JPMorgan Chase & Co (>> JPMorgan Chase & Co.) is shedding mortgage debt from a stable value fund, under pressure from insurers in a case raising questions about suitable investments for funds normally regarded as a super-safe haven for retirement savings.
Stable value funds are used in 80 percent of 401(k) self-directed retirement plans and are meant to be the most conservative choice for employees - liquid, plain vanilla and backed by insurance.
But the $1.7 billion JPMorgan Stable Asset Income Fund has invested as much as 13 percent in private mortgage debt underwritten and rated by the bank itself, according to investment documents reviewed by Reuters. The portfolio is available through a collective trust, which pools assets among various 401(k) plans, as well as through separately managed accounts, whose allocations closely mimic the portfolio.
JPMorgan has cut that mortgage exposure to about 4 percent today but the industry average for all private placements - mortgage and other privately placed securities - in stable value funds is only about half a percent, according to Hueler Analytics Inc.
Stable value funds typically consist of bond funds wrapped in an insurance contract, which guarantees the initial investment. These funds generally return between two to three percent while money market funds have been returning close to zero.
In the years leading up to the 2008 peak of the financial crisis, some fund managers invested in less liquid, higher-yielding investments to boost returns. Experts say that such investments have no place in stable value funds which are supposed to be as liquid as money market funds.
"It's fair to say that there was too much searching for yield," said Lori Lucas, the defined contribution practice leader for Callan Associates.
JPMorgan's marketing materials mentioned its private mortgage debt investments on at least three pages, said Peter Chappelear, head of J.P. Morgan Asset Management's $21 billion stable value business. "Nothing was buried anywhere," he said.
Even with the volatility in 2008, JPMorgan's investment in private mortgage debt has been a great source of returns, Chappelear said. The Mortgage Private Placement Fund, that the stable value fund invested in, has beaten its benchmark, the Barclays U.S. Aggregate Bond Index, for the past one, three, five and 10 years.
Despite those returns, a lawsuit was filed on Tuesday by an employee in Hospira Inc's (>> Hospira, Inc.) 401(k) plan which included JPMorgan's stable value fund. The suit alleges the investment in private mortgage debt violated the Employee Retirement Income Security Act.
"We believe JPMorgan violated its fiduciary duty by taking risky private mortgages from their books and putting the risks on retirees," said Joseph Peiffer, an attorney with Fishman Haygood Phelps Walmsley Willis & Swanson LLP, one of the law firms representing the plaintiff. The attorneys plan to seek class action status, Peiffer said.
A JPMorgan spokeswoman declined to comment on the lawsuit.
RISKS EXPOSED IN 2008
Many employers with 401(k) plans were unaware of the private mortgage component of the fund until after the market crash of 2008, according to retirement plan consultants who worked with companies that held the portfolios.
"The <private mortgage investment> was embedded in the intermediate bond fund," said one plan sponsor consultant who was familiar with the offering but was not authorized to speak to the media about specific funds.
Employers would have to peel back layers to see that part of the intermediate bond fund, which the JP Morgan stable value portfolio invested in, held private mortgage debt.
When the market value of the JPMorgan's stable value fund dropped in 2008, employers and insurers that back funds began to realize the risks associated with the private mortgages.
A unique feature of stable value funds is that while the value of the underlying investments can plummet, the book value, which is backed by insurance, stays the same. But a drop in market value can be detrimental for the fund insurers.
In November 2008, the market to book value of JPMorgan's stable value portfolio for a number of 401(k) plans fell as low as 86.55 percent, according to people familiar with the situation. The average market to book value for stable value funds at that time was 94.8 percent, according to Hueler.
"JPMorgan became one of the worst in terms of market to book value," the plan consultant said.
Insurers are liable for the difference between book and market value if plan participants exit the fund. Some agreements can trap plan sponsors in a plummeting fund.
In response to demands from insurers, JPMorgan has gradually reduced the fund's private mortgage debt allocation to 4 percent. Ultimately, the firm plans to sell out of private mortgage debt completely, Chappelear said.
"We are moving the allocation not because we think it's imprudent or because we do not believe in it, but because the wrap product market has changed," he said. Insurers will no longer back funds with risky assets, such as private mortgage placements.
Meanwhile, the JPMorgan stable value fund has trailed its peers each year since 2008, according to data provided by JPMorgan and Hueler, which tracks an index of 17 stable value collective trusts with $104.6 billion in assets.
Some experts have suggested that the drop in performance is due to JPMorgan's exit from private mortgages.
The question remains, however, of whether illiquid securities like private mortgage debt have a place in a stable value fund, retirement plan consultants said.
"The value of these products is to have the same liquidity as money market funds at a higher yield," said Phil Suess, a partner in Mercer LLC's investment consulting business.
(Reporting By Jessica Toonkel; Additional reporting by Ben Berkowitz; Editing by Jennifer Merritt and Tim Dobbyn)
By Jessica Toonkel