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Competing Funds: "Barbarians at the Gate" or "The Phantom Menace"

Few words can roll more eyes inside the Stable Value community than "competing funds." Or furrow more eyebrows outside it.

Many if not most retirement plan sponsors and providers addressed competing funds long ago. So long ago, in fact, that many may not be sure exactly why they did what they did or whether it still matters. They may be asking themselves, "What exactly are competing funds?" "Why do they matter?", and "How can plans and providers address the issues they raise?" A logical starting point is what competing funds compete with - Stable Value.

Someone once described Stable Value as the closest thing in the investing world to a free lunch. Participants get competitive fixed income returns with the stability of principal associated with money market funds - moderate upside with zero downside. But this economic nirvana may contain the seeds of its own destruction - if not carefully managed.

These seeds bear the innocent name of "competing funds" or, more precisely, "unrestricted transfers to competing funds." Like Stable Value funds, competing funds have moderate upside with zero to low downside.

Money market funds, some short duration U.S. Treasury funds, and other short duration bond funds that respond quickly to changes in short-term interest rates are commonplace examples. These hardly appear sinister. Yet the fault, dear reader, lies not in the funds but in their usage.

The issue arises from the central premise of Stable Value - smoothing the performance of a bond or fixed income portfolio. Rising interest rates make bond prices fall - and vice versa. In a vacuum or in the long run, it's one big ho-hum because everything will be passed through over time.

The real world is not so simple. These ups and downs, if extreme, may create a risk-free moneymaking opportunity for a few particularly shrewd, scheming individuals. The catch is that everyone else gets to pay for it, eventually.

To understand how everyone else pays, let's look at two participants we'll call Peter and Paul. Their 401(k) plan has a Stable Value fund yielding six percent and a money market fund yielding three percent. The money market fund is the "competing fund."

Peter and Paul both have all their money in the Stable Value fund. Life is simple and good.

Suddenly, interest rates shoot up and the money market fund is yielding nine percent. If no one did anything, the change in market rates would gradually be passed through in the Stable Value fund's returns. But, assuming that there are no transaction restrictions, Paul wakes up and says, "Hey, I can make three percent more in the money market fund. Sell! Sell! Sell!" Peter does nothing.

The Stable Value fund pays out Paul's withdrawal at 100? on the dollar, even though the bonds it held are only worth, say, 90? on the dollar. Behind the scenes, the Stable Value fund has realized an economic loss. The fund may have to pay a lower yield and/or take longer to catch up with the rising rate market. In other words, Peter pays for Paul's windfall.

And that's on a slow day. If Mary joins Paul in pulling out, and then others follow, they may pull the Stable Value fund's return down far enough that it never recovers. The rate gets lower, so more people leave, so the rate gets lower, and so on until, well, Doomsday. This Doomsday scenario or "death spiral" is the kind of thing that scares actuaries out of their skins. However, for investors who stay in the fund, unlike Peter, Paul and Mary, they would not lose their investment of principal and accrued interest. However, their future interest earnings could be lowered by extreme cashouts.

Unsettled underwriters aside, this all matters for three reasons:

• Fairness: With unrestricted transfers, some participants - inevitably the less sophisticated -may get hurt.
• Principle: Allowing unrestricted transfers to competing funds undermines the philosophical premise of Stable Value investments.
• Unadulterated (and reasonable) self-interest: Insurers and banks providing the guarantees could suffer potentially mortal losses in a Doomsday scenario.

Yet all is not lost. Retirement plan sponsors and providers have developed three main approaches to minimize this hazard:

• "Just Say No": Like any temptation; the easiest way to beat this one is to avoid it entirely. Many retirement plans offer a Stable Value fund as their sole "safe" investment option.
• "Wild, Wild Wash": The second, and most popular, remedy is to use an "equity wash." Participants cannot transfer directly between competing funds. Instead, those transfers must be "washed" through an equity fund, typically for 90 days. The idea is that exposing the transfer to the stock market for three months turns a risk-free scheme into a nail-biting ride.
• "Transferrus Interruptus": Some plan providers allow participants to transfer among competing funds in "normal" circumstances. The providers' protection comes from reserving the right to shut down transfers to competing funds at any time.

Do the risks justify what some might consider to be unnecessary red tape?

The bottom line is that letting some individuals hatch this kind of "risk-free" scheme harms other individuals - immediately and measurably. It also puts the entire premise of Stable Value at risk, which could negatively affect society at large.

Stable Value has played a critical role in the growth and success of private retirement plans. No other investment has the same capability to grow and protect individuals' plan balances. Improved individual balances translate directly into improved quality of life in those individuals' retirement years.

Within the broad Stable Value community, the answer seems clear - unrestricted transfers to competing funds present a very real threat to the financial health and happiness of defined contribution plan participants. Reasonable steps to address that threat may be among the most prudent investments a plan sponsor can make.

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