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Retirement Plans
Plan sponsors should understand key characteristics of stable value funds before deciding to use this popular capital preservation investment option.
At a glance section
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While stable value funds (both in CIT and General Account Product structures) have been around for many years and are a common choice among plan sponsors, recent market conditions have served as a reminder that there are important distinctions between stable value and money market funds.
Years of low interest rates may have previously made the selection of a stable value fund seem like a relatively easy decision, since stable value fund performance relative to money market funds had generally been better during this time. However, choosing a capital preservation option for a defined contribution plan menu is an important fiduciary decision, and while both money market and stable value fund options may seem similar in that their goal is to primarily preserve investor assets while earning a reasonable rate of return, there are important differences in their investment profiles and operational attributes that plan sponsors need to understand in order to make the appropriate choice concerning investment vehicle selection for their participants.
How widely used are stable value funds?
In order to offer a full fund menu to participants, plan sponsors should include a capital preservation fund. These investment options can play an important role in the overall diversification of a participant’s portfolio based on the goals, time horizon and risk tolerance of the individual. Further, compliance with ERISA section 404(c) generally requires a plan to have at least one capital preservation option, one fixed income option and one equity option. As a result, the vast majority of defined contribution plan lineups contain a capital preservation option. Stable value funds are reportedly offered in 80% of defined contribution plans1 and account for roughly $900 billion, or approximately 8% of defined contribution plan assets.2
The basics of money market vs. stable value fund construction
Money Market Funds are fairly straightforward investment options. The type most often found in retirement plan lineups are government money market mutual funds. These funds focus on investing in Treasury Bills, which are essentially short-term loans to the US government that get paid back with interest within one year or less. Because the portfolio focuses on very short-term securities that are backed by the full faith and credit of the US government, they have very little exposure to daily fluctuations in value, they are highly liquid and they are considered very safe. Money market funds pay out the interest rate received on their holdings, less any fund management fees. The rate of interest on money market funds tends to be sensitive to the Federal Reserve’s policy interest rate, meaning that as interest rates rise, money market funds tend to receive higher rates of return.
Stable value funds are more complicated than money market funds. In general, stable value funds focus on buying short- to intermediate-term bonds issued not only by the US government but also by corporations. This exposes these funds to increased duration and credit risk. Since bonds with longer maturities (i.e., maturities of greater than one year) are more sensitive to changes in interest rates (bond prices and interest rates have an inverse relationship)3 and can fluctuate in value more easily than securities with maturities under one year, these funds enter into contracts with insurance companies whereby the insurers agree to pay the difference between the market value of the underlying portfolio (what the bonds are trading for on any given day) and the book value of the underlying portfolio (the original purchase price of the bonds) in situations where participants make withdrawals. These contracts are known as wrap contracts (i.e., the insurance underlying the contract is wrapped around the portfolio), and they allow a stable value fund to report its portfolio value as book value and consistently pay out participants at book value. This is different from other bond funds, which are required to mark their portfolios to the market value of the underlying bonds on a daily basis and meet redemptions from participants at the net asset value of the fund.
The return that an investor receives on a stable value fund is termed a crediting rate. The crediting rate usually takes into account the interest received on the underlying bonds in the portfolio as well as the change in market value of the securities, less fund management fees and expenses related to its insurance wrap contracts.
Key considerations regarding stable value funds
Potential Returns
Until recently, over the past decade, stable value funds had generally returned more than money market funds and in some cases substantially more. Because the portfolios of stable value funds are more aggressive than money market funds, there are certain market environments where their returns will look highly competitive in comparison. When interest rates are very low for extended periods of time (as had generally been the case from 2009-2022), the crediting rate on stable value funds will be higher than the interest rate on money market funds. When interest rates go down, the price of bonds rises, meaning the overall market value of the portfolio rises. This allows the fund to sell bonds for a profit and contribute those profits toward the overall crediting rate that investors receive.
However, during times when interest rates rise rapidly, this dynamic reverses. The bonds in the stable value portfolio will decline in price. This change in market value will offset the interest paid by the bonds and lower the crediting rate. Simultaneously, the interest rate on money market funds will rise, making their returns look comparably better during these periods, which has been the case more recently.
Market Value Adjustments and Put Periods
Beyond the risk-return tradeoff that exists by the nature of their more aggressive portfolio positioning, there are other elements unique to stable value funds that are important to consider before making the decision to include one in a fund menu. In order to add a stable value fund to a menu, a plan sponsor often has to agree to certain terms. Generally, the terms specify what is known as a market value adjustment (MVA). MVAs only apply to liquidations of a plan’s entire position. They do not apply to an individual participant’s ability to withdraw their assets from the fund at book value at any given time. An MVA takes effect if a plan sponsor wants to sell out of the stable value fund chosen for the plan and choose a different capital preservation option for the plan, and the portfolio of the stable value fund has a market value that is below its book value. In this instance, the fund would have the right to force the plan to liquidate the position at the market value of the bonds or wait a period of time prior to liquidating the position.
This provision allows a stable value fund to prevent major liquidations during times of market stress and therefore not impact other individual participants’ ability to redeem their positions at book value. In order for a plan to exit its entire stable value position and not be penalized when the market value is below the book value, the plan sponsor would have to agree to wait to liquidate over what’s known as a put period. Put periods can sometimes last for more than 12 months, depending on the participation agreement. This makes it possible for the portfolio managers to orderly liquidate large positions as opposed to forcing sales immediately at a loss, however, these MVAs and put periods can sometimes cause frustration for plan sponsors. In scenarios where a plan sponsor wants to change recordkeepers and the stable value fund is only available on the incumbent recordkeeper’s platform, it can cause operational challenges for exiting the fund and fully transitioning service providers in a timely manner. Additionally, in a market environment where money market funds are outpacing stable value funds, it makes it difficult for a plan sponsor to quickly make a change to a more competitive capital preservation option.
Equity Wash Provisions
Another provision commonly required when using a stable value fund is an equity wash. This provision requires a plan that has a competing capital preservation option, generally a money market fund or a short-term bond fund, to impose time restrictions on transferring assets from the stable value fund to the competing option. Generally this requires the participant to move assets from a stable value fund to an equity fund and/or a more risky bond fund for a period of up to 90 days prior to moving into a money market fund or short-term bond fund.
Because of this type of provision plan sponsors generally choose between having either a stable value fund or a money market fund within a plan lineup. In the very least, it makes it difficult for participants to move from a stable value fund to a money market fund during market periods when money market funds are performing better without risking their capital for a period of time. Moreover, a plan using a recordkeeper that cannot enforce equity wash provisions may force the plan sponsor to choose between using a stable value fund or a money market fund.
General Account Products
Many stable value funds are structured as collective investment trusts (CITs) and are portfolios wrapped by multiple insurance providers. However, recordkeeping platforms that are subsidiaries or affiliates of insurance companies often offer stable value funds that are not CITs and are products backed by their own general accounts. These types of products usually allow the provider to offer more competitive pricing since they are able to offset some of their recordkeeping costs with the fees produced from the general account stable value fund.4 Because they are backing the fund with their own general account instead of relying on wrappers from multiple insurance companies, these products can often offer very competitive crediting rates relative to both stable value CITs and money market funds.
However, in addition to the nuances that exist with CIT stable value funds, there are special considerations with these products. The way these products are set up usually implies that the plan ultimately has a claim to the general account of the insurer and not the underlying portfolio assets, as they would with a stable value CIT. This is important because the plan sponsor is concentrating risk into one insurance company. If the insurance company experiences bankruptcy, the plan likely will not be listed first among the creditors of the insurance company. Because of this, it is paramount that a plan sponsor understand how responsibly the insurance company manages its risk and understand the opinion of the credit rating agencies regarding the insurance company’s ability to continue to operate as a going concern.
Conclusion
Stable value funds offer benefits that make them compelling choices for plan sponsors to consider as the capital preservation option for their plans. They tend to offer competitive crediting rates in market environments where yield may not be present for money market funds, and they can even offer offsets to recordkeeping expenses. However, in order to live up to their fiduciary duties to plan participants, it is imperative that plan sponsors understand how the stable value funds they are choosing for their plans generate their returns and the nuances involved in their operations compared to other capital preservation investment options. Plan committees should also establish a process for reviewing and documenting their decisions related to these products. If a plan committee feels they need assistance in implementing a diligent process, they should rely on the expertise of their plan’s investment consultant to guide them.
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1 MetLife. “2022 Stable Value Study.” Page 3. metlife.com/content
. Accessed August 2023.
2 Stable Value Investment Association. “The Facts About Stable Value Funds.” stablevalue.org/the-facts-about-stable-value-funds. Accessed July 2023.
3 At a basic level, if interest rates go up, the price of bonds already in the market will go down. If interest rates go down, the prices of bonds already in the market will rise.
4 General account products do not necessarily charge an explicit management fee. They tend to make most of their fee on the spread produced by the assets in the general account versus what they ultimately pay out as a crediting rate to participants.