The primary objective of this blog is to educate retirement plan fiduciaries about the use of insurance separate accounts in qualified retirement plans. Some providers are proposing insurance separate accounts as less expensive alternatives to popular mutual funds used in retirement plans. This blog will explore the benefits and risks associated with these accounts, as well as the regulatory and compliance issues that fiduciaries need to consider.
Benefits:
- Cost Efficiency: One of the key benefits of insurance separate accounts is their potential for lower expenses compared to mutual fund equivalents. In some instances, separate accounts offer a more cost-effective investment option for retirement plans. Separate accounts may be less expensive than mutual funds because they are not subject to the same regulatory requirements as mutual funds. Mutual funds must comply with various rules and regulations imposed by the Securities and Exchange Commission (SEC), which may increase administrative and operational costs. On the other hand, separate accounts are regulated by state insurance departments, which may have less stringent or different standards than the SEC. This may result in lower fees and expenses for separate accounts.
Risks:
- Inadequate Disclosures: One of the main risks associated with insurance separate accounts is the potential for inadequate disclosures regarding compensation amongst the various parties (e.g., investment manager, insurance company, recordkeeper, auditor, etc.). Fiduciaries may find it challenging to obtain clear and comprehensive information about where compensation is paid within these accounts, making it difficult to make informed decisions.
- Participant Transparency: As institutional investment products, insurance separate accounts have less public information available for retail investors to track their performance and analyze their holdings. This information may be available through the recordkeeping platform but is not typically available through third-party sites that investors may use to track their investment portfolio or research their investment choices.
- Portfolio Construction Variability: Another risk is the potential for significant variability in the portfolio construction of separate accounts compared to their mutual fund equivalents. This variability can lead to unexpected investment outcomes and may not align with the fiduciary’s expectations or the plan’s investment objectives.
- Liquidity: Due to its size and number of investors, the insurance separate account is likely subject to liquidity provisions different from those of the comparable mutual fund. A thorough review of these provisions is advised.
- Recordkeeper Portability: Most insurance separate accounts are proprietary to the insurance provider's recordkeeping platform. As a result, when plan fiduciaries elect to change recordkeeping providers, they may be forced to switch investment products simultaneously with the recordkeeping conversion. This can complicate recordkeeping conversions and force participants out of the market for a period during the conversion process.
- Muddled Fiduciary Oversight: Insurance company separate accounts add an additional layer of fiduciary oversight to the investment product selection as the insurance company is typically a 3(38) investment manager for the separate account products they create. While this may be perceived as beneficial in providing additional fiduciary oversight of the investment products within the plan, in some instances, the insurance company may elect to terminate and replace a sub-advisor using their investment criteria rather than the plan fiduciary’s investment criteria.
Regulatory and Compliance Issues
Fiduciaries must be aware of the requirements under ERISA 408(b)(2) for service provider fee disclosures. These requirements mandate transparency in compensation and ensure that fiduciaries have the necessary information to assess the reasonableness of fees and services.
Additionally, fiduciaries must comply with the reporting requirements on Schedule C of the 5500 filing. This includes providing detailed information about service providers and their compensation, which is essential for maintaining compliance with regulatory standards.
Frequently, with separate accounts issued by insurance companies who provide recordkeeping to plans, the provider is unwilling or unable to differentiate the amount of compensation being paid to an investment manager from the amount of compensation retained by the insurance company packaging the product.
Comparing Insurance Separate Accounts with Mutual Funds and Collective Investment Trust Options
When evaluating insurance separate accounts, comparing them with other investment options available in qualified retirement plans is important. Key criteria for comparison include fees, performance, and flexibility. Even among investment products managed by the same subadvisor, the product with the lowest fee may not generate the best return. Some insurance separate accounts may elect to hold more cash in their portfolios to meet anticipated liquidity needs, thereby reducing returns in up markets. While cost is an important factor, under the insurance separate account, fee savings may not necessarily be passed on to shareholders in higher returns. By assessing these factors, fiduciaries can make more informed decisions about the suitability of separate accounts for their plans.
Conclusion and Recommendations
In conclusion, while insurance separate accounts offer potential cost efficiency, they also come with risks related to inadequate disclosures, portfolio construction variability, liquidity, and additional due diligence requirements. Fiduciaries should carefully evaluate the specific separate accounts they are considering adopting into their plans. Thorough due diligence and a clear understanding of regulatory and compliance requirements are essential for making informed investment decisions.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.