Most 401(k) plans offer something called a stable value fund. These typically pay 6% to 8%. That's much better than money-market funds, and yet their value is assured. How do they do that? I think it involves insurance contracts. Are these types of funds available to investors outside their 401(k) plans?
-- Ken Seiden
You are correct. According to the
Stable Value Investment Association
, two-thirds of 401(k) plans offer a stable value fund as an option, and about 25% of the approximately $1 trillion in 401(k) plans is in stable value. Stable value funds are currently available only through defined contribution plans like 401(k)s or through IRAs. The association's
lists funds that are available to IRA investors.
You also are correct that a stable value fund is an income investment that typically returns 1% to 1.5% more than a money-market fund, but like a money-market fund, it preserves your principal.
How do these funds do it? When you invest in a stable value fund (note they are not mutual funds, although they are comparable to mutual funds), the plan sponsor invests your money or contracts with a money manager to invest it in one of two ways, each involving insurance contracts, explains Christina Stiver, vice president and manager of the stable value investment group at
in Los Angeles.
Stable value assets get invested in either traditional guaranteed investment contracts, called GICs, or in synthetic GICs. Stiver says traditional GICs account for 25% to 30% of stable value assets, and synthetic GICs make up the rest. Both types of GICs are issued primarily by life insurance companies.
New York Life
and Transamerica are among the biggest issuers.
Traditional GICs are almost exactly comparable to bank CDs. The insurance company has custody of the assets for a fixed term and pays a fixed interest rate on them.
, an Internet news service for 401(k) professionals, has a nifty
showing current GIC (and bank investment contract, or BIC) rates.
In synthetic GICs, the insurance company (or bank) writes what's called a "benefit-responsive wrap" for the assets, which are managed either by the plan sponsor or by an independent asset manager. In plain language, the insurance company provides a guarantee to make up any difference that may exist between book value (principal plus accrued interest) and market value of the assets (typically bonds) when participants withdraw funds.
Both traditional and synthetic GICs are valued according to the credit ratings of the insurance company or bank that issues them, which for stable value purposes is either triple-A or double-A. Stable value funds pay higher rates than money-market funds, in part because their credit quality is marginally lower and in part because investors rely on money-market funds more for daily liquidity.
By combining these products in a stable value fund, the plan enables participants to withdraw principal and accrued interest from the fund at any time. That's what distinguishes them from bond funds, in which you may lose principal if interest rates rise. (Of course, in a bond fund your principal may gain in value if interest rates fall, and you may be able to earn a higher interest rate.)
The biggest stable value fund managers include some of the most familiar names in the mutual fund world, including
Invesco's Primco Capital Management
Dreyfus' Certus Asset Advisors
Dwight Asset Management
are two other major stable value managers.
You may recall that GICs issued by a few insurance companies ran into trouble in the early '90s.
Mutual Benefit Life
made bad investments in junk bonds and were unable to repay GIC investors for years after the junk market tanked in 1989 and 1990. That's the bad news. The good news, association President Gina Mitchell says, is that the stable value industry embraced diversification as a result. Plan participants "just don't have that kind of exposure to one issuer" any longer, she says. Still, the episode helped erode stable value's market share. In 1989, stable value assets accounted for more than 40% of retirement plan assets, according to a 1992 survey reported in
The Wall Street Journal
. Of course, the growing popularity of stock funds was also a factor.
In attempting to rebuild its market share, the stable value industry is taking aim at bonds and bond funds. Basically, the industry claims that by investing in a mix of stocks and stable value instead of stocks and bonds, investors have been able to achieve the same rate of return with less risk, or to achieve a higher rate of return with the same amount of risk.
A study by John Hancock supports that claim. The firm found that from 1983 to 1998, a portfolio consisting of 75% stocks and 25% intermediate bonds returned 16.18% a year with a standard deviation of 10.7%. To achieve the same return, the investor could have allocated 77% to stocks and 23% to stable value, and enjoyed a lower standard deviation of 9.9%, the study says. Alternatively, the investor could have allocated 83% to stocks and 17% to stable value for a 10.7% deviation and an average annual return of 16.71%.
It works because stable value funds correlate much less closely with stocks than bonds do, explains Wayne Gates, director in John Hancock's stable value group. "The correlation of returns between stocks and bonds tends to be fairly high, so they tend to do well and poorly together," he says. Stable value and money-market funds, by contrast, have a very low correlation with equities. One can invest in either stable value or money-market funds in combination with equities and enjoy less risk than with bonds. But stable value trumps money-market funds in the scenario because you sacrifice less return in the process.
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