Stable-Value Funds: Their Time Under Heaven

A homework assignment for 457 investors and administrators
April 19, 2012
Girard Miller
By Girard Miller  |  columnist
Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

To every thing (turn, turn, turn) there a season and a time to every purpose under heaven.

— Ecclesiastes (with adaptations by Peter Seeger and The Byrds)

We have now come to an investment crossroads for public employees who invest in 457 deferred compensation and 401a defined contribution plans — and their plan administrators. Interest rates have reached generational low levels, and the typical money market fund used in defined contribution plans pays essentially zero. Bond funds have produced super-sized capital gains in the past decade, but from today's levels, they are almost certain to suffer capital losses whenever interest rates increase. For safety-oriented retirement savers and investors, the leading interest-paying vehicle today is the stable-value fund that is typically offered in these workplace savings plans.

Stable-value products in the defined-contribution world seek to provide a constant share value (in most scenarios, but not guaranteed) and offer an interest rate that often beats the other available options. There are two types: (1) insurance company guaranteed investment products that are essentially obligations of that one issuer, and (2) managed-portfolio funds that are "wrapped" by an independent insurance company or other guarantor who will shortstop the fund for market volatility, but not guarantee against bond default. Neither is foolproof under extreme conditions. The insurance company making a primary guarantee can default, and the portfolio guaranteed by a "wrapper" company can suffer losses so bad that the market-price stabilization is not sufficient. So the plan administrator needs to keep careful watch over the employees' nest eggs.

2013 vs 1976. When I first entered the public finance profession in the mid 1970s, stable value funds were all the rage. Most of them were simply insurance company "GICs" — shorthand for benefit-responsive guaranteed investment contracts. They were viewed as safe havens and "a bird in the hand." The disastrous 1973-74 stock market rout had taken stock prices down 43 percent (almost as bad as the 2008-09 losses of 50 percent), and public employees nationwide wanted absolutely nothing to do with the stock market after that meltdown. The big difference between the shell-shocked mid 1970s and this decade is that back then, inflation was rising rapidly and interest rates were much higher. By 1976, employees could get an 8 percent guaranteed rate of interest on a stable-value insurance company product, so it was a no-brainer for 457 plan peddlers to sell the insurance product which gave them a hefty sales commission. I will never forget the former high school class ring salesman who drove up to my employer's municipal office in a Winnebago with his wife waiting outside, to sell that plan and enroll the cops and building inspectors. (The 457 salesmen from that era have all retired comfortably, I believe.)

Today, public employees enrolled in a workplace savings program like a 457 plan or a 401a defined contribution plan are looking at far lower rates on the stable-value products available to them. Interest rates in the 2 to 3 percent range are much more commonplace these days. That level reflects current government bond yields, which are roughly 2 percent for a 10-year Treasury bond. So the rate is consistent with market levels.

The big selling point today for a stable value fund is that they won't lose money for the investor if interest rates go up. At least in theory. And therein lies the rub.

If the product is a direct issue and a general obligation of an insurance company, then the rate is guaranteed but the principal value is not. It's like a floating-rate bank CD. If the insurance company goes belly-up (in a future recession or for some other reason), the investor has no guarantee that principal will be repaid — unless the state has an insurance company guarantee program, which a few states do provide. For example, I was doing work for a Pennsylvania city in the middle of the Great Recession when this became a worrisome issue, and our findings at the time were that the insurance company's 457 investors with accounts below a statutory guaranteed level were protected by the state insurance company guarantee fund similar to the FDIC. Fortunately that facility was never tested, and nobody should rely on an insurance guarantee fund without performing extensive due diligence.

In today's economic recovery scenario, the odds now favor insurance companies that have successfully weathered the storm of the recent recession. If interest rates rise in a general economic expansion period, there would seem to be less risk to these products, as the issuing insurance companies should improve their balance sheets — unless they have taken huge and imprudent interest rate risks in their reserve fund portfolios. So the first job of a 457 or 401a plan administrator evaluating such a product is to evaluate the financial condition of the insurance company and its underlying general account's duration exposure in the bond market.

Wrapped funds. The other form of a stable-value fund is a portfolio of bonds that is "wrapped" by an insurance company or other guarantor to assure that market value changes are smoothed sufficiently to enable investors to withdraw money at par. "Wrappers" are more common in the industry nowadays, with independent non-insurance firms using "wrap providers" to guarantee the stable-value price but not the underlying portfolio value from defaults. Here, the story is different. A wrap provider simply provides a liquidity facility that hopefully assures investors who leave now that they will get out at par. To do this, they reserve capital gains earned in periods like 2009-11 for a rainy day when interest rates later increase, and sometimes income from higher future rates are used to offset capital losses. This feature will be especially important when interest rates eventually begin to increase. Unlike an intermediate-term bond fund that marks its portfolio to value in the share price, which leaves investors with losses in rising-rate markets, a stable-value wrapper keeps the share price stable. But the question ultimately is whether the portfolio and the wrap provider are able to indefinitely withstand major increases in interest rates.

For example, a 1 percent increase in five-year bonds would normally cause a 4 percent loss in market prices, so a stable-value portfolio manager must rely on the wrap provider to make up for price losses if the portfolio is too heavily weighted toward longer maturities whenever interest rates increase. If rates double from today's levels in a year or two, the bond math gets really ugly and the wrap provider takes a bath. That is why every stable-value wrapped product says explicitly that it "seeks" to maintain a stable value and cannot offer a guarantee because that is mathematically impossible. What I can personally and professionally guarantee is that the average public employee has no idea how this all works. So it's really up to the plan administrator and the plan's investment consultant to make sure that the fund is properly managed and presently has a margin of safety.

Due diligence metrics. The good new here is that the 20 year bond market rally has produced some marvelous capital gains that the average stable-value wrapped fund now enjoys. So the first hard-nosed test that a plan administrator should apply is the stable value fund's market value ratio (the ratio of the fund's actual market value to its par value, which is what participants would receive if they all transferred out today). Every stable value provider is obligated to disclose the most recent market value ratio to the plan administrator — who is a fiduciary entitled to this information. Most of them will provide it to plan participants also, upon request. If that number is not positive today (a value over 100 percent) then something is seriously wrong. In fact, I would prefer a fund today that has a market value ratio above 102 percent given the decade-long bond rally we have enjoyed which has produced whopping capital gains in the past four years. Any fund with substantial size in 2008 should be sitting pretty these days, and those are actually the ones that offer the best cushion to investors today. They have much more margin for error if the economy expands and interest rates begin to escalate in 2014. Funds with lower ratios may be acceptably safe, but they usually enjoy a lower margin for error and less protection from adverse rate spikes assuming the same portfolio characteristics.

Meanwhile, a fund with a strong market value ratio is safer for investors who plan to move their money in the next year or two. However, I should remind readers that a stable value fund typically has an "equity wash" rule which says you can't game the system by transferring from the fund to a higher-yielding money market fund or certain bond funds without first moving the money into a risker fund. Otherwise, everybody would exit their stable value fund when rates are higher and the portfolio is taking losses, which would be a recipe for disaster.

For those seeking more information, the industry association's website is a good starting point. A competent DC plan consultant (independent of the plan administrator and the stable-value provider) with investment-advisor qualifications and credit research capacity should also be qualified to provide guidance on the one-time or ongoing guidance to plan administrators and oversight committees.