Stable value funds facing extinction, despite popularity (CORRECTED)

August 4, 2011

Who wouldn’t want to get a significantly higher yield than a plain-vanilla money market fund — but with limited risk? Most of us in 401(k)s and other tax-deferred savings plan will recognize the stable value fund option as the let-you-sleep-at-night investment.

That promise of a steady performance and protection against losses has made stable value funds one of the most popular choices in tax-deferred savings plans like 401(k)s. Indeed, on average, about 13 percent of all defined contribution (DC) assets, or $540 billion, are allocated to stable value funds and half of all DC plans offer this option, according to EBRI/ICI and the Stable Value Investment Association annual 2010 survey, respectively.

These funds are pools of diversified bond portfolios combined with insurance or bank contracts called wrappers. The wrappers help to prevent prices from fluctuating with the underlying bonds. What you essentially get is the price stability of a money market fund and the higher yield of a bond fund.

But you may not be seeing these funds on your menu of 401(k) investment options in the near future. A Pacific Investment Management Company (PIMCO) study of pension consultants serving defined contribution plans reported earlier this year that half of those surveyed expect clients to reduce their reliance on stable value options over the next several years.

For one thing, the stable value fund rate of return fell from 4.05 percent at year-end 2008 to 3.25 percent as of December 31, 2010.

“About 15 to 20 percent of clients are well along in the process of existing, re-evaluating or putting a stable value review high on their radar screen,” says Kristi Mitchem, head of global contribution and senior managing director at State Street Global Advisors.

Here are Mitchem’s answers to the other key reasons why these funds are falling out of favor:

What is driving the re-evaluation of this popular investment in 401(k) plans?
The first reason is the increasing cost of the [insurance or bank] wrap. They typically charged in the range of six to eight basis points, which amounts to about 60 cents per thousand dollars invested. Right now, they are charging in the 18- to 22-basis point range.

What is causing this wrap cost increase?
It’s in reaction to the 2008 financial crisis, when the market to book value on stable value funds declined significantly. This made insurers more aware of the risk they were taking and made them realize they weren’t charging enough for that level of risk.

Is this also causing a shortage of wrap contracts?

What are the other factors driving a second look at stable value funds?
There’s a trend toward increased transparency and simplicity. Employers want to be able to clearly explain to their [employees] how this investment option works and see the market value on the statements. These funds aren’t very transparent. The plan sponsor sees the book value, not the market value.

Another reason is that many plan sponsors have a desire to be paternalistic and nudge their participants in the right direction. But there are rules around communication with participants with the stable value funds. As a result, plan sponsors feel constrained with these funds on their platform.

Does any part of Dodd-Frank affect stable value funds?
Yes. There is a section that deals with whether or not a stable value fund is considered a swap contract. If so, it would need additional disclosure, higher capital requirements, etc. While it hasn’t been decided yet or even if it is determined that stable value fund is a swap contract whether or not it is in the public’s best interest to regulate them. But the regulatory limbo is causing uncertainty.

What is the takeaway here for individual investors?
Pre-2008, we were all lulled into a false sense of security. We thought we could get absolute safety and yield at the same time. The truth is, we need to realize that there are tradeoffs. What comes first? Principal protection or yield? You can’t have both.

(CORRECTION:  Corrects the amount of money charged by the insurance or bank wrap to 60 cents per thousand dollars instead of 60 cents per dollar.)

One comment

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Stable value funds are no doubt more complex than most investors realize and do require additional scrutiny. If, however, the notion is that falling returns in this category are partially responsible for decreased interest and viability, I would argue that this premise is flat-out wrong. Stable value funds were never intended to produce a specific amount (like 4%) and instead attempt to offer, in normal markets, 1 – 1.5% upside vs. a money market return. The increased return comes in large part from the fact that stable value funds are invested in bonds, not cash. The increase in return is largely attributable to the increased risk profile — which is where all of the fun with the management of that risk, the duration of the fund, cash flow and the wrap contracts comes in to play.

Yes, stable value returns are down because, in part, the interest being paid by the underlying bonds is down AND fees have increased. That said, a 2.5% return is quite a bit higher than 0%. I think extinction is a misnomer.

See more thoughts at: 95-choosing-a-path-for-stable-value-fund s.html

Posted by MarshallC | Report as abusive