Stable value funds are designed to offer steady returns with principal protection. Found in Defined Contribution plans (like a 401(k)), stable value funds are very popular and often one of the best investments for preserving capital in down markets. However, the stable value marketplace has some unique challenges, and some funds are exiting the business. Our goal is to explain these challenges so that plan sponsors - and their investment consultants – can appreciate the advantages and difficulties of stable value managers and make the best selection.
Recent changes to the Stable Value marketplace
In early November, the Defined Contribution world was troubled by the announcement that Charles Schwab’s $7.6 billion dollar Schwab Stable Value Fund was going to liquidate. Investors in the fund have until April 2012 to find a replacement. Rather than an isolated incident, Schwab Stable Value is only the latest fund to close. (State Street’s liquidation of its $8 billion stable value fund in 2010 is another high profile example.) This trend concerns the Defined Contribution industry. After all, stable value products are extremely popular for plan participants, so why are some companies leaving the business?
Since Schwab did just close their Stable Value product, let us consider their stated reasons. Quoting from their letter to plan sponsors:
“The current environment for stable value funds involves a number of challenges:
• Interest rates continue to hover at very low levels and are forecasted to remain low for some time. These ongoing conditions present special challenges in managing fixed income funds.
• Wrap coverage in which the underlying fixed income investments are wrapped by multiple banks and insurance companies continues to be limited.
Throughout the offering of the Fund, Charles Schwab Bank’s responsibility has been to make prudent management decisions which are also in the best interest of the participants invested in the Fund. After evaluating the above challenges, Charles Schwab Bank has made a long-term strategic decision to liquidate and terminate the Fund.”
In the course of due diligence, many investment consultants try to gauge the commitment of the stable value providers. Rather than a warning over a specific fund, Westminster continues to view the spectrum of stable value products with wariness given the industry-wide pressure. For example, the due diligence responses that Schwab released on their Stable Value product – as recently as July 2011 – does not overtly suggest their imminent departure from the market. But clearly, Schwab anticipated limits to their product, as do many providers. Our goal for this whitepaper is to clarify these issues and explain why there is pressure in the markets.
What is Stable Value?
For clarity, let’s review what a Stable Value fund is. In simplest terms, it as an investment vehicle for company retirement plans (like a 401(k)). The fund is typically a pool of short term bonds wrapped with insurance contracts to guarantee a specific minimum returns. So, stable value funds have two components: an investment component (the short term bonds) and an insurance component (a wrap contract). What’s the benefit of this type of investment? The net effect is that 401(k) participants get to invest in a fund with a guaranteed rate of return, but with principal safety and low volatility: clearly an attractive result for the participants.
Financial professionals will point out, correctly, that stable value products involve contract law, separation of duties & liabilities, quality requirements, multiple levels of fees, and a variety of other issues. Still, for the limited scope of this whitepaper, stable value products can be simplified, fairly, as an insurance contract running on top of a short term bond portfolio.
What are the additional challenges to Stable Value funds?
Some investors forget that even comparatively safe investments, like a short term bond portfolio, bears investment risk and can lose market value. Of course, the investment risk for these short term bonds never disappeared: it simply changed hands. The wrap contract provider adopts the investment risk in return for an ongoing fee.
This does not mean that the product is now risk free for the participants. For example, consider an ordinary person who buys a fixed annuity from an insurance company. In a fixed annuity, the ordinary person surrenders a lump sum of cash and gets, in exchange, monthly income for life. One of the risks the individual must consider is failure of the insurance company. A similar analysis holds true for the stable value investor. If the wrap-provider insuring the bond portfolio is under financial strain, will they be able to pay for any losses borne in the fund? For this reason, due diligence reports on stable value products typically disclose the financial credit rating of the insuring wrap providers.
Prior to the 2008 financial crisis, the risk of investment losses were sometimes discounted or even dismissed. While the risks were considered low, insurers did not require a high fee to compensate them for the risk (or to generate the capital necessary to cover a loss). After the high profile failures of several financial firms including AIG, Lehman Brothers, & CIT Group the risks were more apparent. In fact, allegedly “safe” investments such as money market funds and auction rate securities (i.e. “floaters”) suffered during the financial crisis and the seizing markets.
Specifically regarding stable value products, Blackrock notes that, at the height of the 2008 financial crisis, the average market value of Stable Value assets declined to 86% of book value; at these levels, the insurers were providing protection for bond portfolios with significant embedded losses. As a result, the insurers – the wrap-providers – required greater compensation for the higher assumption of risk. So, what are the options for the wrap providers? Insurers can choose to 1: increase their fees, 2: change the terms of the agreement, or 3: exit the business completely. We’ll consider these options one at a time.
First, increasing fees is not easy for the insurers. After three years of nearly zero interest rates, the Federal Reserve has announced that it is going to keep interest rates low for several more years. With low interest rates, stable value portfolios (short term bonds) can only generate very small returns. These low returns may be insufficient to pay for the investment management, and the required insurance for a stable value. In fact, we have seen Stable Value funds that, once recordkeeping fees were applied, actually lose value – contrary to their stated goal. High quality requirements and cash hoarding also act as a drag on returns. As a result, fees cannot be increased enough to be a sufficient incentive for some wrap providers.
Second, stable value managers may change the agreement terms. This is happening in a variety of ways, but one of the key trends is the combination of wrap providers and investment managers. Previously, the investment manager could operate completely independently of the insurer, but the current trend is for the insurers to manage the investment portfolio before adopting the risk.
The risks and rewards to the investment component and insuring component are not equitable. Investment managers have a better reward (the investment manager fee) for only modest risk. The primary risk for an investment manager is simply losing clients and their fee. However, the risks to insuring these portfolios (i.e. – “wrap capacity”) is getting more expensive, so insurers need to keep more of the reward to stay in the business. In other words, insurance companies may continue to run stable value products, just so long as they are also managing the investment part of the portfolio.
Third, some insurers are simply getting out of the business entirely. Many wrap providers (e.g. – JPMorgan, Rabobank) have announced their intention to leave the business. (Note that JPMorgan is still one of the 9 wrap providers for the Schwab stable value product.) Stable Value investment managers, seeing the multi-billion dollar deficit of wrap capacity for the foreseeable future, may simply opt to liquidate their funds and discontinue the business.
Finally, it is worth noting that the legal environment may potentially change for stable value providers as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Without going into the details (wherein regulators must decide if Stable Value products are “swaps” and subject to additional rules), the additional uncertainty does not encourage new stable value providers to enter the business.
What are the options if our stable value provider quits?
First, traditional short term bond portfolios aren’t going anywhere. Investors willing to take the risk and lower liquidity of an uninsured short term bond portfolio will have plenty of options to choose from. Second, Money market funds continue to exist in 401(k) plans despite the limited returns. Third, stable value products still exist with billions of dollars under management, despite the pressure to the marketplace. Plan sponsors should expect to work closely with their investment consultant throughout the due diligence process, since many options will continue to be available. The number of providers may be smaller, and the terms may be more rigid, but the market will adjust and endure.
We invite you to continue the conversation
Naturally, we cannot hope to individually discuss the strengths and weaknesses of each stable value fund in this short paper, but we hope that this primer has outlined some of the discussions to have with your investment consultant. As always, we look forward to discussing these issues with you in person. We hope to keep you informed about how your plan can ensure the best, most prudent stable value manager selections given the changes to the marketplace.