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Stable Value, Money Market or Both?
Implications for Plan Sponsors and for the Stable Value Industry

There has been a recent flurry of interest in a 401(k) plan design that offers a Stable Value fund and a money market fund, plus allows direct transfers between the money market and Stable Value funds. The potential of such a design to hurt participants by lowering the returns they earn from Stable Value funds and to threaten plan sponsor acceptance of Stable Value provides the impetus of this article. The article examines the appropriateness for a retirement plan of Stable Value, or money market, or both. We believe:

1. Stable Value alone is a clear first choice.
2. Stable Value and a money market fund with an equity wash is a defensible choice.
3. Stable Value and a money market fund without an equity wash compromises the advantages of Stable Value, poses concern over fiduciary duty and appropriate disclosure, and could imperil sponsor acceptance of Stable Value.

The superiority of Stable Value over money market funds as a generator of retirement wealth is both undeniable and large. According to an analysis performed in 2000:

"Over the last twenty years, the yield on the Stable Value surrogate exceeds the yield on the money market surrogate by 22%, over the last ten years, by 38%. Differences in yield of this magnitude lead to significant differences in retirement accumulations; using the twenty year return numbers, per $100 per month invested, the Stable Value surrogate investment accumulation over a period of twenty years exceeds that for the money market surrogate by $10,513. "

If this analysis were updated for the last two-years, Stable Value's advantage would have increased even more given the significant drop in money market rates.

In terms of the risk and return profiles, we believe Stable Value funds are clearly the superior conservative investment option. Anything the money market fund can do, Stable Value can do better. Participant dissatisfaction over a plan sponsor's selection of a money market fund to the exclusion of Stable Value is distinctly possible. It may also be legitimate to ask whether a plan sponsorchoosing only a money market fund has met ERISA's "prudent expert" fiduciary standards.

Offering both Stable Value and money market funds without any transfer restrictions is a not a good choice. Veterans of Stable Value clearly know that this plan design gives rise to disintermediation risk for participants who stay in the Stable Value fund and to the sellers of the guarantee contracts ("wraps") which make Stable Value possible. While money market funds generate less wealth over time, in certain rare periods of rapidly rising interest rates and/or yield curve inversions, money market funds can offer a transitory return advantage. In such circumstances, participants can move money from the Stable Value fund to a money market with a higher return. This action can have the result of forcing down the future returns of those who remain in the Stable Value fund. Such reduction of Stable Value returns can serve to encourage more transfers until the Stable Value fund implodes and the wrap providers need to absorb the market to book deficit.

Plan design is the first line of defense against disintermediation. The most obvious plan design that avoids this risk is one that offers only a Stable Value fund and no competing option. A second responsible selection is the use of an "equity wash." An equity wash forces participants to expose withdrawals from the Stable Value fund to market risk by keeping the money they withdraw in equity or long-duration bond funds before being able to transfer to the competing fund. The purpose of the wash is to serve as a disincentive to disintermediation. The general increase in welfare to the Stable Value participants in dual choice plans is worth the headache of imposing/explaining the transfer restrictions. Of course, some participants will make the investment decision to use money market instead of Stable Value, perhaps because they don't appreciate its equivalent safety of principal and superior returns. It can be a challenge to clearly explain Stable Value so that these points come through, especially to participants who aren't investment savvy.

Some plan sponsors think that their plan participants should have their cake and eat it too. They insist on a plan design that has both Stable Value and a money market fund and that permits direct transfers (mainly to avoid the need to explain the transfer restrictions). What are the consequences of this decision? A "risky" plan with both options might necessitate a shorter duration Stable Value fund (to minimize book to market differences), or elaborate portfolio and wrap mechanisms that compromise efficient investment management. Forcing shorter durations alone could easily reduce the Stable Value yield advantage by 50%.

Issuers of wrap contracts may also insist on retaining more flexible contract termination provisions for themselves where direct transfers are permitted. A wrap contract that can terminate just when money market yields exceed Stable Value yields will lead to the total disappearance of principal protection in the Stable Value fund, turning the option into a short-term bond fund with potential market losses. This would come as a rude surprise to participants and could certainly subject plan sponsors to an unforeseen liability to make plan participants whole. Such provisions might even call into question the validity of book value accounting, or suggest disclosure to participants of this risk. Finally, even after the increased protection of more restrictive investment guidelines and more expansive exit provisions, the residual risk is still greater and requires a greater risk charge. This further reduces the yield advantage of the Stable Value option by another 10%.

In total, plan sponsors may sacrifice half or more of the total yield advantage of Stable Value over money market funds when they choose to permit direct transfers between Stable Value and a money market fund. In normal yield environments, all participants will suffer from this loss of yield. Over the periods of time appropriate to consider for a program of retirement savings, the differences in wealth accumulation are meaningful: 2.5% in lost earnings potential over 20 years at typical interest rates. The sole potential beneficiaries of this yield give-up are participants who react quickly to interest rate changes to get slightly higher money market yields, and this will come at the further expense of participants who are slow to move. Even for these fast moving participants, it is likely to be a bad long run trade off.

Conclusions

• Given the clear superiority of Stable Value, we believe all plans should have Stable Value funds instead of money market funds.
• Having just money market funds will substantially reduce the wealth of all participants who seek out the conservative option.
• Offering both with an equity wash is ok.
• Having both without an equity wash will substantially dilute or even eliminate the advantages of Stable Value, may raise questions about book value accounting, and create disclosure and fiduciary duty issues; it hurts all participants on average and may even create financial exposure for the plan sponsor.

A central problem for the industry with dual choice plans without washes is that it could put the very existence of Stable Value funds at risk. Imagine if many plan sponsors began insisting on direct transfers to competing funds, and managers agreed to manage portfolios and wraps in that context. Stable Value return advantages may evaporate, participants will get hurt, financial risks may force issuers out of the business, plan sponsors may experience legal risks, and Stable Value funds may disappear. It is sometimes hard to take the long view when it means foregoing a short-term gain. And it is sometimes easier to be complicit in bad plan design. But that doesn't make it right, or wise.

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