I. The Basics of Stable Value
I. The Basics of Stable Value
Q1 What is a stable value fund? Return to top
Stable value funds are options offered by 401(k) and other defined
contribution plans, typically as the most conservative investment
option. These funds are
invested in GICs and other medium-term fixed-income investment
contracts which offer participants the ability to withdraw or
transfer their funds subject to plan rules without any market value
risk (risk of principal loss as interest rates rise) or other
penalty for premature withdrawal.
The issuer of the investment contracts, a high quality
investment institution, provides this book value liquidity on
participant transactions and also guarantees principal plus
accumulated interest and an interest rate for a specified period of
time.
In
the past the stable value option was usually called the GIC or
guaranteed option. However,
since the advent of many new types of investment contracts for these
funds, fund names such as stable value, fixed income, or interest
income are more frequent.
Historically,
stable value has been the most popular conservative defined
contribution investment option.
A 2001 Hewitt Associates survey
reported that 69 percent
of defined contribution plans offered a stable value option.
As of year-end 2001,
allocations to stable value funds were 29 percent of plan assets in
those plans where it was offered, according to a survey by the
Stable Value Investment Association
.
Q2 Why are stable value funds popular with defined contribution participants
but not institutional
investors?
investors? Return to top
No other medium-term investment offers liquidity without any market value
risk or interest rate penalty, and this favorable risk/return tradeoff is only
available to defined contribution plan participants, which explains why their
relative popularity is limited to this investment group.
Stable value investment contracts do not provide principal
safety to the pension plan contractholder.
Investment contracts in defined benefit plans must generally be reported
at market value (see Q 37), and plan-initiated withdrawals from the contracts
are honored either at market value or at the lesser of book or market (see Q
34). In fact, because stable
value contracts are non-assignable private placement investments which cannot be
readily traded or marketed by the contractholder, they have less liquidity than
corporate bonds of similar yield and credit rating.
This gives them a slightly worse defined benefit risk/return profile than
other fixed income investments, accounting for their low concentration in
defined benefit plans (see Figure 1).
Q3 What types
of people should invest in a stable value fund? Return to top
The stable value option is attractive to two types of defined
contribution participants: those
seeking principal safety and those seeking to diversify their
investments. Many of the
largest plan balances are owned by retirees or those nearing
retirement who may need the security of knowing that their assets
are protected from market value risk.
Many younger participants lack savings outside the plan and
need assets with principal safety to cover contingencies.
Others may intend to use their balances in the near term to
invest in a home or education, alternative ways to invest in their
retirement security. Stable
value funds offer this principal safety in combination with a good
rate of return.
In
addition, the principal stability offered participants by stable
value funds provides better diversification with equities than other
conservative investment options typical in defined contribution
plans. This means
that overall portfolio risk to the investor can be reduced by
investing in a combination of stable value and equities. (see Q4).
Q4 How does the performance of stable value funds compare with that
of other conservative options for defined contribution investors?
Return to top
Stable value funds tend to
have average returns comparable to those available on medium-term
bond funds, but with much less volatility in annual earnings.
Because the option is invested in medium-term assets (see Q
5), the returns are higher on average than those available on a
money market fund. This
is illustrated in Figure 2, which shows that over the period
1983-2000, the stable value portfolio had returns well in excess of
the 6-month certificate of deposit and far less volatile returns
than the intermediate government bond index, which experienced a
loss in one year during this period.
The five-year GIC Index compiled by Deutsche Asset Management
consists of a portfolio that invests monthly in a stable value
instrument with a maturity of 5 years and is held to maturity, so
that the effective duration of the portfolio is about 2.5 years.
The average return for this index over the last ten years was
7.02 percent, compared to 6.77 percent for the Lehman Intermediate
Government Index and only 5.00 percent for the money market proxy.
The
low volatility in stable value returns increases the diversification
benefits it offers with other typical investment options for defined
contribution plans, especially common stocks.
One measure of good diversification between asset classes is
a low correlation of returns, showing that the performance cycles of
the assets differ. Table
1 shows that stable value returns have a much lower correlation with
stock market movements than bonds.
This
low correlation means that stable value investors may have a higher
concentration of equities at the same level of downside risk
than if they invested in a market value bond fund.
In fact, a 401(k) investor with a 10-year time horizon could
shift from a portfolio with 40 percent invested in a medium-term
bond fund and 60 percent in common stocks to one with only 30
percent stable value and 70 percent in stocks with a 95 percent
certainty that annual losses would not be increased. Not
surprisingly, expected returns are higher on the stable value/equity
portfolio as well, 14.4% per year compared to 14.37% on the
stock/bond mix.
Table 1
The low correlation with stocks also means that stable value
investments are better choices for balanced and life cycle funds
than are bond funds, since they offer greater diversification at
similar return levels.
Q5 How is a stable value fund invested?
Return to top
Stable value funds invest in high-quality, fixed income
investment contracts such as GICs (see Q 6) and synthetic GICs (see
Q 7), generally with a credit quality of A or better (see Qs 28
and 29).
Most funds purchase investment contracts with durations of
three to five years and maintain their overall stable value
portfolios at a duration of 2-3 years.
This produces yields substantially above those available on
money market funds in most interest rate environments, while keeping
the portfolio responsive to market interest rates.
A well-structured portfolio produces ample cash flow each
year to both fund benefits and permit reinvestment at the interest
rates then prevailing. This
is typically accomplished with a laddered maturity structure, a
series of growing scheduled contract maturities that extends over
several years so that the maturity in each period is expected to
remain roughly the same proportion of the portfolio.
Many stable value funds also have a cash or short-term
investment fund (STIF) component.
Maintained at a fixed percentage of the fund - usually
between 5 and 15 percent, depending upon the volatility of the
plan’s cash flows - the STIF provides a buffer for the investment
contracts paying participant withdrawals and reduces risk charges on
stable value contracts; however, because the STIF assets have very
short-term maturities, they typically yield substantially less than
the investment contracts.
Weighing the relative cost of withdrawal risk charges or
maintaining the STIF is a key stable value fund management decision.
STIF buffers first became popular in an environment of
relatively flat yield curves; in a steep yield curve environment,
there may be little or no incremental yield benefit.
The STIF must be large enough to cover the sizable
variability in any single plan’s investment transfers and benefits
over time. However,
since GIC and synthetic wrap issuers are able diversify much of this
plan-specific cash flow volatility across a large number of plans,
their risk charges only cover the more systematic or interest-rate
induced risks (see Qs 16 and 20).
