Stable Value Seen Less Risky in Aftermath of Financial Crisis

By: Randy Myers

From an investor’s standpoint, stable value funds have never been terribly risky. Their generally conservative investment approach and contract-value withdrawal guarantees have provided reliable performance. Yet now, in the wake of the most recent financial crisis, many stable value professionals believe their products have become
even less risky. “Not much has changed, but what has changed has been for the better,” says Susan Graef, a principal and stable value manager with Vanguard Group. Graef and four other panelists addressed participants at the 2011 SVIA Spring Seminar in April. They said the challenges the industry is facing, such as limited wrap capacity and pressure from
wrap providers for tighter contract terms, reflect to some degree a reevaluation of risks that always existed in the stable value business—even if senior executives in the corporate offices didn’t always appreciate them. “I would offer that the actual risks—the structural risks relating to our promise of benefit responsive- ness—are actually less now than they were in the past,” Graef said.

Other panelists agreed, noting that the industry has taken a number of measures to reduce risk.

“Whether you look at the duration of our investment portfolios or the credit quality of what we’re holding, there have been a lot of changes for the good,” said John Sturiale, managing director and head of Institutional Asset Management for Charles Schwab Investment Management. “We’ve also been conscientious on the liability side of the equation in terms of knowing who is investing in our fund. That’s something we spend a lot of time on at Schwab, and we know wrap providers look at it closely, too. They want to know who owns the fund and what would happen if they pulled out.”

Thomas Schuster, head of the Stable Value Investment Products Division for insurance company MetLife, where he serves as vice president in the Corporate Benefit Funding Group, said his company now includes more explicit investment guidelines in the wrap con- tracts it issues, particularly as they relate to sector constraints. He noted, though, that fund man- agers operating under wrap con- tracts that were put in place prior to the start of the financial crisis continue to operate under their original investment guidelines.

For all that stable value has endured over the past four years, George Quillan, vice president and actuary at Prudential Financial, suggested that the one risk not tested recently is the risk of rising interest rates. Such periods can have a negative impact for stable value funds if rates rise enough to overcome stable value funds’ significant yield advantage over money markets. First, they reduce the market value of fixed income assets in stable value portfolios.

Second, they can tempt investors to swap money out of stable value funds and into money market funds, which track interest rate changes more quickly.

Accordingly, fund managers can find themselves forced to liquidate assets at depressed levels to meet redemption requests. That can negatively impact investors who stay in the fund, and in some cases could force wrap issuers to make good on their contracts.

While Graef noted that rising rates have not provoked a mass exodus from stable value funds in the past, Quillan said potentially rising interest rates remain, in his view, the biggest risk the industry faces.

“We’re also concerned about the potential for rising rates,” Schuster said. To address that concern, he said, MetLife carefully analyzes retirement plan demo- graphics when underwriting new business and avoids taking on plans where the vast majority of participants are retirees focused primarily on generating income rather than growing capital.

MetLife also has been shying away from providing wrap contracts for separate account funds where the retirement plan client has a money market fund as a core investment option. It avoids such deals, Schuster said, even if the plan has an equity wash rule designed to prohibit investors from swapping assets directly from a stable value fund into a money market fund when interest rates are rising. Investors can often work around those equity wash rules, he suggested.

The panelists generally agreed there are other measures stable value funds can take to hedge against a potential rising rate environment, including holding more cash in their portfolios to facilitate redemptions. “We’re cer- tainly looking at that differently than we did a year or two ago, when we didn’t think we were as close to the end of this bottom on interest rates as we are today,” said Schwab’s Sturiale.

The panelists also generally agreed that they see slightly more risk in pooled funds, which cater to multiple retirement plans, than they do in separate account funds,

which cater to a single plan. A key reason, Quillan said, is the 12- month “put” option that is com- mon to pooled funds. Those options allow plans to exit their funds at contract value within a year of giving notice.

“I worry not only about the concentration risk of the largest plans in a pool but also about whether there is significant conta- gion risk,” Quillan elaborated. He explained that if a number of plans exited the fund at approxi- mately the same time, it could impact the probability of other plans wanting to exit, too.

Sturiale said he also worries about having any one consulting firm advising a large number of plan sponsors in a pooled fund. “If XYZ Consulting advises a large number of plans in our fund and turns sour on that fund, they could move their entire client base out at one time,” he noted.

“That’s a risk that may not be looked at as closely as it should be.”

Still, both Sturiale and Antonio Luna, vice president and fixed income portfolio manager with asset manager T. Rowe Price Group, noted that their pooled funds have had strong cash inflows lately, making it easier for them to hold extra cash if needed to meet any unusual redemption requests. It’s just another example, panelists noted, of how risk has been further minimized in stable value.