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Stable-Value Funds

AT THE END of the first quarter of 2004, money market accounts (a traditional safe harbor for investors) were yielding less than 1 percent, the lowest level in decades. Ten-year Treasury bonds were yielding less than 4 percent. If interest rates rose, longer-term bond prices could fall dramatically. Investors who were unwilling to, unable to, or had no need to take the risks of equity ownership were searching for safe investments that could provide higher-than-money-market yields without significant credit, price, or inflation risk.

Investors’ search for incremental yield intensifies whenever interest rates fall to low levels. Fortunately, there is an investment vehicle that fits the bill, delivering somewhat higher returns without forcing the investor to take significant credit or inflation (price) risk. The product is called a stable-value fund. Stable-value funds are also called interest-income, principal-preservation, or guaranteed-interest funds.

Stable-value investments are fixed-income investment vehicles offered through defined-contribution savings and profit-sharing plans, 529 college savings plans, and individual retirement accounts (IRAs). The assets in stable-value funds are generally very high-quality bonds and insurance contracts that are purchased directly from banks and insurance companies that guarantee to maintain the value of the principal and all accumulated interest. They deliver the desired safety and stability by preserving principal and accumulated earnings. In that respect, they are similar to money market funds, but they offer higher returns.

Stable-value options in participant-directed defined-contribution plans allow participants access to their accounts at full value for withdrawals and transfers. However, since these plans are often purchased within retirement plans that have their own withdrawal restrictions, there might be withdrawal restrictions. In addition, the stable-value fund itself may impose restrictions.

UNIQUE RISK AND RETURN CHARACTERISTICS

A 2004 study, “Why Investors Want Stable-Value Funds,” by the Stable Value Investment Association, covering the twenty-year period ending in 2002, found that stable-value funds outperformed 30-day Treasury bills by 3.2 percent a year (8.9 percent versus 5.7 percent). And they achieved that return with only slightly greater risk. Stable-value funds experienced an annual standard deviation of 2.3 percent, just slightly higher than the 2.1 percent experienced by Treasury bills. And their return virtually matched the return of the Lehman Intermediate Government/Credit Index—and it did so while experiencing less than one-half of the volatility.

The study found another positive attribute of stable-value funds—they exhibited very low correlation with stocks. Their correlation with the S&P 500 Index was just 0.2. Compare that to the correlation with equities of the Lehman Intermediate Government/Credit Index at 0.3 or the correlation with equities of 1-month Treasuries at 0.4.¹

The evidence demonstrates that stable-value funds produced higher returns than short-term instruments and did so with similar risk. They produced returns similar to those of intermediate-term instruments, but with less risk. We can conclude, therefore, that stable-value funds offer unique risk-return characteristics that allow investors to create portfolios that are more efficient at delivering returns for a given level of risk. This helps explain why they are included in two-thirds of employee-directed 401(k) and 403(b) plans, representing more than 33 percent of assets that, according to the Stable Value Investment Association, totaled about $400 billion in value by 2006.²

To gain an understanding of these vehicles, we will look at the types of investments they make and how they are able to offer stability of value yet provide attractive returns.

INVESTMENT PORTFOLIOS

Until recently, most stable-value vehicles were structured as guaranteed investment contracts (GICs). These are contracts issued by financial institutions—typically a highly rated insurance company, though it could also be a bank—guaranteeing investors a fixed rate of return. It is worth noting that in the 1980s several insurers (such as Executive Life, Mutual Benefit Life, and Confederation Life) financed by high-yield bonds sold GICs to retirement plans and then went under. However, even in these three cases, which represented less than 1 percent of the stable-value market, investors were eventually made whole.³

The result is that while stable-value funds may still hold insurance company-issued GICs (or similar instruments) as well as cash equivalents, today most stable-value assets are structured as synthetic GICs, also known as wrapped bonds. Synthetic GICs are created by the purchase of short- to intermediate-term bonds, including U.S. government and agency bonds, mortgages, and asset-backed securities. The bonds purchased are generally of the highest-credit-quality ratings (AAA and AA). Some vehicles include a provision for a very limited allocation, such as 10 percent, to lower-rated bonds. In addition, provisions are often made for the portfolio to invest in futures, options, and forward currency contracts. The portfolio is then protected from fluctuation in value by the purchase of insurance “wrappers.” If the market value of a stable-value portfolio falls below the book value of the portfolio, the insurer pays the difference, keeping the fund’s value stable. The wrapper allows the stable-value vehicle to fix its net asset value at, say, $10 a share (similar to a money market fund). This is why returns are relatively stable.

However, a stable-value fund is not a money market fund, and there can be no assurance that the fund will be able to maintain a stable value over time. Also, note that if a fund holds derivative positions, it can be more volatile than a money market fund and less liquid than traditional securities. The potential greater volatility of these instruments could lead to greater losses.

Typically the insurance wrapper costs the fund from 0.05 percent to 0.1 percent, depending on the credit quality of the portfolio, the structure of the wrapper, and the supply-demand conditions of the market for this type of portfolio insurance. Because of the insurance wrapper, the returns for the funds come solely from their yield. Thus, there is no potential for capital gains and very little risk of loss to consider (unless the credit rating of the insurer and the underlying instruments are not of the highest investment grades).

RISKS

Stable-value funds appear to be a good deal for investors, providing returns similar to those of high-grade intermediate-term bonds with the volatility of a money market account. However, while the risks are minimal, the investments are not risk-free. The earnings of stable-value vehicles can be outpaced by inflation, their yields typically lag interest trends, and unlike money market funds that invest solely in U.S. government securities, they are not entirely immune to a credit blowup among the issuers of the bonds they hold. The 2007 crisis in subprime debt is a good example of the risks that investments in stable-value funds may entail. Although the insurers put their financial weight behind stabilizing the fund’s net asset value (NAV)—“guaranteeing” that investors would never experience a loss in their invested capital—they do not shield the fund from credit problems. While credit blowups do not affect the NAV, credit problems can result in lower future yields for a stable-value fund. In addition, investors accept the credit risk of the insurance provider. Thus, it is important to analyze both the risk profile (credit rating, maturity, individual bond structure, and liquidity) of the individual securities held in the portfolio and the credit rating of the insurance providers. Many stable-value investment vehicles diversify (but do not eliminate) the credit risk of the insurance provider by purchasing contracts from several providers.

COSTS

If the characteristics of stable-value funds are of interest, be sure to keep a particularly close eye on costs, as with any investment vehicle. Within defined-contribution plans such as 401(k)s and 403(b)s, such annual expenses average less than 0.5 percent, but in IRAs the fees are likely to be as high as 1 percent, according to the Stable Value Investment Association.

RESTRICTIONS

Most stable-value offerings place restrictions on when or how often investors can withdraw cash from the fund. For example, they may limit the number of withdrawals that can be made during a specified time period. Consequently, they typically don’t offer the same degree of liquidity or ready access to one’s cash as do money market funds. Note that the liquidity restrictions allow the stable-value funds to invest in less-liquid, longer-term, and higher-yielding investments. For example, most stable-value funds have a weighted average duration of between one and a half and four and a half years.⁴ As an additional restriction, some plans force investors to move their withdrawal amount into an equity fund, instead of another fixed-income investment, which prevents investors from shifting their stable-value assets into the bond market whenever it looks as though interest rates might decline or into money market funds whenever it looks as though interest rates might rise. Also, if the investment vehicle is inside a retirement plan, it will be subject to the rules of that plan.

RETURNS CHANGE SLOWLY OVER TIME

A stable-value investment vehicle typically contains a number of GICs and individual bonds. Each time a contract or bond matures, the principal sum is paid back to the fund. The fund must then reinvest the proceeds in a new contract or bond at whatever interest rate is prevailing at the time. If rates are going down, the current rate will be lower than the rate that was being earned previously, and the return to the stable-value fund will gradually decline. Similarly, if current rates are higher than the rate on the matured contract, the stable-value fund’s return will gradually increase. Most stable-value managers choose to ladder or diversify the maturities of the contracts held within the stable-value fund to smooth these changes. Because book value accounting returns are much more stable and the correlation of stable-value funds to equity holdings is lower than it is for bond funds, stable-value funds are excellent diversification tools for a portfolio.

CASH FLOWS CAN AFFECT RETURNS

If large sums of money flow into a stable-value fund when interest rates are high, and small sums of money flow into a stable-value fund when interest rates are low, everyone in the fund enjoys higher-than-average returns because more money is invested in contracts that continue to pay high rates until their maturity date. The reverse is also true.

The timing of the cash flows is typically the main concern for the manager of the stable-value fund. If the manager didn’t have the ability to accurately forecast contributions and withdrawals, managing the fund for stable value would become very difficult. In addition, the cost of the insurance wrappers would certainly increase (withdrawals would rise whenever interest rates increased and losses would be incurred). This is why stable-value funds are only available in tax-exempt or tax-deferred account environments with heavy withdrawal restrictions. The complete investment freedom of a taxable-account environment has proven to be too great a hurdle to overcome.

SUMMARY

Well-designed stable-value funds are like the old reliable family trip to the beach. They are appropriate for all investors who allocate some portion of their portfolio to fixed-income assets. The three major benefits are as follows:

• Returns are higher than those of similar, high-quality short-term investments, but the risk is less.

• Returns are comparable to those of high quality, intermediate-term investments, but the risk is smaller.

• Returns are less correlated with the returns of equities than are the returns of intermediate-term bonds with equities, making them superior diversification tools.

With these benefits in mind, we offer the following recommendations:

• A significant amount of due diligence should be undertaken on the creditworthiness of both the underlying investments and any insurance contracts, as well as on any restrictions on withdrawals.

• The vehicle should carry contracts with multiple, high-quality insurers (insurers that carry at least a rating of AA or the equivalent from one of the major rating agencies).

• More than 90 percent of the portfolio should be covered with insurance contracts.

• At least 90 percent of the vehicle’s assets should be in investment-grade bonds that are rated at least AA.

• The average maturity and duration of assets should be short-term (for example, not longer than about three years). This helps ensure that the fund won’t be stuck with longer-term, low-yielding bonds if rates start to rise. This is especially important for investors, such as retirees, who are highly sensitive to the risk of unexpected inflation.

• If the portfolio uses derivatives, the investor should thoroughly understand how they are used and whether any leverage is involved.

• The fund’s management team should have a record of producing returns that are competitive with its stable-value peers or an appropriate bond market index.

• Costs are critical. Therefore, consider only very low cost vehicles, preferably with annual expenses under 0.5 percent.

An example of a stable-value product that should be considered is the TIAA Traditional Annuity, available in many 403(b) accounts and in the TIAA-CREF IRA. This product is backed by the claims-paying ability of TIAA-CREF, a highly rated (AAA) insurance company, and it carries no sales or surrender charges.