Income Funds: The Next Evolution for Stable Value?

By Randy Myers

Hybrid cars are the latest innovation in the automotive world, and some investment professionals are wondering if hybrid funds could be the next big thing in the stable value universe.

Only a handful of hybrid funds exist. There isn’t even a consensus on what these funds should be called; some have also floated the term “income funds.” Nevertheless, most agree on the general concept: a traditional stable value fund that also incorporates some investments not covered by a wrap contract. Allowing some assets to go unwrapped would both minimize the fund’s costs—it wouldn’t have to buy as much wrap capacity—and ease the burden of finding wrap providers at a time when wrap capacity is constrained.

Stable value funds traditionally have wrapped most of their underlying assets, of course, except where those assets are cash or money market funds. Wrap contracts assure stable value’s benefit responsiveness, which enables investors to withdraw their assets at contract value under most circumstances, even if the market value of the fund’s portfolio falls below contract value. This benefit responsiveness has been the foundation of stable value.

Interest in blending wrapped and unwrapped assets is largely an outgrowth of the 2008 credit crisis, which crimped capacity for the entire industry. Since then, many of the issuers who remained in the business have been pushing for more restrictive wrap contract provisions while raising fees. This has left some plan sponsors and managers frustrated.

“They see an industry that has not recovered from the financial crisis,” Edward Adams, manager of defined contribution strategy and implementation for IBM Retirement Funds, told participants at the 2011 SVIA Fall Forum. “They see a wrap market where demand and supply are in imbalance, and that is a big concern for many of them. From their perspective, stable value has become an increased administrative burden.”

IBM Retirement Funds oversees the largest 401(k) plan in the country for employees of International Business Machines Corporation (IBM). Adams said IBM still considers its stable value fund sufficiently attractive to justify any extra administrative burden. But not all plan sponsors feel the same way, and some have begun to look for alternatives.

“We are often asked about alternatives,” Brett Gorman, a vice president in the defined contribution practice of fixed income manager Pacific Investment Management Company LLC (PIMCO), told forum participants. He said large and sophisticated plan sponsors understand the changes rippling through the stable value marketplace and to varying degrees are annoyed and frustrated by them. “More than a few are angry,” he added, “having spent more time on stable value-related issues over the past three years than they have on running the rest of their plan.”

Compounding their concerns, Gorman said, are new regulatory requirements taking effect in 2012 that will require sponsors to make additional fee disclosures about their plans to plan participants. “For many sponsors,” he said, “stable value will be their most expensive investment option.”

To be sure, hybrid or income funds would sacrifice one of the prized benefits that stable value funds offer: benefit responsiveness, which is the ability of participants to transact at contract value. Neither plan sponsors, stable value managers, nor wrap issuers know for sure how plan participants would react to the possibility of losing money in a hybrid fund. “It could work,” Adams said, but he stressed that such a fund should not be called a stable value fund because it could cause too much confusion in the marketplace.

Gorman said that when a plan sponsor comes to his firm asking about alternatives to stable value funds, PIMCO first asks the sponsor whether it likes stable value funds and, if it answers in the affirmative, encourages the sponsor not to abandon it. PIMCO reminds the sponsor, he said, that no other investment has come close to delivering “the exceptional risk-return characteristics that stable value has delivered for decades.”

PIMCO then helps the sponsor assess its stable value options by reviewing its wrap contracts. It looks to ensure that they don’t push too much risk onto the sponsor’s plan or its participants, and that the wrap issuers are easy to work with and committed to the stable value business. “Most sponsors,” he said, “find they are in much better shape than they thought and can continue with a 100 percent traditional stable-value solution.”

Nonetheless, Gorman said, hybrid or income funds could represent a reasonable compromise between the current needs of plan sponsors and the interests of wrap contract providers. Before that could happen, however, fund managers and wrap providers would have to figure out just how much of a fund’s assets could be unwrapped and how they would be invested.

Aruna Hobbs, managing director and head of stable value investments for stable value provider New York Life Investments, said her team looked for answers by trying to model how a hypothetical hybrid fund might perform. Using the Barclays 1-3 Year Credit Index as a barometer for the unwrapped assets and the Barclays Intermediate-Aggregate Index for the wrapped assets, Hobbs’ stable value team looked at how the fund might have performed during two periods of volatile interest rates: 1979-1982 and 2007-2011.

Assuming 10 percent of the fund’s assets were unwrapped, Hobbs said, the fund’s crediting rate never turned negative. Nor did the crediting rate vary much from the crediting rate for a pure stable value fund. With 50 percent of the fund unwrapped, however, the crediting rate became much more volatile, and at times was negative.

“Clearly we would not feel comfortable with 50 percent of the assets being unwrapped,” she said. They also would be concerned to know, she said, at what point investors would start pulling money out of a hybrid fund en masse. While she wasn’t sure when participants would start doing that, she speculated that it might be when returns become negative.

Leaving too much of a portfolio unwrapped could also diminish the “stable value” benefits of the fund so much that it might no longer be considered a safe investment option by investors, Hobbs noted. At that point, she speculated, “why not just have an unwrapped intermediate-term bond fund?”

Hobbs also wondered whether, in the absence of a pure principal-protected investment option such as a stable value fund, more retirement plans might consider adding money market funds to their investment menus.

Hobbs said New York Life Investments would look at proposed hybrid funds on a case-by-case basis before determining whether it would be willing to issue wrap contracts for that portion of the fund managed by conventional standards.

“If we keep it under certain parameters, it passes the smell test,” Hobbs concluded. “But from an underwriting standpoint, the devil is always in the details.”