Stable value fund

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A stable value fund is a type of investment available in 401(k) plans and other defined contribution plans as well as some 529 or tuition assistance plans. [1] Stable value funds are often made available in these plans under a name that intends to describe the nature of the fund (such as capital preservation fund, fixed-interest fund, capital accumulation fund, principal protection fund, guaranteed fund, preservation fund, or income fund among others). [2] [3] They offer principal preservation, predictable returns, and a rate higher than similar options without proportionately increasing risk. [4] [5] The funds are structured in various ways, but in general they are composed of high quality, diversified fixed income portfolios that are protected against interest rate volatility by contracts from banks and insurance companies. [5] For example, a stable value fund may hold highly rated government or corporate debt, asset-backed securities, residential and commercial mortgage-backed securities, and cash equivalents. [6] Stable value funds are designed to preserve principal while providing steady, positive returns, and are considered one of the lowest risk investment options offered in 401(k) plans. [2] [7] Stable value funds have recently been returning an annualized average of 2.72% as of October 2014, higher than the 0.08% offered by money-market funds, and are offered in 165,000 retirement plans. [4] [8] [9]

Contents

Explanation

The investment objective of stable value funds is to provide capital preservation and predictable, steady returns. [4] During the 2008 financial crisis, stable value funds were one of the few 401(k) investments that produced a positive return; stable value fund returns generally ranged between 3 and 5 percent for 2008. [7]

Stable value funds generally invest in high credit rating bonds, typically AAA and AA, and then “wrap” them with contracts issued by banks and insurance companies that help smooth out the returns of the underlying portfolio of bonds. [10] [11] The wrap protects the fund in times of market volatility by smoothing out the losses and gains of the underlying investments over the duration of the fund. [7] Another popular stable value structure is the general account product which provides a fixed rate of return for a stated period backed by the full faith and credit of the insurance company and transfers investment risks to the insurer as well. [12] Stable value funds have a level of risk and stability similar to that of money market funds but generate higher returns. [4] [5]

Stable value funds are offered in approximately half of all 401(k) plans and some 529 tuition savings plans. Individuals have invested $770 billion in stable value funds through 165,000 defined contribution plans, which include 457, 403(b) and 401(k) plans as of June 2015. [1] [9]

History

Stable value funds have been around since the inception of US defined contribution plans in the 1970s. [13] Initially they consisted of guaranteed investment contracts, or GICs, which were backed solely by the issuer's claims-paying ability. GICs are issued by insurance companies and guarantee principal invested plus a periodically-reset interest rate for a specific duration. The primary concern plan sponsors had in regards to GICs was the lack of flexibility and ownership of assets, which was partly remedied with the creation of separate account GICs. Separate account GICs hold the assets of the plan in a separate account that cannot be used to settle claims against the insurer's general account. [3] Then in mid-1988 a broader array of stable value funds began to be offered, including the now common synthetic GIC. A synthetic GIC is a contract for a separately managed portfolio of fixed securities that is owned by the plan, often referred to as a wrap because it wraps the portfolio and protects it against rate fluctuations. [3] In 2007, the Department of Labor excluded stable-value funds from their list of qualified default investment alternatives (QDIAs), but allowed retirement plans using stable-value funds to "grandfather" their choice. [14]

Today, the most commonly used type of contract in stable value funds is the synthetic GIC [5] and from 1999 through 2014 stable value funds averaged a total return of 4.35% with a standard deviation of 1.23%. For money-market funds, the average total return was 1.93% with a standard deviation of 2.08%; and for intermediate-term bonds, 4.82% and 3.15%. [9]

Types of stable value funds

Stable value funds are structured in one of three ways: as a separately managed account, which is a stable value fund managed for one specific 401(k) plan; as a commingled fund, which pools together assets from many 401(k) plans and offers the benefits of diversification and economies of scale for smaller plans; or as a guaranteed insurance company account, which issues a group annuity contract directly to the plan. [1] [15] [16]

Regardless of how stable value funds are structured, they are a diversified portfolio of fixed income securities that are insulated from interest rate movements by contracts from banks and insurance companies. How this contract protection is delivered depends on the type of stable value fund investment purchased and is provided through one or more of the following investment instruments: [5] [15] [16]

Guaranteed Investment Contract (GIC)/General Account Contract

A group annuity contract with an insurance company that provides principal preservation and a specified rate of return over a set period of time, regardless of the performance of the underlying invested assets. The invested assets are owned by the insurance company and held within the insurer's general account. [15]

Separate Account Contract

A contract with an insurance company that provides principal preservation and a specified rate of return over a set period of time on an account that holds a combination of fixed income securities. Separate accounts may provide either a fixed, indexed, or periodic rate of return based on the performance of the underlying assets. The assets are owned by the insurance company and are set aside in a separate account solely for the benefit of the specific contract holder or retirement plan. [15]

Synthetic GIC

A contract with a bank or insurance company (commonly referred to as a wrap) that guarantees a rate of return for a portfolio of assets held in an external trust. The rate of return is reset periodically and is based on the actual performance of the underlying assets. The assets are owned by the participating plan or plans. [15]

The typical stable value fund will diversify contract protection by investing in more than one instrument type and/or with more than one insurance company or bank. Stable value portfolio managers also limit risk by holding a mix of maturities, such as intermediate-term bonds and short-term bonds generally with credit ratings of AAA or AA. [10]

Risks

Stable value funds are considered one of the lowest risk investments offered in 401(k) plans; [2] however, like any investment, they do have some risks, which include: [11]

Interest Rate Lag

In rapidly changing rate environments the returns on stable value funds may change more slowly than those of the marketplace, including similar investments such as money market funds. However, stable value funds still tend to outperform investments such as money market funds over time. [11]

Liquidity Risk

To prevent yield chasing, stable value funds generally contain “equity wash rules” limiting transfers to competing investments such as a money market fund or short-term bond fund. Generally a participant must first place money in a stock or equity fund for at least 90 days, but cash withdrawals have no waiting periods. [13] [17]

Contract Issuer/Guarantor Risk

Contract issuers can become less financially stable. This risk is most pronounced in funds with non-synthetic GICs because a single guarantor is backing the fund with the full faith and credit of the company. Most stable value funds mitigate this risk by purchasing contracts from multiple issuers, and stable value contract providers are generally strong financial institutions. [4]

Investor Cash Flows Affect Returns

An influx of money to a stable value fund during a period of low interest rates can result in more investments at the current rate, which may dilute returns for investors. However, the alternative is also true. Large inflows of money into a stable value fund when interest rates are high can alternatively increase returns. Most stable value funds include a cash buffer to pay out withdrawals and minimize cash flow effects so the stable value fund crediting rates remain stable and consistently positive. [18]

Employer Initiated Events

Certain employer initiated events can limit the liability of contract issuers, potentially leaving investors with losses. Events such as major layoffs, mergers, and bankruptcy will typically invalidate the portfolio's contracts since they increase the possibility that an issuer would have to pay out on contracts for these management initiated events. Losses in such cases are rare, since most companies generally have enough time to negotiate continued coverage for the stable value fund. [16] Many stable value funds have survived bankruptcies without any losses, for example in the case of Enron in 2001. [2]

Regulations

Stable value funds have multiple layers of government oversight. The vast majority of funds are regulated by the Department of Labor's Employee Benefits Security Administration and must comply with the federal pension law, the Employee Retirement Income Security Act (ERISA). Stable value funds in defined contribution plans for state and local governments (457 plans) are regulated by the states, which have adopted requirements similar to ERISA. [19]

In addition to the Department of Labor, stable value investment structures provided and/or managed by banks are regulated by the Office of the Comptroller of Currency and/or the Federal Reserve. Stable value funds offered by insurance companies are regulated by the various state insurance departments, and commingled investment funds are regulated by the Securities and Exchange Commission under the Investment Company Act. [19]

All stable value funds must comply with accounting regulations by the Financial Accounting Standards Board (FASB) (for corporate defined contribution plans) or the Governmental Accounting Standards Board (GASB) (for state and local defined contribution plans) to qualify for contract value accounting and reporting. Generally, FASB and GASB require that a stable value fund must meet all of the following criteria: [20] [21] [22]

Role in a Portfolio

Stable value funds are a low risk option for retirement plans and provide stability for investors seeking to minimize volatility, which is important for an investor nearing retirement or in retirement who would want to preserve principal and minimize risk. [7] Because of their low risk and stable, consistent returns they also can help diversify 401(k) asset allocation for all investors. [10]

Comparable Investments

Money Market Funds

A money market fund (also known as money market mutual fund) is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are widely (though not necessarily accurately) regarded as being as safe as bank deposits yet providing a higher yield. Regulated in the US under the Investment Company Act of 1940, money market funds are important providers of liquidity to financial intermediaries. Stable value funds have outperformed money market funds in every 12-month period since 1985 with similar volatility and risk and slightly less liquidity. [4] [5] [11] [23] [24]

Bond Funds

A bond fund is a fund that invests in bonds or other debt securities. Bond funds can be contrasted with stock funds and money funds. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodically realized capital appreciation. Bond funds typically pay higher dividends than CDs and money market accounts. Most bond funds pay out dividends more frequently than individual bonds. Stable value funds offer returns similar to those of intermediate bond funds but with less volatility and risk, and are often recommended as a replacement for bonds in diversified portfolios. [3] [4] [10]

Related Research Articles

Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, which is the study of production, distribution, and consumption of goods and services; the discipline of financial economics bridges the two. Financial activities take place in financial systems at various scopes; thus, the field can be roughly divided into personal, corporate, and public finance.

In finance, a high-yield bond is a bond that is rated below investment grade by credit rating agencies. These bonds have a higher risk of default or other adverse credit events, but offer higher yields than investment-grade bonds in order to compensate for the increased risk.

<span class="mw-page-title-main">Bond (finance)</span> Instrument of indebtedness

In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged – depending on the terms – to provide cash flow to the creditor. The timing and the amount of cash flow provided varies, depending on the economic value that is emphasized upon, thus giving rise to different types of bonds. The interest is usually payable at fixed intervals: semiannual, annual, and less often at other periods. Thus, a bond is a form of loan or IOU. Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure.

A mutual fund is an investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV in Europe, and the open-ended investment company (OEIC) in the UK.

Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the principal amount on maturity. Fixed-income securities can be contrasted with equity securities that create no obligation to pay dividends or any other form of income. Bonds carry a level of legal protections for investors that equity securities do not: in the event of a bankruptcy, bond holders would be repaid after liquidation of assets, whereas shareholders with stock often receive nothing.

A money market fund is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are managed with the goal of maintaining a highly stable asset value through liquid investments, while paying income to investors in the form of dividends. Although they are not insured against loss, actual losses have been quite rare in practice.

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.

Investment management is the professional asset management of various securities, including shareholdings, bonds, and other assets, such as real estate, to meet specified investment goals for the benefit of investors. Investors may be institutions, such as insurance companies, pension funds, corporations, charities, educational establishments, or private investors, either directly via investment contracts/mandates or via collective investment schemes like mutual funds, exchange-traded funds, or REITs.

<span class="mw-page-title-main">GIC (sovereign wealth fund)</span> Singaporean sovereign wealth fund

GIC Private Limited is a Singaporean sovereign wealth fund that manages the country's foreign reserves. Established by the Government of Singapore in 1981 as the Government of Singapore Investment Corporation, of which "GIC" is derived from as an acronym, its mission is to preserve and enhance the international purchasing power of the reserves, with the aim to achieve good long-term returns above global inflation over the investment time horizon of 20 years.

<span class="mw-page-title-main">Asset allocation</span> Investment strategy

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A bond fund or debt fund is a fund that invests in bonds, or other debt securities. Bond funds can be contrasted with stock funds and money funds. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation. Bond funds typically pay higher dividends than CDs and money market accounts. Most bond funds pay out dividends more frequently than individual bonds.

A stock fund, or equity fund, is a fund that invests in stocks, also called equity securities. Stock funds can be contrasted with bond funds and money funds. Fund assets are typically mainly in stock, with some amount of cash, which is generally quite small, as opposed to bonds, notes, or other securities. This may be a mutual fund or exchange-traded fund. The objective of an equity fund is long-term growth through capital gains, although historically dividends have also been an important source of total return. Specific equity funds may focus on a certain sector of the market or may be geared toward a certain level of risk.

A guaranteed investment contract (GIC) is a contract that guarantees repayment of principal and a fixed or floating interest rate for a predetermined period of time. Guaranteed investment contracts are typically issued by life insurance companies qualified for favorable tax status under the Internal Revenue Code. A GIC is used primarily as a vehicle that yields a higher return than a savings account or United States Treasury securities and GICs are often used as investments for stable value funds. GICs are sometimes referred to as funding agreements, although this term is often reserved for contracts sold to non-qualified institutions.

<span class="mw-page-title-main">Catastrophe bond</span>

Catastrophe bonds are risk-linked securities that transfer a specified set of risks from a sponsor to investors. They were created and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge earthquake.

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<span class="mw-page-title-main">Investment fund</span> Way of investing money alongside other investors

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A with-profits policy (Commonwealth) or participating policy (U.S.) is an insurance contract that participates in the profits of a life insurance company. The company is often a mutual life insurance company, or had been one when it began its with-profits product line. Similar arrangements are found in other countries such as those in continental Europe.

United States policy responses to the late-2000s recession explores legislation, banking industry and market volatility within retirement plans.

References

  1. 1 2 3 "Stable Value Investment Association FAQ". Stable Value Investment Association. Retrieved 17 December 2012.
  2. 1 2 3 4 Bedway, Barbara (16 March 2009). "Inside Stable Value Funds". CBS News Moneywatch. Retrieved 17 December 2012.
  3. 1 2 3 4 Babbel, David; Miguel A. Herce (12 September 2009). "Stable Value Funds: Performance from 1973 through 2008" (PDF). The Wharton School of Business, Departments of Insurance and Finance, University of Pennsylvania; Charles River Associates. Archived from the original (PDF) on 18 June 2013. Retrieved 17 December 2012.
  4. 1 2 3 4 5 6 7 Willoughby, Jack (7 April 2012). "Steady Eddies". Barron's.
  5. 1 2 3 4 5 6 "What Is a 'Stable-Value' Investment?". Smart Money. 31 May 2005. Retrieved 17 December 2012.
  6. ↑ Lemke and Lins, ERISA for Money Managers, §2:135 (Thomson West, 2013 ed.).
  7. 1 2 3 4 Kenny, Thomas. "Are Stable Value Funds a Good Choice for Your 401(k)?". About.com. Retrieved 17 December 2012.
  8. ↑ Grant, Tim (January 21, 2015). "'Stable value funds' deliver on promise for baby boomers". Pittsburgh Post-Gazette. Retrieved February 10, 2016.
  9. 1 2 3 Ward, King & Barrasso (2016). "Expanding the Case For Stable Value" (PDF). Prudential. Retrieved February 10, 2016.
  10. 1 2 3 4 Luxenberg, Stan (26 March 2012). "Protect Nest Eggs With Stable Value Funds". Forbes. Retrieved 17 December 2012.
  11. 1 2 3 4 "Frequently asked questions about stable value funds". JP Morgan. Retrieved 17 December 2012.
  12. ↑ "Apples to Apples Investment Information". Stable Value Insights. Galliard.
  13. 1 2 Zweig, Jason (3 December 2011). "What Price Stable Returns?". The Wall Street Journal. Retrieved 18 December 2012.
  14. ↑ Postal, Arthur D. (October 23, 2007). "QDIA Rule Allows VAs, Excludes Stable-Value Funds". ThinkAdvisor. Retrieved 2020-09-09.
  15. 1 2 3 4 5 "Report on Stable Value Funds and Retirement Security in the Current Economic Conditions". Executive Summary. Department of Labor. Retrieved 18 December 2012.
  16. 1 2 3 Ody, Elizabeth (21 September 2011). "Savers Flooding Stable Value Funds May Have Limited Access". Bloomberg. Retrieved 18 December 2012.
  17. ↑ Novack, Janet (26 November 2012). "Worried About A Bond Bubble? Consider A Stable Value Fund For Your 401(k)". Forbes. Retrieved 18 December 2012.
  18. ↑ Cress, Kevin. "How Stable Are Stable Value Funds?". 401Kafe.com. Retrieved 17 December 2012.
  19. 1 2 Mitchell, Gina. "Comment for Proposed Rule 76 FR 53162". Study of Stable Value Contracts. Commodity Futures Trading Commission. Retrieved 18 December 2012.
  20. ↑ "Accounting and Reporting by Defined Benefit Pension Plans". Financial Accounting Standards Board. Retrieved 18 December 2012.
  21. ↑ "Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans". Governmental Accounting Standards Board. Retrieved 18 December 2012.
  22. ↑ "Accounting for Pensions by State and Local Governmental Employers". Governmental Accounting Standards Board. Retrieved 18 December 2012.
  23. ↑ "Time to Buy Stable Value Funds?". AHEAD OF THE CROWD. Barron's. Retrieved 18 June 2013.
  24. ↑ "Stable Value". Main Stay Investments. New York Life. Retrieved 18 December 2012.
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