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Should plan sponsors want trading restrictions for self-directed 401(k) Accounts?

Equity Wash: A provision in a stable value product that any transfers made from the stable value fund must be directed to an equity fund option of the [defined contribution] plan for a stated period of time (usually 90 days) before said transferred funds may be directed to any other plan-provided competing fixed income fund (such as a money market fund.) This provision is intended to reduce interest rate arbitrage by plan participants, thus permitting stable value contract issuers to underwrite the plan without excessive risk exposure. Source: Stable Value Investment Association, www.stablevalue.org.

The equity wash has long been a feature of 401(k) plans. Now, as some plans sponsors push to eliminate the trading restriction, industry veterans argue that it’s a protection worth keeping.

Equity wash rules still exist in nearly every defined contribution plan where stable value funds are offered alongside directly competing investment options such as money market funds and short-duration bond funds. The goal is simple: to discourage investors from switching into those competing funds en masse during periods of fast- rising interest rates. (Yields on money market and short-term bond funds react more quickly to rate changes than do stable value funds.) Historically, the equity wash has been broadly accepted as it protects the interests of both the long-term stable value investors and the issuers providing the stable value guarantees.

The 401(k) landscape began to change in the 1990s, though, as more and more plan sponsors began adding self-directed brokerage accounts and mutual fund windows to their plan’s investment lineup. On the surface, these SDAs weren’t direct competitors to stable value funds; their primary purpose was to give plan participants the opportunity to invest in stocks and mutual funds otherwise unavailable to them in their retirement plans. But SDAs did, in fact, have competitive potential; participants could use them to invest in a broad array of money market and short-term bond funds if they so wished.

Recognizing this latent threat, most stable value issuers chose to treat SDAs as competing investments subject to an equity wash. But over time, as the occasional plan sponsor would balk at including the trading restriction in their plan, a few issuers would sometimes forego the wash rule. Now, some issuers report an increase in the number of plan sponsors requesting these exemptions, and question whether accommodating them makes sense. “We received two or three requests in a six-month period,” reports Richard Taube, assistant vice president with stable value contract issuer Pacific Life Insurance Co. “It’s not like we had a flood of requests, but prior to that we’d only received one or two requests over a period of several years.” He says his peers at some other insurance companies have reported similar experiences, although still other issuers say they haven’t been similarly called out.

Where they are happening, these new requests put stable value issuers in a difficult position. Fundamentally, they recognize the real arbitrage risk that SDAs would present if interest rates spiked. Practically, they recognize they need to be as responsive as possible to the desires of their plan sponsor clients. Privately, they worry that acquiescing to their clients could be harmful in the long run, not only to stable value issuers but also to the retirement plan participants who are the ultimate end-users of their products. Stable value managers generally agree.

“We basically think that prohibiting disintermediation (interest-rate arbitrage) is a good thing,” says Stephen LeLaurin, senior account manager with stable value manager INVESCO Institutional. “It would not be good for the industry if a common plan design included stable value and money market funds right alongside each other without transfer restrictions. If it were common, certainly advice providers would make a business of counseling participants into switching out of stable value and into money market funds in those rare moments when it was good for participants, and it would likely happen in great quantities. The ultimate effect of this kind of environment would be shortening of stable value fund durations, lowering of yields, and compressing of the spread over money market funds. Hence, the good part of stable value-higher returns-would likely go away.”

“In a perfect world,” agrees Aruna Hobbs, head of the pensions and savings market for wrap issuer AEGON Institutional Markets, “we would like to have an equity wash, because there is the potential for self-directed accounts to offer competing options under very egregious conditions. It’s very remote, but there is that potential.”

Indeed, it is the remoteness of that potential that has convinced some stable value issuers that it is okay to forego the equity wash for some plans offering SDAs. After all, relatively few 401(k) plans even offer SDAs-less than 20 percent, according to numerous surveys-and where they are offered, few participants actually use them. Many plan sponsors report that the money in SDAs accounts for only a few percent or less of their total plan assets.

Even so, issuers who have been willing to forego equity wash requirements for SDAs say they continue to make that decision only on a case-by-case basis. “We don’t have a one-size-fits-all policy,” says Hobbs. She adds that while her firm would prefer to have the wash in place in all cases, “we realize there are other issues to consider. If a plan wants to introduce a brokerage window, we can take some comfort from the usage trends in the industry and perhaps come up with some trigger level where we will implement trading restrictions at a later time--if, for example, use of the window goes up significantly and there are more opportunities for arbitrage. But in every situation, we will work with the fund manager to find a solution that the manager and the plan sponsor can live with.”

“We look at each situation on a stand-alone basis,” echoes Jon Fraade, managing director at wrap provider AIG Financial Products Corp. “There is no absolute rule for self-directed accounts. If someone comes to us with a wonderful underwriting opportunity for a strong plan with lots of positive cash flow, we can make a risk decision we are comfortable with, and, in some cases, forego the equity wash. That being said, in the vast majority of cases, there is an equity wash in place that protects us from that potential arbitrage.”

Steve Butters, managing director with wrap provider IXIS Capital Markets, says his firm also considers SDAs on a case-by-case basis, looking at, among other things, whether there are other disincentives in the plan that could discourage investors from arbitraging interest rate, such as higher fees to use the self-directed account.

For some industry veterans, the rationalizations made for excusing SDAs from equity wash rules remain unconvincing. Taube, for example, suggests that the fees associated with SDAs pale in comparison to the rewards that interest rate arbitrage could offer investors under the right market conditions. He also questions whether the users of SDAs might not have a bigger impact, under the right conditions, than their limited numbers might suggest. Perhaps, he says, SDA users control more money than the typical 401(k) investor.

In fact, it appears they do. A nonpartisan study of 401(k) plan data by the Employee Benefit Research Institute and the Investment Company Institute found that the average 401(k) account balance at year-end 2004 was $56,878. By contrast, plan provider Charles Schwab & Co. reports that the average account balance at year-end 2004 for plan participants using its self-directed brokerage accounts was $102,073, or nearly twice as high. Schwab also notes that its SDA clients invest on average 85 percent of their assets through their SDA, and only 15 percent in their plan’s other investment options. David Wray, president of the Profit Sharing/401(k) Council of America, a non-profit association of 1,200 companies and their employees, also notes that compared to the average 401(k) investor, those who use SDAs are more likely to have their overall investment portfolio managed with the help of outside advisors.

Taube also argues that while it’s true that few plan participants use SDAs today, and that those who do generally haven’t used it as an arbitrage tool, it is also true that the conditions which could spark mass arbitrage-i.e., a sustained period of sharply rising interest rates-haven’t been in place since SDAs started popping up in retirement plans. “The opportunity does exist in the right interest rate environment,” he insists. “I think most insurance companies would agree that while it hasn’t happened to date, we’re trying to protect against what could happen in the future.”

“We’d like to find the right solution for everyone,” says Taube, “as we believe in providing all the available tools for a participant to properly save for retirement. This includes investment advice and SDAs. We just need to find a way to offer SDAs in a manner that can’t disadvantage any particular group of participants or the issuers providing the stable value guarantees. We’ve discussed various equity wash triggers with clients, such as the relationship between short-term interest rates and stable value crediting rates,” he continues, “but both feasibility to implement and willingness to impose the triggers have been barriers to date.”

It does seem ironic that as some plan sponsors have been adding new rules to prevent the potential for abusive trading in other plan investment options (see “401(k) Plans Wrestle with New Trading Restrictions,” Stable Times, Second Quarter 2005), that other plan sponsors are looking to eliminate the equity wash for stable value funds. Given the potential for interest rate arbitrage between stable value funds and self-directed accounts-however remote-plan sponsors pushing to eliminate the equity wash should be sure they are taking into account not only past experience but also the possibility of disintermediation in the future, and its long-term impact on stable value funds and the investors who have come to depend upon them. They should also remember that stable value issuers who forego equity wash requirements may try to account by other means for the potential increase in risk they’re assuming. They may, for instance, try to modestly bump up the price they charge for a wrap contract, or seek to extend the book value amortization period in the event a contract has to be terminated. Plan sponsors must decide whether these are worthwhile tradeoffs.

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