Insurance companies have managed to build a better mousetrap to profit from retirement accounts -- all under the radar. This product, known as stable value funds, is marketed to investors as a guaranteed means to a fixed rate of return over a given time period. They invest in short- to intermediate-term bonds whose returns are protected by investment contracts in order to preserve principal and stabilize fund returns over time. As very attractive options for yield-hungry investors, stable value funds account for 17% to 37% of 401(k) plan allocations. They’re offered in about half of all 401(k) plans with a total of $721 billion in assets under management, according to the non-profit The Stable Value Investment Association.

Stable value funds have returns similar to intermediate bond funds with the liquidity and stability of money market funds. They offer a principal preservation feature that’s particularly critical to retirees who don’t have stomachs for volatility in their portfolios. Stable value funds offer the certainty of annuities but with a few advantages. Retirees can use stable value funds to create a given income stream similar to annuities but at a lower cost. They also let plan participants take out money without a penalty as they don’t require a set holding period.

Lack of Transparency

However, stable value funds are not subjected to rigorous reporting requirements like mutual funds or other investment vehicles in 401(k) plans. They’re not required to report their underlying portfolio holdings nor all the related costs, which eat into returns. As a result, a stable value fund with a stated return of 3 percent may only pay 2 percent. One percent may sound small but that’s 33 percent less income than what investors thought they would get.

Although insurance companies have to disclose the management fees they collect on stable value funds, they do not have to disclose the hefty profits they make from the spread - the difference between the money insurance companies make on stable value funds’ assets and the payout to plan participants.

Morningstar estimates that insurance companies generally make about 200 basis points on the spread. Their inconsistent methods in disclosing fees makes it impossible to evaluate them on an apples-to-apples basis for plan sponsors and advisers. They have to be evaluated on an individual basis instead of simply looking at yields and returns.

Increasing transparency for stable value funds is crucial in light of the U.S. Department of Labor’s recent proposal to apply the fiduciary standard to anyone who oversees retirement plans.  Fulfilling this standard requires advisers to know exactly what they are investing in and how the costs of those investments add up. Furthermore, in a post-Lehman Brothers world, investors should always know what they are holding.

In today's low-yielding environment with the 10-year treasury under 2 percent, investors should be mindful of such higher-yielding "alternatives". The immediate question that should come to mind is "what is under the hood of this fund?"

Unfortunately, a lack of transparency means that many of these funds could be holding some of the energy issues that have flooded the high-yield space for the past two to three years. With the price of oil crashing from $100 to $40, defaults in this space will undoubtedly occur. Due to the large volume of paper issued, some of it may have found a home in some of these higher-yielding stable value funds.

A Lesson From Lockheed Martin

Lockheed Martin (LMT) in February agreed to pay $62 million to settle a lawsuit that claimed it failed to disclose excessively high fees within the company’s 401(k) plan that offered a stable value fund. Employees alleged the defense contractor hid how portfolio managers invested too conservatively within the fund, causing it to underperform. They also claimed the stable value fund was administered as a money market fund.

The lawsuit also claimed that Lockheed failed to fulfill its fiduciary duty by allowing the investment manager, State Street, to receive “unreasonable compensation for its services.” As part of the settlement, Lockheed has to share information about the assets and performance of the stable value fund and company stock funds among a list of other duties.

Philip J. DeAngelo, is the owner and managing director of Focused Wealth Management, an SEC-registered investment advisor with $420 million in assets under management in Highland, N.Y.