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Stable Value Funds: A Vehicle for 401(k) Diversification

Creating retirement security for the public has challenged Washington policymakers, plan sponsors and service providers. The retirement savings community is tasked to increase coverage, savings, and provide the tools necessary to plan participants to enable them to save and plan for their retirement financial security. The community has met these challenges head on. However, the final test of the retirement savings community’s work will come when the babyboomers’ retire and the question that we are trying to met will be answered, "Can they afford to retire?"

State of Play for the Voluntary Retirement

According to recent Department of Labor numbers, employer-provided pensions now cover 65 million active employees or 63% of the workforce. This coverage is increasingly fueled by the growth of defined contribution plans. The Department of Labor’s 1994 Annual Form 5500 Reports found a 9% increase in the number of active participants covered by defined contribution plans to 25.2 million, with a 13% rise in the number of 401(k) type plans to 175,000.

Importantly, the Department of Labor release demonstrates that the employer-provided pension system is working and working very well for those in the system. For 1994, benefit payments were $163.9 billion with the amount almost evenly split between defined benefit plan and defined contribution plan payments (respectively, $82.6 billion and $81.3 billion).

Although total contributions to all pension plans declined by 6% from $153.6 billion in 1993 to $144.4 billion in 1994, defined contribution plan contributions actually rose by 4% to $105.3 billion. Further, in 1994 total contributions in defined contribution plans made by plan participants were almost equal to employer matching contributions.

With the report’s preponderance of information, it is easy to gloss over one surprising fact: "plans with over 100 or more participants’ aggregate rate of return in 1994 was 2.9%." This is the lowest rate of return over the 10-year life of the statistic. The 2.9% return was well below the report’s 10.3% average rate of return for the ten-year period, 1985-94. When 401(k) returns are separated out, the total aggregate rate of return for defined contribution plans was shown as 3.8% for 1994 and 10% for the ten-year period.

Preparing Individuals for Market Realities

1994’s investment/return experience may or may not reoccur. However, it illustrates that our challenge is not just encouraging participation and increasing contribution rates, its teaching and preparing individuals for the realities of the financial market that may include less than double digit rates of returns and even the possibility of negative returns in some asset classes. For plan sponsors and participants, this may well mean rediscovering the stable value funds that are currently offered in two-thirds of all defined contribution plans and comprise roughly $250 billion in assets.

Stable value funds, which invest in conservative fixed income investments, offer investors certainty by providing predictable returns that average one and a half to two percentage points above money market funds. Returns for stable value funds currently average six and a half percent, which is comparable to intermediate corporate bond funds minus the market risk. Since they do not have market risk, stable value funds preserve both investment principal and accumulated interest earnings.

The certainty that stable value provides make them an excellent choice for anyone who wants to protect assets and optimize their retirement savings portfolio. Stable value funds permit an individual to direct more money into riskier and higher earning investments such as equities, and achieve higher longer-term returns without increasing risk. Conversely, stable value funds can be used to reduce risk without sacrificing return. The pie charts (attached) demonstrate how stable value can be used by an individual to optimize risk and return to achieve his or her investment goals.

Diversification, A Necessity

It is stable value’s ability to be a vehicle for diversification that will spur its rediscovery. The EBRI/ICI Participant-Directed Retirement Plan Data Collection Project, which provides 1996 information on 6.6 million active participants with $245 billion in assets shows how. The data demonstrates not only the role stable value can play in retirement savings but how plan participants have applied the concept of diversification across broad age spectrums.

Asset Allocation, By Age

Source: Tabulations from EBRI/ICI Participant-Directed Retirement Plan Data Collection Project

Market realities and a retirement system that has shifted to more individual self-reliance will continue to test the retirement savings community’s ability to prepare individuals to plan their retirement income needs. 401(k) participants’ understanding and use of the concept of diversification is fundamental to ensuring individuals have the ability to adequately plan and save to meet their retirement income needs. Asset allocation models may become the new vehicles for giving 401(k) participants the information and the tools to make these important choices that will affect participants’ income at retirement.

Giving Participants Information to Make Appropriate Choices

In May of 1996, the Department of Labor provided guidance that distinguished information from advice in Interpretive Bulletin 96-1. Briefly, the bulletin says the use of asset allocation models will not be considered recommendations or advice if the models:

• Are based on generally accepted investment theories that take into account the historic returns of different asset class over time.
• Provide all material facts and assumptions used in the model.
• Provide a statement that other alternatives having similar risk and return characteristics are available and where information can be obtained if any specific investment alternative available under the plan is identified.
• Provide a statement that in using the model, participants should consider their total financial resources including assets outside of the 401(k) plan.

Challenges for Stable Value to Be Part of Participants’ Package

Stable value looks like a natural for asset allocation models. However, the very characteristic that makes stable value funds advantageous and distinct from other fixed income options such as money market funds and bond funds ¾ the certainty of principal and accumulated earnings or benefit responsiveness ¾ may serve as a hurdle for some to incorporating stable value funds into models.

Hueler Company reports that stable value can offer participants 1.5%-2% higher annualized return than money market funds and over a five year period ending 12/31/98, have comparable returns of an intermediate bond fund with 45 times less volatility. On a cost basis 401(k) stable value funds provide a competitive, lower cost option, with costs averaging between 10 to 30 basis points depending on the specific type of stable value fund.

Yet, as data from Hueler Company illustrates, stable value’s features make it too important an asset class to simply leave out. The challenge for plan sponsors, stable value issuers, wrappers and managers, is getting the unique characteristics of stable value and acceptance of stable value as an asset class distinct from bond and money market funds widely recognized in asset allocation models and other 401(k) informational material.

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