DEMYSTIFYING STABLE VALUE FUNDS

A WHITE PAPER FOR FIDUCIARIES OF PARTICIPANT-DIRECTED QUALIFIED PLANS

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On November 8, 2011, Charles Schwab announced that they will be winding down the Schwab Stable Fund, a large and highly respected stable value fund, and terminating it effective April 30, 2012.[i] This was done for legitimate business reasons, and not because of any problems in its portfolio. Indeed, even among stable value fund providers, it has always been managed conservatively. Nevertheless, this announcement not only causes current clients of the fund to find a replacement (plan sponsors and multi-asset class funds that invest in the Schwab product), but also triggers a fresh interest in the what, how and why of stable value funds. Indeed, Jason Zweig, in his weekly Wall Street Journal column, writes “Stable is nice, but it isn’t perfect. …[R]ising fees, falling interest rates and reduced flexibility make [stable value] funds a bit trickier than some might realize.”[ii] This paper is written to help plan sponsors understand stable value funds, and to assist them in their fiduciary duties to prudently select and monitor such funds.

The author of the paper has spent the last quarter century in helping 401(k) plans understand, select, monitor and deal with stable value products. While the paper utilizes peer-reviewed academic studies, its perspective is driven by what plan sponsors need to know in order to make good decisions, an understanding of how plan sponsor fiduciaries, committees and participants react within a large array of sudden and unexpected events, and the business consequences of their 401(k) plans.[iii] It is written in the hope that it will be useful to plan sponsors who offer or are interested in stable value funds.

Stable value funds are designed as a conservative investment option for 401(k) plans (and similar plans) that provide safety of principal and accumulated earnings. They constitute the largest conservative investment in defined contribution plans.  As of December 31, 2010, almost half of such plans offered a stable value fund, with over $800 billion dollars in assets. As of February 2009 stable value reached 36.7% of the assets of plans that offered them.[iv]

Typically, stable value funds and money market funds are considered the most conservative investment options, and they often are the only option in a 401(k) plan with a capital preservation objective. When used, they become a larger share of the balance of older participants in target maturity funds, as well as participants who are risk-adverse or who want to reduce risk as they draw nearer to retirement. Thus their importance is even greater than their assets might suggest. But their nature is complex and obscure not only to participants but also to plan sponsors. Unlike stocks, bonds, and money market funds there is little scholarly literature focused on such funds. Because their “fair value” is book value (principal) plus accumulated interest, they have an almost magical quality to them compared to other investment options. From quarterly statement to quarterly statement, they seem slow, steady, sure and safe.

Yet beneath the 24-hour news cycle, there are events that pose special challenges for Stable Value Funds. These include the Dodd-Frank Act, the exit of a major stable value provider from the market, European Bank Issues, a reduced number of banks and insurance companies that provide contract guarantees to such funds, the increasing cost of such guarantees, low Treasury interest rates, and interest rate volatility. In order to understand, select and monitor a stable value fund, we first must explain how they work–take the magic out of the magic box. We then will discuss the factors that should be used in any evaluation of such funds. Then we will evaluate the historical performance of such funds in ordinary times and extraordinary times. Finally, we will identify the current issues facing stable value funds.

We are only going to look at the typical stable value funds. Just because a fund has “stable value” in its name does not mean it is a stable value fund.[v] Also, there are several types of funding vehicles classified as stable value, such as Guaranteed Investment Contracts (GICs), Bank Investment Contracts (BICs), Participating Interest Contracts, Synthetic GICs and Separate Account GICs (see Appendix II for a description of such products). We will not be discussing any of these products. Instead, we will only examine Stable Value Funds that pool the monies of many qualified plans via the collective trust structure and use several financial institutions to provide the required contract guarantees.

For reasons described below, stable value funds are only offered in participant-directed retirement plans, including 401(k) plans, profit-sharing plans, money purchase pension plans, 457 plans and 403(b) plans.[vi] Thus it represents an investment opportunity often overlooked when compared to the scrutiny of more broadly available investment options. Some plans, especially smaller plans, may offer certain type of insurance contracts that look similar to stable value funds, but lack the elements we define below. We will not be examining such contracts. Finally, some plans, especially very large plans, have a stable value fund that is managed in-house as a separate account of the plan. While they have certain similarities to the stable value funds described below, they may differ on several key provisions and there are additional fiduciary duties consider in the selection and oversight of such a fund. We will not be examining these types of stable value funds.

The paper is divided into two parts. Part I describes the mechanics of stable value funds, such as the bond portfolio, how wrappers work, how earnings are credited, the limits imposed on participants and plans, plan sponsor issues and a review of the laws that govern stable value funds and their clients. Part II reviews the historical performance of stable value funds as a stand-alone investment option and in diversified portfolio. Furthermore, it looks at how they have performed under stress, such as the Financial Crisis of 2008 and the inflationary times of 1979-1982. Finally, it looks at current issues that affect stable value funds and their future in participant-directed defined contribution plans. The appendix describes the basic bond concepts used throughout this paper.

[ii] Jason Zweig, “What Price Smooth Sailing?”, Wall Street Journal, December 3-4, 2011. His “The Intelligent Investor” column appears weekly in the Saturday/Sunday Business & Finance section.

[iii] Although not widely discussed, the offering of a 401(k) plan is voluntary and it is a business decision designed to attract and keep good employees, and 401(k) plans do affect business and their principals and agents. In the author’s experience, all of the businesses and its employees also believed they were fulfilling a moral obligation to help their employees achieve the means to retire in dignity, within the constraints their business imposed. One can certainly find court cases where businesses and other parties acted immorally and even criminally with respect to their retirement plans, but this is very rare. The author and those who helped in preparing this paper certainly share this widely held moral view of the role of businesses in a free society.

[iv] Stable Value Funds: Performance to Date, David F. Babbel (The Wharton School, University of Pennsylvania and Charles River Associates) and Miguel A. Herce (Charles River Associates), January 1, 2011, available at www.stablevalue.org. Allocations to stable value funds among plans that offered them have typically ranged between 17-37% percent according to the SVIA 15th Annual Invest Policy Survey Covering Stable Value Assets (as of year ended 2010), but due to stock market declines were unusually high during the worst stage of the financial crisis.

[v] A particularly egregious abuse of this is described in an SEC lawsuit, which can be found at : http://www.sec.gov/litigation/complaints/2009/comp21010.pdf.

[vi] At the end of 2010, the three largest types of plans invested in stable value products were 401(k) plans (62%), 403(b) plans (22%) and 457 plans (7%). SVIA 15th Annual Stable Value Fund Investment and Policy Survey.