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Probing the Boundaries: Assessing Alternate Markets for Stable Value

Some people think it's time for the stable value industry to move beyond the 401(k) comfort zone.

To be sure, nobody is complaining about the 401(k) market; it is home to the vast majority of the approximately half trillion dollars that investors have entrusted to stable value managers. It's just that there are numerous other markets in which investors could potentially benefit from the unique value proposition-bond-like returns paired with the low volatility of a money market fund-that stable value investments offer. Aruna Hobbs, head of Aegon Institutional Markets' Pension & Savings Group, told attendees at the Stable Value Investment Association's 2006 Spring Seminar that potential avenues of expansion for the stable value industry include other defined contribution plans similar to 401(k)s. These include 403(b) retirement savings plans that cater to employees of educational institutions and certain non-profit organizations, the newly introduced Roth 401(k) plans that made their debut this year, multi-employer Taft-Hartley retirement savings plans operated for union workers, 401(a) plans funded solely by employee contributions on an after-tax basis, and even, perhaps, defined contribution retirement savings plans outside the United States. In addition, Hobbs said, the stable value industry should consider opportunities to serve participants in Health Savings Accounts (HSAs), which are a fairly new wrinkle in the health benefits arena, and in lifecycle funds outside the mutual fund market.

403(b) Plans
Kappie Bogart, Director of Stable Value Accounts for Aegon, said 403(b) plans are a $600 billion market that is growing at 9 percent annually. Stable value investments account for only about $29 billion, or just under 5 percent, of those assets, according to the Ninth Annual SVIA Investment and Policy Survey. However, 80 percent of 403(b) assets are invested in annuities, many of which have attributes similar to stable value. The leading 403(b) provider, TIAA-CREF, has over $155 billion in annuities that have some characteristics in common with stable value.

The small current market share for stable value funds can be attributed at least in part to interpretations of Internal Revenue Service rules that appear to prohibit 403(b) plans from investing in annuity contracts while allowing investment in commingled funds. Some industry executives believe stable value could be made more accessible to 403(b) plans.

As Joseph Chadwick of The Chadwick Group Inc. reported last year in the Stable Times, the State of Georgia won a private letter ruling from the IRS in 2002 that allowed the state to offer a stable value fund in its 403(b) plan. It had already been using stable value in two other retirement savings plans it sponsored, one a 401(k) and the other a 457 plan. (A 457 plan is similar to a 401(k) but is generally offered by state and local governments rather than corporations. Private companies can offer them, too, but only to a select group of highly compensated or executive-level employees.) After convincing GIC and wrapper issuers to agree to new underwriting conditions, finding a willing custodian, and attending to some accounting mechanics, Georgia finally began offering the stable value fund to its 403(b) plan participants in 2004.

While the IRS private letter ruling is binding only on the plan sponsor who received it, it suggests that other plan sponsors willing to embark on the same course of action might be able to offer commingled stable value funds in their 403(b) plans. Bogart identified AIG, Fidelity Investments, and ING as major players in the 403(b) marketplace, although TIAA-CREF is by far the dominant participant, with about half of the university market.

Apart from the prohibition against commingled funds, stable value managers would confront other challenges in moving into the 403(b) market, Bogart warned. For example, they would be faced with a system in which the plan itself is actually a contract between the participant and the vendor, not between the employer and the vendor. Under IRS Revenue Rule 90-24, participants can generally transfer their plan assets from one provider to another with no tax ramifications, possibly raising cash flow issues for stable value managers. Also, stable value funds sold in the 403(b) market would need to comply with SEC Rule 151, also known as the "safe harbor" rule, which among other things requires that crediting rates be reset no more than once per year and that funds have a minimum floor rate. A few religious organizations' 403(b)(9) plans have claimed exemption from SEC rule 151 and added stable value portfolios to their investment lineup.

Bogart said the IRS announced in 2004 that it was going to change many 403(b) rules to make the plans function more like their 401(k) cousins, but backlash from plan providers stalled the initiative. Nonetheless, she said, the IRS remains committed to making changes. It is possible the IRS could announce the rules this year. If so, many of the hurdles to offering stable value funds in 403(b) plans could disappear.

401(k) Plans with Roth feature
Roth 401(k) plans function much like traditional 401(k) plans, although employee contributions are made on a post-tax, rather than pre-tax, basis. In exchange, distributions from a Roth 401(k) are tax free, whereas distributions from a regular 401(k) are taxed as ordinary income.

There are no major barriers to offering stable value funds in Roth 401(k)s; indeed, most plan sponsors who adopt them are expected to offer the same investment lineup they make available in their existing 401(k) plan. Doris Fritz, Vice President in Fidelity Investment's FIRSCo Investment Consulting Services group, explained that one of the reasons employers have been slow to offer the Roth feature is because the enabling legislation, the Economic Growth and Tax Relief Reconciliation Act, sunsets in 2010. There's no assurance Congress will extend its provisions. If it doesn't, most industry observes guess that existing Roth 401(k) s will be grandfathered, but probably won't be permitted to take any new contributions.

Beyond that uncertainty, choosing between pre-tax and post-tax contributions essentially forces investors to project whether their tax rate will be higher or lower in retirement than in their working years. This may keep some participants from participating in the new Roth accounts.

HSAs
One of the more intriguing potential markets for the stable value industry is the health care market. Health Savings Accounts were created by the Medicare Modernization Act of 2003. HSAs are available to individuals who have a high-deductible health plan-one with a minimum annual deductible of $1,050 for an individual, or $2,100 for a family-and who do not have access to Medicare or another health plan. HSAs are ostensibly a tool for saving pre-tax income to fund later medical expenses. Some benefits experts predict that many people will use them as another tax-advantaged savings account. Unused balances in HSAs aren't forfeited, but roll over from year to year. And in addition to paying for qualified medical expenses, assets in an HSA can be used to pay for long-term care premiums.

Mike Norman, a principal with Galliard Capital Management Inc., told attendees at the SVIA Spring Seminar that about 29 percent of large employers plan to start offering high-deductible health plans, or HDHPs, this year. On average, he said, the plans cost employers about 18 percent less than a PPO (preferred provider organization) and 13 percent less than an HMO (health maintenance organization).

While most HSAs to date have offered only limited investment options, such as low-yielding money-market funds and passbook accounts, providers are beginning to introduce others. "Less than 5 percent of U.S. consumers have an HSA now," Norman said, "so the market has huge growth potential. It is estimated that in the next five years, more than six million users will have more than $79 billion in these accounts."

Like most potential new markets, however, the HSA market presents challenges for stable value managers. Because they aren't considered qualified plans under tax law, the book-value accounting treatment used by stable value funds could be problematic. Also, under current law, individual participants can only contribute $2,700 per year to an HSA, and families only $5,450. This means that account balances could be small, at least in the early years. Finally, because HSAs are relatively new, there is little historical data available to predict how investor behavior might impact cash flows and asset allocation decisions within the accounts.

Despite the obvious hurdles, stable value executives say it's important for the industry to explore new market opportunities like these. "While we primarily think about the defined contribution plan marketplace as being about 401(k) plans, its scope is actually quite broad," said Hobbs. "As an industry, it is important that we keep abreast of developments in these other arenas."

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