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What is a stable value fund?
Stable value funds are capital preservation investment options available in 401(k) plans and other types of savings plans.
They are invested in a high quality, diversified fixed income portfolio that are protected against interest rate
volatility by contracts from banks and insurance companies. Stable value funds are designed to preserve capital while providing steady, positive returns. Stable value funds are considered a conservative and low risk investment compared to other investments offered in 401(k) plans.
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How widely used are stable value funds?
Stable value funds are offered in approximately half of all 401(k) plans and some 529 tuition
savings plans. Individuals have invested $520 billion in stable value funds through 138,000
defined contribution plans, which include 457, 403(b) and 401(k) plans. Stable value funds
are one of the most widely used investments by 401(k) investors. Investors on average
allocate roughly 15 to 20 percent of their 401(k) assets to stable value funds.
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How are stable value funds structured?
Stable value funds are structured in two ways: as a separately managed account, which is a
stable value fund managed for one specific 401(k) plan; or as a commingled fund, which pools
together assets from many 401(k) plans. Commingled funds offer the benefits of diversification
and economies of scale for smaller plans.
Regardless of how stable value funds are structured, they are comprised of a diversified portfolio
of fixed income securities that are insulated from interest rate movements by contracts from banks and
insurance companies. The protection from interest rate volatility is universal to stable value funds.
How this contract protection is delivered depends on the type of stable value fund investment purchased.
The contract protection against interest rate volatility is provided through the following investment instruments:
- A Guaranteed Interest Contract (GIC) is a contract with an insurance company that provides
principal preservation and a specified rate of return over a set period of time, regardless of the performance of the
underlying invested assets. The invested assets are owned by the insurance company and held within the insurer's
general account.
- A separate account contract is an account held by an insurance company that holds a
combination of fixed income securities and provides principal preservation and a specified rate of return over
a set period of time. Separate accounts may provide either a fixed rate of return or a periodic rate of
return based on the performance of the underlying assets. The assets are owned by the insurance
company and are set aside in a separate account solely for the benefit of the specific contract holder.
- A synthetic GIC is a diversified portfolio of fixed income securities that are insulated
from interest rate volatility by contracts (wraps) from banks and insurance companies. In this arrangement,
the 401(k) plan and its participants own the underlying invested assets-the portfolio of fixed income securities that
support the stable value fund.
The typical stable value fund will diversify contract protection by investing in more than one instrument type
and/or with more than one insurance company or bank.
What do I need to know about stable value funds?
The investment objective of stable value funds is to provide capital preservation and predictable steady,
returns. During 2008, stable value funds were one of the few 401(k) investments that produced a positive
return. Stable value fund returns generally ranged between 3 to 5 percent for 2008.
Stable value funds are comprised of a diversified portfolio of fixed income securities that are insulated
from interest rate movements by contracts from banks and insurance companies. The protection from interest
rate volatility is universal and unique to stable value funds.
- What does protection against interest rate volatility mean?
The market value of all fixed income investments, including the underlying assets in a stable value fund,
is volatile by nature. That is, the market value of the assets moves inversely with interest rate changes.
As interest rates move up, the market value of the assets declines, and vice-versa. This volatility
is not unusual.
Unlike other 401(k) investments, however, all stable value funds have protection against interest rate swings
via the protections in insurance company and bank contracts. This means that investors in a stable value
fund are able to transact (make deposits, withdraws, transfers) at book or contract value, which is principal
plus accrued interest. If the market value of the stable value fund's underlying assets is insufficient
to honor benefits for covered withdrawals at book value, then the contractual protections kick in to ensure
that participants continue to transact at contract value. Contract value, or book value, is the value of all
the assets supporting the stable value fund plus the contractual protection against interest rate
volatility.
- Are there instances when book value or contract value does not apply?
There are a few, limited instances when participants do not get book value from a stable value fund.
These limited instances are typically contractually defined. One such instance typically not covered is security
defaults or downgrades. In order to protect the integrity of the stable value fund, most contracts incorporate
investment guidelines establishing minimum credit quality requirements for the underlying securities. These
contracts have established mechanisms to address downgraded or defaulted securities that fall outside the contractual
guidelines.
Corporate-initiated events, which are employer-driven events such as an early retirement program, layoff,
or bankruptcy, are also typically not covered. Corporate-initiated events generally cause withdrawals
in masse from a stable value fund. These withdrawals can negatively impact investors and plans that
choose to remain in the fund. Additionally, the cost for insurance against such events would be prohibitive.
To treat stable value fund investors equitably and to maintain reasonable costs, employer-initiated events
are not covered in most contracts. However, because these events are typically known in advance, the 401(k)
plan sponsor and the stable value fund generally have time to negotiate coverage of these events so that all
participants continue to transact at book value.
This did not occur in the Lehman Brothers bankruptcy due to a combination of extenuating factors: the
financial markets had undergone a historic adjustment, the scale of the Lehman Brothers' bankruptcy (it is the
largest bankruptcy ever), the speed at which the bankruptcy proceeded, and the veracity of the bankruptcy-half
of Lehman Brothers' workforce lost their jobs immediately. The immediacy of the bankruptcy did not give
the stable value fund time to work out protections to keep the stable value returns positive. Consequently,
Lehman Brothers stable value fund investors had a negative return of 1.7 percent in December and an annual return
for 2008 of 2 percent.
- What happens in bankruptcy to a stable value fund?
There are several ways a stable value fund may be affected by bankruptcy. The 401(k) sponsor or
employer may go into bankruptcy. As stated above, bankruptcy is typically considered a corporate or
employer-initiated event and may not be covered by a stable value fund. However, because there is a
process for bankruptcy, the 401(k) sponsor and the stable value fund generally have time to negotiate coverage
during the bankruptcy so that all participants continue to transact at book value.
A stable value fund may also be impacted by bankruptcy if an issuer of a stable value fund investment becomes
insolvent. In the event of an insurance company insolvency, a general account GIC contract holder would
have claim at the policyholder level, in front of the insurer's general creditors. For a separate account
contract, the separate account assets are used solely to satisfy the claims of the contractholder. Any
shortfall would be subject to claim against the insurer's general account, alongside policyholders and ahead
of general creditors.
If an issuer of a contract that wraps or covers a fixed income portfolio (synthetic GIC) became insolvent,
it is important to remember that the bulk of the assets-the portfolio of fixed income securities that support
the stable value fund-are already owned by the 401(k) plan and its participants. In the event of any
ultimate claim against the issuer for failure to meet any financial obligation under the contract, such claim
would be settled during the normal bankruptcy process.
Insolvencies among stable value issuers have been rare. When this did occur in the late 1980's, participants
were made whole. The assets affected by the failure of three issuers -- Executive Life, Confederated Life and
Mutual Benefit-represented less than one percent of stable value assets.
- Are there waiting periods and other restrictions that affect withdrawals from stable value funds?
Stable value funds do not have waiting periods or surrender charges for participants. In fact, the accounting
rules for stable value funds do not permit these types of restrictions on participant-driven transactions.
Most stable value funds have equity wash provisions that restrict transfers from stable value funds directly to
competing funds. Competing funds are typically money market funds or short-duration bond funds. The
restriction requires transfers from stable value to sit in an equity fund for a set period of time, usually 90
days before the transfer is invested in a competing fund. Equity wash requirements serve to minimize arbitrage,
which negatively impacts investors who choose to remain in the stable value fund.
In cases where a plan sponsor wishes to terminate its participation in a commingled stable value fund, a 12-month
put or waiting period may be imposed to protect remaining investors by ensuring an orderly liquidation of the departing
fund's proportionate share of the stable value fund's underlying assets. However, plan participants continue to
transact at book/contract value.
Given its fixed rate nature, GIC contracts may impose a surrender charge if the stable value fund elects to terminate
the contract prior to its stated maturity date.
- How have stable value funds been affected by recent market turmoil?
Like other 401(k) investment options, stable value funds are not immune to current market stresses as demonstrated
by lower market value to book value ratios and thus lower returns than previous years. However, because stable
value funds are supported by well-diversified portfolios of high credit quality fixed income securities that have
protections against interest rate volatility, they have been one of the few 401(k) investment options to provide
positive returns even throughout this historic market upheaval.
- Have stable value funds been affected by defaulted securities?
Despite extreme pressure on fixed income securities, most fixed income securities are currently performing-making
principal and interest payments. While losses due to defaults may occur in the future, risk of loss is mitigated
by stable value funds' guidelines to hold high quality, well-diversified fixed income securities.
- Have stable value funds been affected by credit downgrades?
Stable value funds may be affected by credit downgrades of contract issuers and/or the underlying securities
in a stable value portfolio of assets. That is why most stable value funds have strict investment guidelines
that set overall standards for all securities held by a stable value fund. Investment guidelines require
stable value portfolios to maintain a specific, overall, high credit quality standard and to be highly diversified.
Further, assets that are downgraded below the minimum credit quality guideline are generally limited to a
specific percentage, usually no more than five percent of the portfolio. Such assets that exceed the
specified threshold must be rehabilitated -either sold and replaced with high credit quality securities or
enhanced to restore credit quality-within a set period of time.
How are stable value funds regulated?
Stable value funds have multiple layers of government oversight. The vast majority of funds are
regulated by the Department of Labor's Employee Benefits Security Administration and must comply with the
federal pension law, Employee Retirement Security Act (ERISA). Stable value funds in defined
contribution plans for state and local governments-457 plans-are regulated by the states, which have adopted
requirements similar to ERISA.
In addition to the Department of Labor, stable value investment structures provided and/or managed by:
- banks are regulated by the Office of the Comptroller of Currency,
- insurance companies are regulated by the various state insurance departments, and
- commingled investment funds are regulated by the Securities and Exchange Commission under the Investment Company Act.
All stable value funds must comply with accounting regulations by the Financial Accounting Standards Board (FASB)
(for corporate defined contribution plans) or the Governmental Accounting Standards Board (GASB) (for state and
local defined contribution plans) to qualify for contract value accounting and reporting. Generally, FASB
and GASB require that a stable value fund must meet all of the following criteria:
- the contract is effected directly between the fund and issuer and prohibits the sale or assignment of the contract or
its proceeds to another party without the consent of the issuer;
- the repayment of principal and interest credited to participants in the fund is a financial obligation of the issuer
of the contract. Prospective interest-crediting rate adjustments are permitted as long as they are not less than zero, and
the contract issuer must be a financially sound institution;
- the terms of the contract require all permitted participant-initiated transactions with the fund to occur at contract
value;
- an event that limits the ability of the fund to transact at contract value with the issuer and limits the ability of
the fund to transact at contract value with participants in the fund must not be probable of occurring;
- the fund itself must allow participants reasonable access to their funds.
All investments have risks associated with them. Stable value funds are considered one of the lowest risk
investments offered in 401(k) plans. They have return stability similar to a money market fund but generate
higher returns. Because of their low risk and stable, consistent returns they can help diversify 401(k) asset
allocation. As an investor, you should evaluate your risk tolerance to make sure you are comfortable with the
level of risk in your stable value fund and other 401(k) investments.
