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Auto-Balanced Fund Options: An Opportunity for Stable Value?

The global migration from defined benefit pension structures to defined contribution retirement savings programs has been largely successful in transferring the liability of benefits and investment risk from the employer to individual plan participants. Yet, many participants who are now assuming the market risk on their retirement investments are either unprepared for managing this risk or have no desire to do so. For these participants, a growing number of plan sponsors are offering an option aimed at alleviating the burden of portfolio management altogether: auto-balanced funds.

Auto-balanced funds (which may also be described as Life Cycle, Life Style, Balanced, etc.) provide participants with a pre-selected mix of asset classes based on a general profile of investor needs, e.g., risk tolerance, lifestyle, investment horizon, etc. These types of fund options will either automatically maintain the given risk-return ratio or become increasingly conservative as the account holder/beneficiary ages. Since the funds automatically rebalance based on pre-determined criteria, participants are relieved of the need to make individual buy/sell decisions.

Auto-balanced options have quickly gained significant traction in the defined contribution markets. Balances as of November 2005 are estimated to exceed $180 billion, with as much as 30 percent of defined contribution participants at least partially invested in this type of option. Additionally, auto-balanced options dominate some participant-directed markets, such as 529 college savings plans, where over 65 percent of all investments reside in age-based allocation options. The increasing popularity of these options is an example of a participant's aversion to asset management.

Critics of auto-balanced funds point out that, because these funds are rebalanced automatically in order to maintain the pre-defined allocation mix, it is possible that shares from a profitable asset class are rebalanced to an underperforming asset class. Other observers have noted that, by offering a "one stop" fund option, plan sponsors may be implying that they have a certain level of fiduciary responsibility regarding the performance of these investments. Additional criticism for use within 401(k)s is that they are often used improperly (i.e., people use the lifestyle funds along with a whole bunch of other options, thereby defeating the purpose). Also, these options usually add another layer of fees on top of the underlying investment expenses.

Despite these concerns, there is every reason to believe that the popularity of auto-balanced funds will continue to grow, which makes them an attractive opportunity for stable value. The size of this opportunity can be estimated by looking at the current utilization of conservative asset classes with risk-return characteristics comparable to stable value, including money market funds and short to intermediate bond funds. Historically, stable value products have been a superior alternative to these conservative asset classes. Of the $180 billion invested in auto-balance funds in the defined contribution market, 15-20 percent, or approximately $30 billion, may be invested in allocations suitable for stable value.

Further, the unique characteristics of stable value make it ideally suited to the structure of auto-balanced funds. Conservative investment options are typically utilized in a significant capacity only toward the end of the accumulation cycle. Stable value's principal protection feature automatically locks in gains as assets are shifted to a more conservative position, and the book value liquidity feature can continue to provide growth and protection as the distribution phase begins.

Several challenges must be addressed if stable value providers are to gain entry into the auto-balanced fund segment. For example, stable value products are not registered, and published third-party due diligence or performance measures may therefore not be readily available to plan sponsors and/or participants. In addition, these funds are typically comprised of a collection of various mutual funds. The mutual fund format allows the manager to register the auto-balance fund and attract funding from various markets. Another important deterrent to including stable value in auto-balanced accounts is reliance upon optimization models to construct auto-balancing accounts. These models, as with most performance models, do not accurately capture the risk versus return characteristic of stable value and generally either underestimate the returns or overstate the volatility of stable value funds.

Although problematic, these issues are not insurmountable if plan sponsors, fund providers, and stable value providers work together to find appropriate solutions but therein lies perhaps the biggest obstacle for stable value. The vast majority of auto-balanced fund options are available only through full service providers, simply because these firms have the greatest administrative resources necessary to manage these funds. Full service providers can also offer the underlying funds (in mutual fund format) within auto-balanced options. For this reason, they are simply not motivated to utilize any third-party funds, including stable value products.

In order to gain any significant funding from the auto-balancing segment, stable value providers must penetrate the full service providers and encourage the utilization of these products among non-full service providers.

The only remaining issue is the suitability of stable value within the auto-balancing products from the provider's perspective. Stable value providers should gain comfort from the fact that, at least in theory, auto-balanced funds should be less volatile than static stable value funds, since the raison d'etre of auto-balance funds is to make participant transfers and market timing unnecessary.

In addition, to the extent that there are interim transfers and withdrawals from a stable value account in an auto-balanced option, the movements should work inversely to those in a static stable value fund. Traditionally, stable value funds see heavy outflows after significant gains in the equity markets and heavy inflows following downturns in the market. Sitting alongside equity in auto-balanced options, however, stable value should see inflows to rebalance after large equity gains and outflows to rebalance following equity declines.

Despite the challenges stable value providers face in the auto-balanced segment, this market represents an attractive opportunity. Stable value has been proven to provide superior returns and lower volatility compared to the money market funds and bond funds. Therefore, utilizing stable value products to anchor the conservative allocation in auto-balanced fund options will enhance their overall performance and lower the relative volatility.

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