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Differing Views on Defined Benefit Plans Use of Stable Value

With the fixed-income markets suddenly in a funk, and a three-year rout of the equity markets still fresh in the public's mind, it's not surprising that Stable Value funds have reaped a flood of new money in recent years from 401(k) plan investors anxious to inject some stability into their retirement portfolios. Stable Value funds are starting to attract renewed attention from some defined benefit plans. The defined benefit plan sector of the pension market has generally avoided Stable Value investing over the past decade.

It is, to be sure, far too early to call this anything like a trend. John Lee, an Associate with investment consulting firm Ennis Knupp & Associates in Chicago, says that while his company has seen interest in Stable Value investing from some of the defined benefit plans it counsels, he is not aware of any of them actually making an allocation to Stable Value. "There has been an uptick in inquiries," concurs Peter Bowles, President of Fiduciary Capital Management, a Stable Value manager headquartered in Woodbury, Connecticut. "But as yet that hasn't materialized into cash flow."

Where defined benefit plans are sniffing around the Stable Value marketplace, Lee says, it appears to be a direct consequence of the recent volatility in the bond market and the low yields being generated by money market funds. Stable Value funds generally invest in intermediate-term bonds, of course, wrapped by an insurance or bank contract that promises investors they can cash out at any time, with certain restrictions, at book value. Thanks to this unique accounting treatment, Stable Value funds provide bond-like returns without the volatility of bonds and the safety and liquidity of money market funds.

If pension plan sponsors have been slow to make the leap from tire-kicker to buyer, it may simply reflect the division that exists within the Stable Value community itself about whether its products are appropriate for defined benefit plans. The debate revolves around accounting rules that make it difficult for those plans to take advantage of the unique book value accounting treatment accorded to Stable Value products, and the potentially negative impact that defined benefit plans could have on other Stable Value investors if those plans began jumping in and out of Stable Value funds in an opportunistic search for yield.

The Accounting Condundrum

Prior to changes in accounting rules in 1992, it was common for defined benefit plans to invest in Stable Value products. As recently as the fourth quarter of 1990, such plans accounted for 19 percent of the assets held by Stable Value funds in the Hueler Analytics Pooled Fund Universe. Bowles says pension managers used Stable Value for a variety of reasons:

• to opportunistically lock in unusually high returns, as they did when yields on guaranteed investment contracts popped up to the 17 percent level during the first half of 1982;
• as a substitute for bonds when interest rates were low and the plans wanted to avoid the probability of capital losses once rates started trending back up; or
• as a strategic component of their asset allocation mix, since the low volatility of Stable Value products could help to offset the high volatility in the equity portion of their portfolios.

All that began to change in 1992 after the Financial Accounting Standards Board issued a new accounting rule, FAS 110, which said defined benefit plans had to start valuing all their plan assets at "fair value," meaning market value. Previously, these plans had taken advantage of the book value guarantee embedded in Stable Value products to record those investments at book. With the new accounting standard stripping away this volatility-reducing benefit, interest in Stable Value products among defined benefit plans quickly waned. By the fourth quarter of 1993, their share of the assets in the Hueler's pooled fund universe was down to 3.9 percent. Today it's less than 2 percent.

FASB left the accounting rules for defined contribution plans, such as 401(k)s, under the purview of the American Institute of Certified Public Accountants. In 1994, that organization affirmed, in Statement of Position 94-4, that those plans could continue to carry Stable Value investments at book value. But by ignoring defined benefit plans, some believe that the AICPA implied that those plans should follow FAS 110 and mark their Stable Value assets to market.

While many defined benefit plans left Stable Value in the wake of FAS 110, some continued to invest. As attorney and actuary Paul Donahue notes, their auditors found ways to work around the accounting guidelines. "Auditors looking at the effect any difference between book value and market value would have had on the statement of the plan's assets may have regarded any such differences as immaterial," theorizes Donahue, Senior Manager, Fixed Income Product Development, and Counsel, Fixed Income, for Stable Value manager INVESCO Institutional Inc. "They also may have considered that the effort and cost that would have been required to determine the more accurate valuation would not have been in the best interests of the plan or its participants because of the immateriality of that difference."

As it happens, Donahue has since concluded that the practical solution hit upon by the auditors was actually on the mark. In a technical article published in February in Risks and Rewards magazine, Donahue argues that the best estimate for fair value of units in a pooled Stable Value fund is, in fact, book value. Among other things, he notes that beyond the duration of a Stable Value portfolio, which is typically only a few years, the expected market values and book values for the fund quickly converge.

Who Benefits?

Ironically, that tendency for book and market values to converge over time is also used by some investment professionals to argue against having defined benefit plans investing in Stable Value funds. Ennis Knupp's Lee says, for example, that his firm generally advises defined benefit plans to steer clear of Stable Value in favor of bonds. The firm figures that over the typical pension plan's long-term investment horizon, bond portfolios not weighed down by a wrap fee should outperform Stable Value funds. The lower volatility Stable Value funds offer, relative to bonds, is primarily a benefit to investors with a short investment horizon, he adds.

Donahue generally concurs, arguing that pension plans have little to gain by paying for the book value guarantee offered up by a Stable Value fund. The wrap contract, he suggests, amounts to a put option that allows the defined benefit plan to sell its Stable Value fund investment back to the fund manager at a predetermined price, namely, book value. "I cannot expect the value of that put to be worth what the wrap costs, and from that perspective, it is my view that buying Stable Value cannot be in the best interests of participants in a defined benefit plan," he says.

Some Stable Value professionals will argue that point. Jon Fraade, Managing Director at wrap provider AIG Financial Products Corp., says that in a vacuum, Donahue's argument makes sense, but that pension plans don't invest in a vacuum. "If I'm a defined benefit plan and I've brought down the volatility of my bond investments by wrapping them with a book value guarantee," he says, "it might mean that I can invest more aggressively with my other assets, and to the overall fund, this may be beneficial."

"We think defined benefit plans should invest in Stable Value," agrees Bruce Goode, President and Chief Operating Officer of Goode Investment Management Inc. in Cleveland. "It gives them the bulk of the return they would get from a fixed-income investment, without the volatility. In today's environment, a lot of defined benefit plan sponsors are looking for things that will dampen volatility in their overall portfolio."

Donahue also argues, however, that the expected volatility for a Stable Value fund is, for periods longer than the duration of its underlying portfolio of bonds, essentially the same as the expected volatility for the bond portfolio itself. Accordingly, he says, sacrificing any return with the aim of dampening volatility beyond that period of time would be ill-advised. That said, even Donahue concedes that Stable Value investing could be advantageous at times to a corporation sponsoring a defined benefit plan. In a rising rate environment, Donahue explains, the value of any bonds held by the pension plan would quickly decline, but the value of a Stable Value investment would not, thanks to its book-value guarantee. Accordingly, the Stable Value fund would improve the plan's funding status, and so could reduce the amount of money the sponsor had to contribute to the plan, at least in the short run. Of course, he adds, that would not directly benefit participants.

Many Managers Remain Gun Shy

Pension plan sponsors who weigh the pros and cons of Stable Value investing and decide they'd like to invest in the sector can still find it challenging, simply because only about half of all Stable Value managers accept defined benefit money in their pooled funds. "Our view is that a defined benefit plan buying into a Stable Value commingled fund is not consistent with the spirit of the guidelines provided by SOP 94-4," says John Axtell, Managing Director at Stable Value manager Deutsche Asset Management. As a result, he says, his firm does not accept investments into its Stable Value funds from defined benefit plans.

In addition to concerns about appropriate accounting, many Stable Value managers also worry that defined benefit plans might be too quick to pull their money out of the funds during periods of sharply rising interest rates, when money market funds, which invest in shorter-maturity instruments, can briefly outperform Stable Value funds. Under such circumstances, Stable Value managers could be required to cash out defined benefit plans at book value at the very time when their fund's underlying assets are likely to be trading below book value. That could hurt other investors in the fund.

To mitigate this risk of disintermediation, Stable Value funds that do accept defined benefit money typically reserve the right to make those plans wait 12 months to redeem their investment after making a decision to get out. Yet fund managers recognize that even after a year, under some market conditions, they could be forced to make payouts at book value when fund assets are trading below book value. Accordingly, they generally limit the amount of defined benefit money they will accept to five percent or less of their fund's total assets.

Proceed with Caution

Whatever the arguments for or against defined benefit plans investing in Stable Value funds, there's no arguing that interest rates, which have been in a long-term downtrend since the early 1980s, showed strong signs of reversing that trend in the first half of this year. If, as some economists believe, rates now have nowhere to go but up, plan sponsors will be worried about returns from their fixed-income portfolios and will be looking for alternative investment opportunities. While Stable Value funds may strike some as a possible solution, they will have to carefully consider the accounting issues and their fiduciary responsibility to act in the best interests of their plan participants. At the same time, Stable Value managers will need to continue weighing the implications for other investors of allowing defined benefit plan sponsors to join their investment pools.

Graphic

DB Plans Show Small But Persistent Appetite for Stable Value

While demand for Stable Value investments has gone down among defined benefit pension plans since accounting guidelines were handed down in 1992, the dollar value of defined-benefit investments in Stable Value funds has held relatively steady over the past five years.

* Hueler Analytics Pooled Fund Universe

Source: Hueler Companies

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