Wednesday, February 12, 2014

Stable Value Funds: 8th Wonder Of The World Or Smoke And Mirrors?

How Stable Value Funds Work And How Best To Use Them

Get it?  A stable.

Many 401k and 403b plans have a stable value fund (AKA interest income fund) as one of the investment options.  These funds don't have a ticker symbol, have sometimes rather vague and opaque disclosure documents available on them, and it is hard to get any research or informed opinion on them. Stable value funds are only offered in "qualified" retirement plans such as 401ks and 403bs.  All most plan participants know about them is that they are "stable" and sometimes what the current interest rate offered by the fund has been recently.  In this post I will discuss how these funds are constructed and the best way to use them in your 401k or 403b.

First, what exactly is in these funds?  In days of yore, these funds were primarily made up of "Guaranteed Investment Contracts (GICs) issued by a large, creditworthy life insurance company.  Traditional GICs typically have a fixed rate of return promised for a specific time period and the insurer generally agrees that the funds can be withdrawn before the scheduled maturity of the contract if the stable value fund experiences large withdrawals by 401k/403b participants.  GICs are fairly simple instruments that resemble a jumbo (millions of dollars) deferred fixed annuity or a CD.  Traditional GICs were the mainstay of the stable value fund industry and remain a important component of stable value funds.  However, they have a couple of key drawbacks.  First, these are unsecured promises from an insurance company.  There is no FDIC equivalent for life insurers, so if the insurer goes belly-up, the manager of the stable value fund gets to get in line with all of the other policyholders and creditors in the hopes of getting some recovery.  Second, stable value fund managers are very picky about which insurers they will buy traditional GICs from because of their unsecured nature.  As a result, they will generally only buy traditional GICs from the largest, best-rated insurers which presently total 6 or 7 life insurance groups in the US.  With only a handful of insurers to buy from and given that the creditworthiness of all these insurers is probably highly correlated between one insurer and the rest, relying solely on traditional GICs to assemble a stable value fund means that such a fund would be very poorly diversified.  Since these funds are meant to be the least risky investment option in a retirement plan, a lack of diversification is simply not acceptable.

The solution was the development of the "synthetic GIC."  Stable value fund managers really have three requirements for their funds: a high degree of safety and liquidity, accounting treatment such that the NAV of the fund never fluctuates aside from the increase due to interest income, and a reasonable rate of return.  The traditional GIC provided all three, but required accepting a material degree of counterparty risk and a lack of diversification.  So stable value managers began deconstructing the traditional GIC to meet the requirements of stable value funds.  What insurers do with the cash generated by selling a traditional GIC to a stable value fund is invest the money in a portfolio of liquid, highly rated fixed income securities that mature about the time the GIC matures.  The insurers then earn more in interest on the portfolio of bonds than they pay out to the stable value fund in interest.  Stable value fund managers usually also manage large portfolios of bonds, so they chose to cut out the middle man.  Rather than handing over money to insurers on an unsecured basis and getting less than the resulting investments earned, the stable value managers kept the money in the stable value fund and invested it in a high grade bond portfolio.  This satisfies two of the three requirements for stable value fund assets, namely safety & liquidity and a reasonable rate of return.

However, such a portfolio would not qualify for accounting treatment of no NAV fluctuations as the fund would drift up and down with the market price of the bonds.  To achieve a stable fund NAV, managers of these funds contract with financial institutions (including insurers and banks) to have the stable NAV guaranteed by the institution in return for a fee.  These contracts are known as "stable value wraps" or "synthetic CGICs" and usually have the financial institution guarantee a specified pool of assets for an agreed upon period of time.  Synthetic GICs also usually have numerous terms and conditions, including the allowed make-up of the guaranteed bond portfolio, where the specific contract stands in line if there is a large withdrawal from the fund, and even restrictions on competing investment options available to plan participants (no money market funds allowed, for example) or how plan participants can move their money among investment options (the so called "equity wash" - more on this later).  Once again, the stable value wrap contract is an unsecured exposure of the stable value fund to the financial institution counterparty.  Although this is a risk to the fund, because the fund retains the invested assets rather than having the insurer control them the risk of insurer insolvency is reduced to the amount the guarantee comes into the money rather than the entire invested amount (in most cases, a synthetic GIC might have 5% of the counterparty risk that a traditional GIC would have).  The inclusion of banks and other financial institutions in the stable value wrap market also allows much greater counterparty diversification compared with the 6 or 7 life insurers that dominate the traditional GIC market.  Not surprisingly, stable value fund managers have made extensive use of stable value wrap contracts and most stable value funds have a mixture of traditional GICs and synthetic GICs.

To summarize, stable value funds typically contain a mixture of insurance contracts from the largest, most highly rated life insurers plus pools of high grade bonds with a guarantee extended by the largest and most highly rated financial institutions.  These underlying instruments will typically have maturities ranging from 2 to 5 years and be of AA/Aa2 or better average credit quality.  This is not equivalent to an FDIC-backed instrument like a CD, but the diversification, very low credit risk, and modest interest rate risk of stable value funds means that it is very unlikely that plan participants will ever lose money on the stable value fund in their plan.  The nature of these funds also means that their returns over time will approximate the yield on medium term, high grade bond funds.  Unlike bond funds, stable value funds do not expose investors to fluctuations (both positive and negative) in NAV due to market price movements in the underlying bonds.

So now that you know what is in these funds and how they work, what is the best way to use a stable value fund in your portfolio?  By far, the lowest hanging fruit is to use stable value funds as a stand-in for a money market or short term bond fund if you choose to hold that asset class in your tax deferred portfolio.  Stable value wins on both counts: lower risk and usually higher return than either alternative.  Another good use for a stable value fund is as a core bond holding when rates are rising.  In a rising rate environment it is likely that a stable value fund and a bond index fund will have similar yields, yet the bond fund NAV and total return get hurt by the mark to market losses on the bonds while the stable value fund remains, umm, stable.  This is similar to buying a long term D with a small early surrender penalty: if rates rise you stay in the CD or stable value fund until market rates have moved up enough to make chasing them worth the risk to principal, then you get out at par without having suffered all the losses that bond investors took as rates rose.  Note that when rates are falling, you would be better off in a bond fund than in a stable value fund.  Again, both funds will have similar yields but the bond fund NAV and total return move with the market values of the underlying bonds while the stable value fund does not.  So if market rates are falling and bonds are appreciating in value, bond funds will offer greater total return than stable value.  Finally, a third good use for stable value funds is for investors with a very conservative orientation who simply wish to reduce their total portfolio volatility.  Since stable value funds are effectively a pile of very high quality bonds with a put option that allows you to dump them at par any time you like, they are a great choice as a core holding for the risk averse.

In order to protect themselves, the providers of traditional GICs and stable value wraps typically underwrite each deal they participate in.  In addition to restrictions on the underlying bonds, financial institutions also look at the characteristics of both the plan and the plan participants and they may require certain restrictions be placed on the plans.  A common requirement is that there be no money market fund offered to compete with the stable value fund.  Since stable value funds are generally better investment options, this is no great loss to plan participants. A somewhat more odious restriction that is fairly common is what is known in the industry as an "equity wash" provision.  An equity wash in place means that plan participants cannot trade between bond/money market funds and the stable value fund.  This is intended to keep plan participants from moving money around in search of the best rates/returns.  However, if you maintain a diversified portfolio in your retirement plan it is easy to do an end-run around the equity wash.  Suppose you have a portfolio that is $100,000 bond index fund, $100,000 stable value fund, and $100,000 equity index fund and you wish to sell $50,000 of the bond fund and move the money to the stable value fund.  Because the plan has an equity wash rule in place, you are not allowed to sell $50,000 bond index fund and buy $50,000 stable value fund.  However, the equity was provision would not prevent you from arriving at exactly the same target portfolio by doing the following: sell $50,000 equity fund, buy $50,000 stable value fund, sell $50,000 bond fund, buy $50,000 equity fund.  In both the direct case (prohibited by the equity was rule) and the workaround you end up with the same portfolio:$50,000 bond index fund, $100,000 equity index fund, and $150,000 stable value fund.

As always, do your own due diligence, consult your advisors, take your own risks.  Not intended as investment advice.  I suppose it is theoretically possible that someone could lose money in a stable value fund, so be careful.


  1. This post and the one on LTC insurance were very educational for me. Thanks.

    1. Happy to help. I will have to poke around for some similar topics to cover.

  2. One small addendum to an excellent post.

    "Stable value funds are only offered in "qualified" retirement plans such as 401ks and 403bs."

    At least one 529 plan, Colorado's, offers a SVF backed by MetLife. It's currently paying 2.64%. That beats 1- to 4-year CD rates handily, so I'm aggressively stashing funds there for my HS senior's college fund.

    Question: My 457b provider had a SVF option in its fund lineup for many years, but recently dropped it. Is this a trend?

    1. Fascinating. I had no idea that 529s included stable value funds. In addition to Colorado's, a very lazy search showed that there are several state plans administered by TIAA-CREF that include a stable value option. The big difference between a traditional stable value fund in a retirement account and what is offered in the 529 plans is that the 529 stable value fund is not diversified. 100% of the money in the fund is an unsecured policyholder obligation of one company (MetLife and TIAA in the cases I can see). These are large, strong companies, but it is still worth noting that the lack of diversification is an increase in risk to the investor. Still, this could be an attractive option for certain investors.

      I have seen some evidence that plan sponsors have been dropping stable value funds in recent years. My last employer had a stable value option that had 80% of the entire fund's assets in it, and the stable value option was dropped. Stable value managers had to deal with a lot of problems during the financial crisis, including insurance company downgrades, bonds they thought were high grade and liquid proving not to be, and a sudden lack of providers of stable value wraps. Since the performance over time is similar to a bond index or target maturity bond fund and the plan sponsor may incur liability by telling plan participants that this is the safe option in the plan, it is not that surprising that some plans are dropping the stable value option.