Home > 529 college savings plans

The Case for Stable Value in College Savings Plans

The unique benefits of stable value products helped establish 401(k) plans as the premier retirement savings vehicle for millions of Americans. Today, they're poised to do the same thing for 529 college savings plans.

Inside:

• Stable value overview
  What is stable value?
  
  
• Product attributes
  Stable value's unique benefits
  
  
• The stable value/529 fit
  Stable value inside 529 plans
  
  
• The stable value advantage
  Sample risk/return comparisons
  

Introduction

With the emergence of defined contribution retirement plans in the late 1970s, the responsibility for retirement savings began to shift from employers to employees. Over the years since, stable value products have helped attract millions of participants and billions of dollars to these plans by delivering a unique combination of:

• Principal safety;
• High comparative rates of return;
• Liquidity for withdrawals.

That is why stable value products remain a bedrock asset class in most qualified retirement plans today. That is also why they belong in the asset allocation mix of state-sponsored 529 college savings plans.

Parents need the highest return at the lowest risk

For most parents, saving for a child's college education is a financial challenge second only to saving for retirement in terms of the amount of money that needs to be accumulated.

Most people, however, have 30 to 40 years to accumulate enough funds for retirement - adequate time to weather short-term-market volatility in return for long-term growth. For college funding, the time horizon is compressed to only 18 years - if parents start saving when children are born.

This shorter time horizon presents a significant challenge in balancing the need for growth with the need for principal safety as children reach college age. Most states attempt to achieve this balance through age-based allocation models that automatically shift from relatively aggressive to relatively conservative as children grow older. Other states use a portfolio allocation that offers a pre-determined balance between fixed income and equities. Still others allow donors to divide contributions among equity and fixed income portfolios using a fixed allocation percentage.

Stable value offers an attractive means of balancing growth and safety at any stage of a child's life.

Stable value offers an attractive means of balancing growth and safety at any stage of a child's life.

Stable value offers an attractive means of balancing growth and safety that can be used in any of these asset allocation models at any stage of a child's life. Through the unique attributes available only through stable value products, 529 participants can:

• increase returns without increasing risk;
• reduce risk without reducing return;
• lock in investment gains as children reach college age;
• provide book-value liquidity when withdrawals begin.

The purpose of this paper is to provide a greater understanding of what stable value is, how it works, and how it can be applied to help states attract more funds and participants to their 529 plans, while better assisting participants in the achievement of their college savings goals.

What is Stable Value

The term "stable value" generally refers to an investment fund (traditionally within a qualified retirement plan) that protects principal and accumulated interest, and provides penalty-free liquidity for participant-initiated withdrawals. Also, because of the way stable value funds are typically structured, returns are almost always comparable to intermediate bond funds over time.

Stable value can be thought of, essentially, as a "hybrid" asset class, combining the safety, stability and liquidity of cash, with the higher returns available from bond funds.

This unique combination of benefits has made stable value a proven performer in retirement plans for over two decades. Today, stable value funds are fixtures in nearly two-thirds of all defined contribution retirement plans. Within these plans, stable value assets total $250 billion, about 25% of total plan assets¹.

How are stable value benefits delivered?

Traditional GIC guarantees are backed by the issuer's faith and credit.

All stable value funds provide the same essential benefits; however, the funding vehicles, (i.e., the investments within the fund) that deliver these benefits can differ from fund to fund. The most predominant funding vehicles are known as "guaranteed investment contracts" (GICs). The plan sponsoring the stable value fund can purchase and own GICs directly, or invest in a "pooled" stable value fund made up of multiple GICs from multiple providers and managed by a third party.

Two primary types of GICs are available: "traditional" and "synthetic." Both deliver the primary stable value benefits - principal safety, participant liquidity, and bond-like returns - but the way each delivers these benefits is quite different.

Synthetic GIC guarantees are backed by the issuer's faith and credit and the underlying stable value assets.

Traditional GICs are issued by insurance companies and guarantee principal and a fixed or floating-rate of interest for a specified time. Under this structure, the issuer owns the underlying assets and, therefore, the plan sponsor has no control over how those assets are invested. The contract's guarantees are backed solely by the issuer's faith and credit.

In the late 1980s and early 1990s, "synthetic" GIC structures emerged which allowed plan sponsors to retain legal ownership of the underlying assets. Thus, the guarantees are backed by both the issuer's credit and the underlying assets. Synthetic GICs are issued by banks, insurance companies, or other financial institutions.

Under a synthetic structure, the plan holds legal title to the assets backing the stable value fund. The fund may invest in a single asset or, more commonly, in a portfolio of high quality fixed income securities. The assets can be passively or actively managed either in-house by the plan, or by an approved third-party money manager. The fixed income portfolio is then "wrapped" by a contractual agreement from the issuer that provides the following stable value benefits:

• Stable returns through a mechanism that amortizes market gains and losses over the life of the contract and applies a "smoothed" crediting rate to the portfolio. In addition to smoothing the portfolio's return, the crediting rate mechanism also ensures a total pass-through of the portfolio's actual investment performance, enabling the plan to benefit from a potentially higher-yielding investment strategy.
• Principal safety through a "floor" guarantee that ensures the crediting rate will not fall below a pre-determined level.
• Liquidity provisions to fund participant-initiated withdrawals regardless of the underlying value of the portfolio's assets.

From a plan perspective, whether to choose a traditional or synthetic GIC depends on the plan's specific needs and goals. Traditional GICs generally provide the simplest solution; however, synthetic GICs generally offer enhanced diversification and flexibility. Innovative "hybrid" combinations of the two may also be designed.

Product attributes

The stable value product attributes that have helped attract millions of participants and billions of dollars to defined contribution plans can deliver the same performance to 529 college savings plans.

Principal guarantee

The stable value product attributes that have helped attract millions of participants and billions of dollars to defined contribution plans can deliver the same performance to 529 college savings plans.

Stable value is the only qualified plan investment available that provides a contractual guarantee of principal from the issuer. Traditional GIC issuers offer a straightforward general account guarantee - that's why the issuer's credit rating is so important.

Synthetic GIC wrap issuers provide a crediting rate "floor," which ensures the credited rate will not fall below a pre-determined level - typically 0%. The crediting rate floor allows the plan to benefit from market upswings while remaining insulated from dramatic, short-term declines.

Low, cash-like volatility

Traditional GIC providers guarantee a fixed or floating rate of interest for the life of the contract, so there is little or no volatility at all. Synthetic GIC wrap issuers achieve stable returns to the plan through a mechanism that applies a smoothed crediting rate to the portfolio by amortizing market gains and losses over the life of the contract.

The result is a stable return to plan participants, regardless of market fluctuations. At the contract's maturity, the total interest credited to the portfolio equals the portfolio's total investment returns. Thus, the crediting rate mechanism ensures a complete pass-through of actual market performance.

Higher, bond-like returns

Compared to money market funds, stable value maintains the same stability and liquidity while delivering higher bond-like returns.

Stable value consistently outperforms both money market funds and bond funds in return and risk characteristics, respectively. Compared to money market funds, stable value maintains the same stability and liquidity while delivering higher bond-like returns. Compared to bond funds, stable value delivers the same level of returns, while maintaining lower, cash-like volatility.

Liquidity

Compared to bond funds, stable value delivers the same level of returns, while maintaining lower, cash-like volatility.

Stable value delivers principal safety, low volatility, and higher comparative returns while still guaranteeing liquidity for participant-initiated withdrawals without penalty. For traditional GICs, payments are simply funded from the issuer's general account at the time a withdrawal request is received.

For synthetic GICs, payments are generally funded from the underlying portfolio. The wrap provider guarantees that participant-initiated withdrawals will be made at book value (principal + credited interest), regardless of the market value of the underlying securities.

The wrap provider bears the risk that the market value of all the underlying securities may be insufficient to meet the book-value payments at the time a withdrawal request is made. The book value payment guarantee typically applies to performing securities only; defaulted securities are generally excluded from coverage.

The stable value/529 plan fit

Except for a comparatively compressed time horizon, the characteristics of 529 college savings plans closely parallel those of defined contribution retirement plans:

• Both are tax-qualified savings plans.
• Both have a specific, pre-mapped investment horizon to meet.
• Both have similar investment goals in terms of maximizing return and minimizing risk.
• Both tend to employ a relatively aggressive investment allocation to start out, gradually shifting towards a relatively conservative allocation as the fund's beneficiary reaches the "payout" age.

The similarity between the structure and characteristics of each type of plan means that stable value is an exceptionally good fit for college saving plans. In fact, the product benefits that have made stable value such an enduring success in retirement plans can help parents achieve excellent performance in college savings plans:

• Reduce risk and enhance returns from day one
  Since time horizons for college savings are short compared to retirement savings, especially for parents who get a late start in saving, stable value can help make the most of every dollar saved, every day. For example, replacing an allocation in a bond fund with stable value can allow an increased allocation to stocks for enhanced long-term growth potential with no commensurate increase in the portfolio's overall risk.
  
  
• Lock-in investment gains as children reach college age
  Typical 529 allocation models reduce exposure to stocks and increase exposure to bonds and cash as the intended beneficiary ages. This strategy reduces overall risk, but any market gains are still subjected to bond market volatility and/or the insufficient growth of cash funds.
  
  By contrast, increasing allocations to a stable value fund as the child ages locks-in any investment gains through the principal guarantee. Moreover, the higher returns and reduced risk available from stable value helps ensure higher overall growth up to college age.
  
  
• Fund college payments through book value liquidity
  When the fund's beneficiary reaches college age, educational expenses can be funded through stable value's book value liquidity feature, rather than by liquidating other securities. This ensures that the full value of principal and accumulated interest is available when it's needed, and eliminates the possibility of having to liquidate stocks or bonds during a market downturn.
  
  
• Invest without fear of market volatility during payout phase
  Most children will need to pay college expenses for a period of at least four years or longer. During this payout phase, stable value allows remaining funds to continue growing at bond-like returns while cash-like stability and liquidity is maintained. Many SVIA member companies have years of experience in the stable value industry and can help you develop a stable value fund that meets your specific 529 plan needs

Getting started

Because stable value is a proven performer in defined contribution retirement plans, and retirement plan characteristics closely parallel those of 529 plans, the benefits of stable value can be effectively transferred to college savings funds.

In most cases, a traditional GIC can be easily added to current asset allocation models. Alternatively, a synthetic GIC structure can generally be applied to existing fixed income funds, whether they're managed in-house or by a program manager. Either way, it is usually a simple process to provide your college savings plan participants at every stage of life with all the benefits stable value offers.

Many member companies of the Stable Value Investment Association have years of experience in the stable value industry and can help you develop a stable value fund that meets your specific 529 plan needs. Contact us, or visit our website, for more information:

Stable Value Investment Association
2121 K Street, NW Suite
800 Washington, DC 20037
Phone: (202) 261-6530
Fax: (202) 261-6527
www.StableValue.org

For this comparison we used the S&P 500 Index to represent equity, Bond is represented by Lehman Brothers Intermediate Govt/Corp Bond Index, Money Market is represented by iMoneyNet Taxable MMF averages and Stable Value is represented by Hueler Pooled Fund Index.

For this comparison we used the S&P 500 Index to represent equity, Bond is represented by Lehman Brothers Intermediate Govt/Corp Bond Index, Money Market is represented by iMoneyNet Taxable MMF averages and Stable Value is represented by Hueler Pooled Fund Index.

For this comparison we used the S&P 500 Index to represent equity, Bond is represented by Lehman Brothers Intermediate Govt/Corp Bond Index, Money Market is represented by iMoneyNet Taxable MMF averages and Stable Value is represented by Hueler Pooled Fund Index.