Understanding Stable Value
Plan sponsors’ misunderstandings about stable-value funds fall at two ends of the spectrum, says Marcia Peters, chief investment officer at Warren, New Jersey-based adviser Portfolio Evaluations Inc. “Historically, most sponsors thought of stable value as being similar to money market, and that they could put it in the plan lineup and it would perform,” she says. “The other extreme is, sponsors have started to realize that they are not a money-market fund and they have things in them that are higher risk than a money-market fund. Some have said, ‘These things are too complicated.’
“Our goal is to educate plan sponsors so they understand where stable value really falls, and help them understand its benefits and its potential risks,” Peters says. Advisers can help sponsors comprehend stable-value funds by encouraging them to follow these five rules:
1) Stay abreast of industry dynamics. Some stable-value providers, such as State Street Global Advisors, have announced decisions to exit the market. Fund managers and wrap providers worry that if interest rates start to rise rapidly, while stable-value fund yields are low relative to current interest rates, participants and plans may pull their money and look to get higher returns elsewhere. Many stable-value funds let plans withdraw with a 12-month notice; otherwise, participants may transfer out at any time. Those allowances could be problematic, considering many of the stable-value funds hold underlying investments in the two- to three-year duration range, on average. If plans and participants want to leave, stable-value funds would then have to sell underlying investments at losses to fund the redemptions. “If that happens, the fund is stuck,” says Charles Nelson, president of Great-West Retirement Services. “That is why many wrap providers are saying, ‘I am only making a few basis points, and I am taking a lot of risk for that.’” As a result, stable-value managers have found that the wrap market tightened up quite a bit.
That means wrap providers can push the envelope on fees. Wrap-contract fees once ran between seven and 12 basis points and now run 18 to 25, says Sue Walton, a Chicago-based senior investment consultant at Towers Watson. “The risks have not been completely sorted out,” Nelson says. “Everybody is still asking, ‘When are interest rates going to rise? How fast will they rise? And to what level will they rise?’ Since those answers are unknown, fees may continue to rise.”
2) Know these products’ mechanics. The biggest misunderstanding about stable-value funds among sponsors and advisers is not knowing how much they can differ, says Chris Tobe, principal at Louisville, Kentucky-based Stable Value Consultants. “They think of it as a generic, plain-vanilla investment,” he says.
Most plans have, in recent years, used synthetic stable value—a fixed-income portfolio with an insurance wrapper around it. “With synthetics, you have the assets in your name,” Tobe says. “If the insurance company goes under, maybe you are out three or four cents on the dollar, at most.”
Adapting to the capacity constraints in the wrap market, some fund managers have added more traditional guaranteed investment contract (GIC) and sub-advised structures to their products. “The landscape has changed so dramatically that a lot of stable-value funds increasingly have been forced to use these tools in the face of mounting underwriting standards the insurance industry has placed on the managers,” says Edward McIlveen, director of investment analytics and research at adviser Francis Investment Counsel LLC in Pewaukee, Wisconsin. That makes it key to track the credit-worthiness of all entities providing capacity for these stable-value funds; so, he sends quarterly updates to sponsors with stable-value options.
Sponsors also need to know how the wraps work. Since a number of wrap-contract providers have exited the market, those who remain have more leverage in how to structure the wraps. “You used to have more ‘global’ wrap contracts, so if there were five wrap providers, the others had to step up if one failed,” Walton explains.
“Now, they are structured so that you have got a wrap provider covering a portion of the portfolio.” So if a wrap provider covering one part of the portfolio fails, a wrap provider covering another portion is unaffected.
3) Learn about the underlying holdings. Stable-value funds traditionally have yielded about 3% more a year than money-market funds, Peters says. But prior to the 2008 to 2009 market problems, that return rose to 4% or 5% a year for some. “We knew that was not just a short-duration fixed-income portfolio,” she says, adding that many invested in asset-backed securities and longer-maturity fixed income, and some even went into private investments, equities and currencies.
“There were funds that were overly aggressive, and they paid the price,” McIlveen says. “Some had the mindset to get the highest yields possible, and we are not comfortable with that.”
Prodded by wrap providers, funds’ investment guidelines have tightened, requiring higher-quality investments in a portfolio, more diversification limits on the concentration of holdings and limits on lengthening investments’ duration, to name a few. Funds’ investment guidelines still have their differences, however, and advisers and plan sponsors need to thoroughly understand a manager’s holdings, McIlveen says. “Are they willing to talk about any problems they have had in the past? And are they willing to share some of their credit research, so you can understand how they think?” he asks. “These are conversations that we have with fund managers at least twice a year, in terms of actually talking to and seeing people.” He talks to managers informally more often.
4) Look for duration issues. Fund managers must handle their portfolios’ average duration carefully: Having too short a duration leads to subpar returns, but a fund with too lengthy a duration will have fewer dollars to reinvest in higher-yielding investments if rates start rising. “If you look at a stable-value fund with a 1.75-year average duration, and others with a three- or four-year duration, it makes a difference in the current yield, and it makes a difference in how fast that fund would be able to react in a rapidly rising interest-rate environment,” Nelson says.
Talk to stable-value managers about how they manage the portfolio with an eye to what they will do when rates start going up, Peters recommends. For instance, she goes beyond the average duration number, since funds can arrive at that in many different ways. “We ask them to give us a breakdown of the portfolio: What percentage has an average duration of longer than three years versus what percentage has an average duration shorter than one year?”
5) Explain the withdrawal restrictions. Participants usually have fund-imposed restrictions if they pull their money from a stable-value fund, Peters says. Generally, for 60 to 90 days, they cannot move into a competitive investment such as a money-market fund or a short-term bond fund. That has gone a step farther, recently. “Now some wrap-contract providers say that if a plan sponsor adds stable value to the lineup, they will not allow a money-market fund,” she says. “A lot of our plans have both, and we would advocate that that is a good thing, but not always possible, depending on a number of administrative and investment factors.”
These funds usually require a plan to have a 12-month waiting period—called a 12-month put—before switching the plan out of that investment, so the fund does not have to pay back all of the investment money for one year. “Now we are seeing wrap-contract providers require longer periods, like 24 or 36 months,” Peters says. “That makes it more challenging for plan sponsors when considering a new stable-value fund.”