagine Ellis will lead to fairytale endings for other defendants. In Goldilocks, the girl never returned to the home of the three bears again. While companies cannot be as certain that stable value fund lawsuits will never return, Ellis gives defendants a strong ally in chasing away such cases.

 

At the table in the kitchen, there were three bowls of porridge.  Goldilocks was hungry.  She tasted the porridge from the first bowl.

“This porridge is too hot!” she exclaimed.

So, she tasted the porridge from the second bowl.

“This porridge is too cold,” she said

So, she tasted the last bowl of porridge.

“Ahhh, this porridge is just right,” she said happily and she ate it all up.

 

Virtually all companies that offer participant-directed retirement plans permit their participants to elect an income-producing, low risk, liquid fund, such as a money market fund or a stable value fund. A stable value fund, as the name suggests, is a conservative investment option designed to provide stability, as opposed to growth.

Stable value funds have desirable features.  By combining bonds and an investment wrap, participants can achieve bond-like returns without the interest-rate volatility present in bond funds.  But those features do not eliminate the risk of losses, they just delay them. Indeed, a stable value fund with a longer duration is riskier than a fund with a shorter duration.

The stability-enhancing features of a stable value fund mean that, if a stable value fund invests in a bond that defaults, the value of the fund will not take an immediate tumble, but the loss will be amortized over a period of time.  Over the long run, the performance of a stable value fund approaches the performance of the underlying bond portfolio, minus the expenses of maintaining the wrap coverage and administering the fund.

There is, however, no typical stable value fund. According to How to Evaluate Stable Value Funds and Their Managers by Andrew Apostol, “[d]ue to the varying expectations of individual plan sponsors and the range of management techniques used by their stable value managers, there is not a single style or strategy that is common across all stable value funds.” For example, the plans for a Silicon Valley startup or a hedge fund will differ. Even if both aim for stability, the participants likely have different risk targets, which will lead to different markups across stable value funds.

Even though there is no typical stable value fund, there are three typical types of lawsuits filed against fiduciaries offering stable value funds. Fiduciaries have been sued for 1) offering a stable value fund that is too risky and 2) offering a stable value fund that is not risky enough. Only Goldilocks, it seems, could safely offer a stable value fund.

Considering the litigation risks for fiduciaries who do not set the stable value fund just right—a task that always looks easier in the hindsight of a lawsuit—a fiduciary may conclude the best option is not to offer a stable value fund at all. Yet fiduciaries have also been sued for 3) not offering a stable value fund. Let’s take a deeper dive into these three bears of a lawsuit. Continue Reading Stable Value Funds: A Financial Investment with Risky Litigation Consequences