Stable Value Cash Flow Volatility: The Macro View
by Judy Markland
based on a presentation at the IIR GIC Symposium, April 2001
Stable value fund managers have reported significantly increased volatility Ė both positive and negative Ė in fund cash flows of late. The greater uncertainty in fund flows has complicated investment policies and underwriting withdrawal risk on stable value contracts. Both managers and providers should be interested in understanding the macro reasons for the increased volatility.
Landmark Strategies has identified five primary causes:
∑ the smaller relative size of SV funds within the plan;
∑ larger participant allocations to equities and greater specialization within equity investment options;
∑ large exposure to company stock;
∑ growing participant Internet access; and
∑ greater availability of self-directed brokerage accounts.
Each of these plays a role in the new dynamics of SV funds, as will be discussed below.
I. I. Smaller relative SV fund size.
The decline in the percentage of funds allocated to stable value from the early 1990ís is well-known. As the chart below indicates, SV funds were about 35% of large DC plan assets in 1993, but only about 11% by 2000. The percentage allocation in plans where the fund was offered is higher, but the downward trend virtually identical.
Think about the implications of this shift for SV cash flows. The same level of plan transfer activity among investment options now has three times the impact on the stable value fund that it did in 1993.
II. Larger allocations to equities
Stable valueís relative allocation decline was largely due to the phenomenal surge in equity returns during the second half of the 1990ís. Itís not surprising then, that the average stable value fund has shrunk relative to the total investment in common stocks in the plan.
In 1993, the average stable value fund was about 70 percent of the size of all of the average planís equity funds combined;. by 2000, it was only stable value dollars were only 70 percent of the equity investments. That shift has made stable value much more vulnerable to changes in attitudes about stock investments and to fluctuations in stock prices. In 1993, the decision to increase the planís equity allocation by 5 percent by taking the funds from stable value would have meant withdrawing about 7 percent of the SV fund. That same decision in 2000 would have meant withdrawing almost 30 percent of the stable value fund.
Increasingly DC plans are adding specialized sector or industry stocks, prompting participants to increase their investments in these less diversified holdings. Industry stock movements are much more volatile than those of the market as a whole, as can be seen in the chart below. Moreover, industries and stock sectors have varying correlations with interest rates. While such sector stock price swings boost the expected cash flow volatility at the individual SV fund level, this effect is easily diversifiable at the issuer level - if the exposure is properly underwritten and structured.
III. Large concentrations of company stock
Company stock is also a source of undiversified stock price volatility in DC plans. And company stock positions are large relative to stable value funds. The chart below shows that, where both funds are present, company stock has 26% of plan assets on average and stable value 19%. The allocation to company stock is larger than that to stable value for every age group except those in their 60ís.
This matters because single stocks are even more volatile than industry sector stocks. An NBER study [Campbell, Lettau, Malkiel, and Xu;, Working Paper 7590; March 2000] found that over the period 1962-67 individual stock prices had more than twice the volatility of the markets (NYSE, AMEX and NASDAQ) and that market movements accounted for only 17 percent of the variability in an individual stockís price. This volatility varies appreciably by firm size, with only the top decile of the NYSE by size having stock volatility less than that of the index.
The level of volatility in individual firm stock prices has more than doubled over the past thirty years, as the chart below indicates. These price swings will likely generate significant swings in 401(k) investment flows and transfers. These swings may well have large impacts on individual SV funds, but the effects are diversifiable at the issuer level. However, be aware that greater diversification is required because of the higher individual firm volatility. The NBER study found that over the 1963-85 period, a portfolio of 20 stocks provided good diversification. Since 1986, a portfolio of 50 stocks is needed for the same level of diversification.
IV. Growing Participant Internet Access
Access to the internet and web-based advice and investment opportunities have also significantly expanded cash flow volatility at the plan level. A survey by WorldatWork reported in November 2000 found significant internet availability to 401(k) participants:
401(k) Internet Penetration - 2000
% of plans
access to financial planning data
access to investment advice
Access to oneís account on the internet has been shown to vastly increase the volume of participant transfer activity in 401(k) plans. An NBER study analyzed the investment activity of two 401(k) plans for a period of time before and after the introduction of web allocation capabilities for participants. No other significant plan changes were made during the period analyzed.
The two plans experienced significant increases in participant account activity after internet access was introduced. On balance, trading activity doubled. Plan Aís participant switches increased by 128% and plan Bís, which had been higher, increased by 67%. Presumably this is due to easier access to account balances and transaction capabilities. Clearly, having internet access means greater transfer activity between funds in the plan and consequently more action in and out of the stable value fund.
V. Self-directed brokerage accounts
Another major trend in 401(k) plans is the introduction of self-directed brokerage accounts (SDBAs), giving participants a myriad of investment options. Although these options are not yet present in many plans, they are attracting meaningful amounts of plan assets where offered. Overall as of
12/31/2000SDBAs accounted for less than .5% of 40(1)k assets in Hewittís 401(k database. This is a relatively large percentage, since a 2000 Mercer survey found that the option was present in only 12-14 percent of plans. Where present, the brokerage option was gleaning 3-5 percent of assets.
The effect of these options on the stable value fundís cash flows will vary depending on the structure of the SDBA and the plan rules. Some are structured so that funds invested in the SDBA cannot be Ďrepatriatedí back into the rest of the plan. Others allow funds to be returned but are treated as competing funds for purposes of transfers to and from the stable value fund. Still others have no restrictions, on the theory that only small amounts of funds will be invested in the SDBA. However, itís important to realize that a brokerage option with 5 percent of plan assets is quite large relative to a stable value fund with 15-20 percent of the plan, and that itís effects on the fund cash flows can be quite large.
VI. Fund Leverage
This greater level of cash flow volatility matters, because funds have increased their internal "leerage" or vulnerability to interest rate exposure over the years. While most funds have cash reserves and well-structured maturity flows on investment contracts, they also have ever-increasing percentages of participating wraps. LIFO contracts have gained greatly in popularity. The table below illustrates the average exposure to each risk factor across four segments of the stable value universe.
Funds today are much more exposed to interest rate volatility at the same time that increased cash flow volatility has become the norm. The effects remain to be seen.
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