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The Great Debate: Do Advice Providers "Get" Stable Value?

Modeling stable value funds in defined contribution plans is a bit like classifying a platypus: the latter may have a beak, webbed feet and the ability to lay eggs, but it's no duck. Just the same, a stable value fund may invest principally in fixed-income securities and generate returns similar to those of a short-term bond fund, but it isn't a bond fund. And while a stable value fund guarantees the book value of an investor's principal and so enjoys low volatility patterns akin to those of a money market fund, it isn't a money market fund, either.

This is a problem, both for the growing number of companies now providing online investment advice to participants in 401(k) plans, and the plan sponsors, plan providers and plan participants who rely upon that advice. If stable value funds aren't properly modeled, the argument goes, investors could be given inaccurate advice on whether to hold stable value funds in their defined contribution plans, and to what extent.

All this raises the question of whether plan providers or plan sponsors might one day be held liable for giving bad advice. (See "Investment Advice: The Liability Issue.") It also presents contractual headaches for stable value managers whose wrap providers—the insurance companies who guarantee the book value of stable value funds—consider the introduction of investment advice a plan change that could, in the extreme, invalidate the wrap contract. (See "Adding Investment Advice: What it Means to Wrappers.")

"Too often, stable value is just not clearly identified in this these advice models," said Steve LeLaurin, senior account manager with PRIMCO Capital Management, addressing the 2000 National Forum of the Stable Value Investment Association in Washington, D.C. "Either they classify them as money market funds, which gets the volatility right but not the returns, or they classify them as bond funds, which gets the returns right but not the volatility."

Michael Melcher, investment manager for Hallmark Cards, said the confusion extends to the user community. For the past year, his firm has used Financial Engines to provide online investment advice to participants in its 401(k) plan. Financial Engines' modeling techniques assume that stable value funds behave much like short-term bond funds over long periods of time.

This problem is especially clear at Hallmark, Melcher noted, because in his company's 401(k) plan the stable value fund is exactly the same as the bond fund, but with the addition of a book value contract, or wrapper, to guarantee participant withdrawals at book value.

"I think it is confusing for our participants to look at charts (generated by Financial Engines) of the bond fund in our plan and the stable value fund and see no difference," Melcher complained. "I'm not sure it's clear to them, for example, that they could modestly increase their returns by using the bond fund rather than the stable value fund in exchange for accepting more risk. Or that they could decrease their risk exposure without sacrificing much in the way of returns by using the stable value fund in lieu of the bond fund."

"Admittedly, the expected return for the bond fund isn't dramatically higher than it would be for the stable value fund, but it would be modestly higher over time because it doesn't have the wrap fees," Melcher explained. In exchange for this small reduction in long term expected return, the stable value fund protects participants from substantial short-term volatility (including the potential for negative returns).

Stable value professionals also complain when advice models project that stable value funds could produce negative returns; that, they say, seems to ignore their key attribute: the guarantee that investors can always redeem their shares at book value. The problem appears to lie in the fact that the advice models project returns on a real, or inflation-adjusted, basis. In periods of very high inflation, insisted Scott Lummer, chief investment officer of advice provider mPower, stable value funds could produce negative real returns.

Lummer and Christopher Jones, vice president of financial research and strategy for the online advice firm Financial Engines, spent much of their time at the SVIA's National Forum trying to reassure industry participants that their advice models do fairly represent stable value products. Though neither advice service defines stable value as a distinct asset class, they said, they do model stable value funds on an individual basis, taking into account the type of assets they hold, their plan provisions and the terms of their wrap contracts.

"Our return calculations reflect the value of the underlying assets and they do account for the economic value of the cost of the wrap contract," Jones said. "However, those contracts actually turn out to be of little economic value because they are so seldom tapped." Lummer concurred, noting as evidence that the cost of a wrap contract is typically as little as 5 to 10 basis points.

To the charge that advice services focus only on terminal wealth distributions rather than the volatility of the returns logged en route, Jones argued that most 401(k) investors have long investment horizons and that return distinctions between stable value funds and bond funds are typically not material beyond five years.

"I think we are objective," Jones said. "We have no ax to grind in terms of favoring or not favoring stable value, and therefore I feel we are not, nor are most of our competitors, a threat to the stable value industry."

Lummer added that the early experience of plans which make investment advice available to their participants support the notion that advice services don't short-change stable value products. In reviewing the 401(k) plans for which his company was providing participant investment advice in July 2000, he said, he found 33 plans that had both stable value funds and a competing option, such as a short-term bond fund or a money market fund. mPower's recommended allocations to stable value funds in that group were much higher than its recommendation to the competing options, he said. Specifically, he said, mPower's recommended allocation to stable value funds ranged from 65% to 90% of the total fixed- income allocation, with the mean allocation 80% and the median allocation 83%.

Lummer said he also analyzed one of the plans for which mPower has been providing investment since October 1998 and found that in the ensuing two years participant allocation to stable value funds had changed little, despite the introduction of the advice service and despite some big changes in short-term interest rates during that period of time.

In separate breakout sessions with forum attendees who wished to pursue the issue in more detail, both Jones and Lummer continued to defend their treatment of stable value funds in their asset allocation models. There was little evidence, though, that they succeeded in changing the minds of the people attending the National Forum.

"They're flawed models," concluded LeLaurin. "They emphasize terminal wealth distributions while ignoring the path of returns, and they suggest that negative stable value returns are a possibility. They ignore the realities of stable value in general." According to John Hancock's Wayne Gates who serves as the head of the Asset Allocation Task Force, "there is still more to be done." For additional information contact Wayne or visit www.StableValue.org for more information on the Task Force's work.

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