Fidelity Faces ERISA Lawsuit over Stable Value Fund

The suit says Fidelity was overly conservative in its underlying investments and used strategies to appease wrap providers to the detriment of 401(k) plan participants.

A recently filed lawsuit accuses Fidelity Management Trust Company of engaging in imprudent investment strategies for the Fidelity Group Employee Benefit Plan Managed Income Portfolio Commingled Pool (MIP), a stable value fund offered as an investment option in some 401(k) plans trusteed by Fidelity.

According to the lawsuit, during a specified class period, the MIP had such low investment returns and high fees that it was an imprudent retirement plan investment. The poor performance and high fees of the MIP were the result of the intentional actions and omissions of Fidelity as trustee of the plans, the suit alleges. Fidelity delegated day-to-day management of the MIP to its affiliate, Fidelity Management and Research Company, and the lawsuit accuses Fidelity of failing to continuously monitor and supervise its affiliate.

In a statement to PLANSPONSOR, Fidelity said, “We believe that the claims in this case are without merit and we intend to defend it vigorously.”

The compliant says that prior to 2009, Fidelity engaged in an imprudent investment strategy for the MIP that caused substantial losses to the fund and accordingly exposed itself and the MIP’s “wrap providers” to substantial losses. Faced with a substantial decline in the MIP’s market value, and with resulting pressure from the wrap providers—which were exposed to liability in the event of significant MIP fund withdrawals—Fidelity responded by adopting an unduly conservative investment strategy that was contrary to the purposes of stable value fund investing, agreeing to allow the wrap providers to charge excessive fees, and charging excessive fees for its own account.

As of October 1, 2009, the MIP held nearly $9.4 billion in assets, but as of September 30, 2014, the MIP held less than $6.3 billion in assets. This precipitous decline in assets was due largely to participant withdrawals caused in part by the consistently poor performance of the MIP, the lawsuit says. Participant withdrawals totaled $1.1 billion in 2010, $822 million in 2011, $995 million in 2012, $100 million in 2013, and $511 million in 2014.

NEXT: Makeup of a synthetic GIC

According to the compliant, in addition to its fiduciary breach under the Employee Retirement Income Security Act (ERISA), Fidelity also attempted to conceal its improperly conservative investment and excessive fees from investors by solely reporting to investors an inappropriate “money market” benchmark for the MIP rather than a proper stable value fund benchmark that made the MIP returns appear to be competitive.

This combination of poor performance and high fees caused the MIP at the relevant times to fail to produce a net investment return sufficient to outpace inflation. The MIP also performed far worse than the average stable value fund and far worse than the most relevant benchmarks, the lawsuit alleges.

The MIP is a synthetic guaranteed investment contract (GIC), which consists of two principal features, the complaint explains. The first is an intermediate term bond fund. The investment manager for the stable value fund invests in a portfolio of intermediate term bonds with an average duration of approximately three to four years that will provide a significantly higher interest rate, or yield, than for example the short-term (average 60 days or less) securities typically held by a money market fund.

The second principal feature of a stable value fund is a “wrap contract” issued by an insurance company or other financial institution that provides a guaranty that investors will receive the “book value” of their account, the value of their initial investments plus interest accrued at certain intervals of time that reflects the performance of the underlying bond fund. The latter element is referred to as the “crediting rate.”

NEXT: Mismanagement of the fund and excessive fees

Fidelity, pursuant to the Trust Agreement for the MIP and industry practice, promised to the plans and their participants that it would manage the underlying intermediate term bond portfolio in a manner consistent with the objectives of stable value investing and credit participant accounts using the rate determined by the formula set forth in the wrap contracts. However, in an effort to boost the yield of the MIP and thereby garner more management fees for itself, Fidelity, before the period at issue in the lawsuit, engaged in an imprudent and ultimately unsuccessful investment strategy by, among other things, causing large amounts of the MIP’s assets to be held in various forms of securitized debt. For example, in 2006, asset-backed securities, mortgage-backed securities and collateralized debt obligations represented nearly 60% of the MIP’s assets.

Those and other investments declined in value when the financial crisis struck in 2008, causing the MIP and the plans that invested in it to suffer damage beginning in 2009 and continuing for years afterwards. Specifically, in the fiscal year ending 2008, the MIP experienced a market value loss of about $381 million. This caused the effective return of the MIP on a market value basis to be close to zero for that year. By contrast, during that same fiscal year, the stated benchmark for the MIP earned close to an 8% yield despite the financial crisis.

The lawsuit contends that competing stable value funds which were subject to the exact same underlying economic conditions as the MIP and had the same conservative investment goals earned substantially higher returns than the MIP during the relevant time period while at the same time preserving principal, ensuring liquidity, and providing stable returns.

In addition, the lawsuit says, “At the same time as Fidelity provided a gratuitous benefit to the Wrap Providers by reducing risk to the Wrap Providers at the expense of investors’ yields, it also paradoxically agreed to an increase in the fees paid to the Wrap Providers. Between 2009 and 2011, Fidelity agreed to increase the wrap fees for the MIP from 8 basis points to 22 basis points or more.”

The complaint in Ellis v. Fidelity Management Trust Company is here.