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Editor's Corner - Stable Value Cash Flow - What Really Matters?

Along with other interesting articles, this information packed issue of the Stable Times includes an article from Judy Markland subtitled "Macro influences on 401(k) contributions" and an article from Paul Curran entitled "Stable Value in a Rising Interest Rate Environment." The first article highlights economic changes that are affecting the overall growth rate for the 401(k) market. In addition to other issues created by rising interest rates, the second article talks about the impact that cash flow experience can have on stable value funds. Building upon these articles, I wanted to share some thoughts on the factors that drive stable value fund cash flows at the micro (i.e., individual plan) level.

Over time, the cash flows for a particular plan's stable value fund will be driven by the overall growth rate of the 401(k) plan as a whole. While plans with a stable work force and relatively small retiree populations can experience reasonable net contributions, an expanding work force (or other favorable demographics such as increasing participation rates) generates the fastest growth rate. It is worth noting that even if macro factors such as the ones Judy Markland discusses reduce the net contributions on an economy wide level, individual plan cash flows can still experience rapid growth.

While we should not completely ignore the short term cash flow trends for the stable value fund, plan level cash flows should carry more weight when trying to predict future stable value fund cash flows. Clearly, any planned changes to employee levels or drastic changes to the plan structure should also be considered. This long term expected cash flow trend should be a key input into determine the duration target for a stable value fund with growing plans managed to longer duration targets.

Deviation from the trend suggested by overall plan level cash flows are primarily driven, not by interest rate movements or the difference between stable value returns and money market yields, but by equity returns. I am skeptical that even a sharp increase in interest rates (keeping equity prices constant) would generate significant withdrawals from stable value funds. This statement assumes that we are talking about a separately managed stable value fund (i.e., not a pooled fund) and that intraplan transfers from the stable value option to a money market option/competing fund are not permitted, either because there is no money market fund or an equity wash requirement must be met. Interest rates do not drive cash flows for the following reasons:

1. The vast majority of plan participants change their allocations (either the existing allocations or the allocations for new contributions) with the same frequency that Dick Grasso will be inviting Elliot Spitzer to stop by one of his houses for drinks. To paraphrase Bill Murray, financial planner extraordinaire:

   "Even if rates rise so far above our heads that our noses bleed for a week to 10 days; even if every man, woman and child joined hands together and prayed for rising rates, it just wouldn't matter because all the 401(k) participants would still rather do just about anything other than change their 401(k) asset allocations. It just doesn't matter if interest rates go up or down. It just doesn't matter!

2. For the small minority of participants who do seem to care, the absence of a money market fund or presence of an equity wash provision prevents a risk free arbitrage (Small exceptions to this rule may be possible e.g., sophisticated participant transfers money from stable value to domestic equities while the participant's spouse transfers from domestic equities to money markets; a larger exception would be non-active participants that could withdraw money from an old 401(k) and roll it into a money market fund in an IRA or new 401(k)). Transferring money to equities to capture a modest differential between the market value and book value in their stable value fund is a very risky strategy. Any potential benefit could be wiped out in a day let alone 90 days. Even the incremental risk of moving to a high quality fixed income alternatives such as an intermediate bond or TIPS funds, if offered, probably outweighs the benefits. The Lehman Aggregate index was down x.x% in May and the Lehman TIPS index fell by x.x%). Furthermore, as noted in the most recent John Hancock survey of defined contribution plan investor investment knowledge, x% of participants think the best time to invest in bonds is when rates are expected to rise. It just doesn't matter!

So, what does matter? For the majority of the minority of participants who actually modify their investment allocations, the key is equity prices. When equity prices go up, people sell stable value and buy equities (see 1998 - 2000). When equity prices fall, they do the reverse (see 2001 - 2002). This clearly demonstrates the ever successful buy high, sell low strategy. Maybe the participants who ignore their 401(k) allocations are on to something?

If it is not general equity prices driving cash flow, then my second choice is the price of the plan sponsor's stock (if offered as an investment option). While these flows are clearly driven by a very small number of plan participants, movements between company stock and stable value, at some companies, can explain a disproportionate share of the stable value fund transfers. The only good news on this front, based on my anecdotal evidence, is that these participants at least try to buy company stock on dips-unfortunately dips sometimes turn into long slides.

Even if you are now convinced that stable value cash flows are caused by the equity market that does not mean that cash flows are not negatively correlated with interest rates (i.e., stable value experiences negative cash flow when rates rise). Correlation does not prove causality. If interest rates and stock prices tend to rise at the same time, a negative correlation would likely result.

While the future may differ from the past and we need to make a lot of simplifying assumptions to facilitate our analysis, we quickly looked at the 37 calendar years since 1929 that had equity returns in excess of 15% (high enough to get the return chasers moving). For each those years, we estimated the year-end market value to book value surplus (deficit) by comparing the estimated market value return on a 5-year Treasury over the prior 3-years to the estimated book value return over the same period assuming no cash flows. The results shown in the chart indicate that market value would generally have been above book value at the end years when equity returns exceeded 15%.

If participants chased the equity market returns (transferring from stable value to equities) when MV>BV, they would leave behind this surplus for the remaining participants. This would increase the crediting rate for the remaining participants. In only 12 of the 37 "high equity return" years was there a market value to book value deficit, and, in most of these years the deficit was quite modest.

Anecdotally, most of our accounts ended 2003 with market value to book value ratios around 102%. So the withdrawals that occurred in late 2003/early 2004 as investors chased the equity market rebound would have helped the remaining participants. Even after the worst calendar quarter (2Q2004) for the bond market in over a decade, the ratios were hovering around 100%, but, with the Federal Reserve in play and the equity markets struggling, cash now appears to be moving into stable value.

If a booming equity market causes rates to rise sharply from here, withdrawals would negatively impact stable value funds now that the MV/BV ratio are close to 100%. While it is not difficult to imagine (or forecast) higher interest rates, I doubt this will be accompanied by the kind of equity returns necessary to get the money moving. Furthermore, money market rates would still need to rise by at least another 300 basis points in (assuming no increase in stable value returns) in order to close the gap with stable value fund returns. Enjoy the rest of the summer.

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