Three cases against Hartford Life Insurance Co. now in litigation in California illustrate that public plan sponsors or their employees increasingly are willing to confront their providers - in court if necessary. Depending on their outcomes, the suits could encourage more challenges from other public plans. In all three instances, the plans already have made changes in their rosters of service providers, a trend that is rapidly gaining momentum.
In northern California, San Francisco is suing Hartford Life over two exit charges on an investment option the Bay Area’s pension plan would like to change. The two other California lawsuits were filed against Hartford on behalf of the 10,000 municipal employees of Los Angeles and the 14,000 county employees of San Diego. In both of these cases, the plaintiffs are challenging the so-called mortality fees, asset-based charges that are collected annually on variable annuity accounts.
The San Diego and Los Angeles suits were both filed in November 1997; in each case, Hartford Life has filed for summary judgment, and the motions are pending. The San Diego case has a November trial date; the judge has yet to certify the Los Angeles plaintiff’s lawsuit as a class action. The San Francisco case is scheduled to go to trial in February.
Contending that nearly $13 million in exit charges do not bear “any relation to any actual loss suffered by Hartford” and are simply a penalty for a straightforward business decision to switch providers, San Francisco is suing for compensatory damages, as well as interest and attorneys’ fees. (Whether it wins or loses in court, the San Francisco plan, with close to $1 billion in assets and almost 19,700 participants, has already terminated Hartford as its defined-contribution-plan administrator and replaced it with Aetna Life Insurance Co.)
Like their Bay Area counterparts, the employees and retirees of the two other California plans allege that Hartford’s fees are significantly higher than the insurer’s costs. “Employees’ accounts in San Diego were being charged 85 basis points, and the lead actuary for the Hartford testified in deposition that the real cost to the company was approximately 7.5 basis points,” explains James Lance, one of the partners in the San Diego law firm Post, Kirby, Noonan & Sweat, which is litigating the two Southern California suits. Hartford declines to confirm Lance’s description of the deposition.
The two funds have already changed their relationships with the insurer. The Los Angeles plan, with more than $1 billion in assets, negotiated its way out of some investment contracts with Hartford and kept a few others. The San Diego plan, with more than $300 million in assets, has hired T. Rowe Price as a second investment manager to work alongside Hartford.
Insurers frequently misprice fees, erring on both the high side and the low, says Moshe Arye Milevsky, a finance professor at York University in Toronto. Milevsky, who has consulted with insurers as well as class-action plaintiffs, confirms that the mortality fee on variable annuities should be no more than 15 basis points.
Before the lawsuit in San Diego, Hartford had reduced the mortality fee from 85 basis points to 50. Since the suit was filed, Hartford has reduced that fee again; now, in combination with administrative and other expenses, the total comes to between 35 and 45 basis points.
What are these oddly named fees, which only an actuary could love? The mortality fee, calculated daily and collected annually, reflects the insurers’ guarantee of the principal in case the participant dies. Sometimes declining over time, these fees can be charged on an insurer’s variable annuity on top of the 80 to 120 basis points collected by the mutual fund company that creates the annuity.
“Market-value adjustments” are exit fees, imposed on fixed-income instruments, comparable to a mutual fund’s back-end load. They can run as high as 10 percent of the assets in the fixed-income investment option.
Both market-value adjustments and the ongoing fees are based on the premise of the insurer’s bet on the law of large numbers. Individual participants have the right to take their book value out of an insurance account (variable annuity, fixed annuity or insurance general are the three most common types of accounts). But if a plan sponsor chooses to move the fund to another provider altogether, or dismantle it overnight, that presents a different kind of risk. In theory, the provider cannot give up the arbitrage opportunity of turning over book value to the plan sponsor when the market value of the vehicle has dropped below book. The investment is like a bond, which can trade below par if interest rates rise or above par when interest rates fall. The market-value adjustment compensates the insurer for an investment that is trading underwater. Thus the origin of the fees.
In concept, mortality fees compensate the insurer for the risk of the obligation to make a participant’s survivors whole in the event of death. In practice, insurance investment contracts frequently last as long as that of the city and county of San Francisco with Hartford Life, a full 18 years. The value of the investment is fairly well established, ergo Hartford doesn’t have the same risk.
As for the market-value adjustments, with interest rates dropping fairly steadily, the rationale for these fees has dwindled. The San Franciscans purchased their contract with Hartford in 1980, when the prime was close to 20 percent, and informed the insurer of its termination in 1998. The crux of the legal issue at stake in this case: What are the true exit costs? Does the individual insurance contract have clearly defined equations?
Gregory Seller, senior vice president for government markets at Great-West Life and Annuity Insurance Co., one of the three largest service providers in the market, with $22 billion in assets in so-called 457 plans - state and local governments’ equivalent of 401(k)s - says, “I don’t know of any positive market-
value adjustments; these [MVAs] are loaded against the plan sponsors.” An insurance general account is not a registered investment product, points out Scott Fisher, a consultant with Aon Consulting, so the insurer is not required to file an annual report in which interest rates and exit formulas are clearly defined.
Christine Kellogg, a consultant at Watson Wyatt Worldwide, says: “I’ve been having some really nasty fights over unwinding these insurance general accounts [for larger clients]. And those accounts are still out there for loads of smaller plans.”
The lawsuits end a long and relatively harmonious period for 457 plans and their providers. The state and local funds represented relatively small pots of money that were easily claimed by the financial services industry. According to a recent survey by Spectrem Group, the Windsor, Connecticut-based research consulting firm, approximately 32,000 state and local governments across the country sponsor 457s. These defined contribution plans currently have about $98 billion in assets.
Participation rates in 457s tend to be low, roughly 25 percent among the plans that responded to a recent survey by the National Association of Government Deferred Compensation Administrators, the Lexington, Kentucky-based trade association for 457 plans. Investment options are conservative; fixed annuities account for 20 percent of total assets and stable-value funds for 23 percent. Insurers administer about 50 percent of 457 plan assets, says Spectrem consultant Gerald O’Connor.
But change is in the air. In Massachusetts the 457 plan has just been completely overhauled with new investment options, administrators and recordkeepers. As of June 1 the Bay State’s deferred compensation plan, with about $2.6 billion in assets and more than 123,000 participants, has moved its administration to Aetna. It has also added life-cycle funds, which vary the asset mix depending on the participant’s age, created by State Street Global Advisors. By year-end Massachusetts will consider modifying other plan options, including stable-value investments, life insurance and variable annuities.
Massachusetts is not alone. Among the four largest 457 plan clients advised by Fisher of Aon Consulting, one has totally changed its service providers in the past two years, two are strongly considering such a change, and one mulled it over and decided against it. Each of these plans has between $50 million and $250 million in assets. Of their willingness to undertake wholesale changes, Fisher says, “they are probably pretty representative of the market segment as a whole.”
The new adventurousness among 457 plans follows a Department of Labor initiative, begun in late 1997, to make defined-contribution-plan sponsors more aware of the fees they pay their service providers. Consultant Fisher recently analyzed the fees of two 457 plans, each with more than $200 million in assets. One, a city-sponsored plan with a mutual fund vendor, has been paying about 90 basis points per participant in annual fees. The other, a state-sponsored plan with an insurance company provider, pays about 150 basis points per participant. “Some of this discrepancy reflects reasonable expenses for services rendered: Insurers have a lot of folks on the ground,” says Fisher. But the relative numbers of insurance salespeople versus mutual fund salespeople does not account for much of the 60 basis point differential.
In addition, the basis for calculating market-value adjustments seemed unclear in the San Francisco case. In the complaint, the San Franciscans assert that they could not have known or understood what would happen if the plan terminated because the “formulae were incomplete within the contract.” Hartford Life, of course, begs to differ. In an e-mail response explaining the insurer’s position in all three California lawsuits, Hartford officials wrote: “The sponsors selected these programs for their employees with the help of expert consultants and counsel. We believe these programs were excellent choices and offered exceptional value for employees.”
That will be up to the courts to decide. As Aon Consulting’s Fisher notes, “If the San Francisco case demonstrates that MVAs are unfairly advantageous to insurance companies, this case could be a bellwether.”
