Stable value is a unique fixed income asset class that is primarily used by qualified DC plans. Compared to other liquid and illiquid fixed income strategy options, the goal of stable value is to offer plan participants:
Stable value funds can be offered by traditional asset managers, trust companies or insurance companies. Typically, the underlying portfolio of stable value funds consists of short- and intermediate-term, high-quality bonds and derivatives. The assets are then “wrapped” with an insurance guarantee to provide the “stable” value.
The key differentiating feature of stable value funds is the use of wrap contracts, which generally allows participants to invest and redeem at book value. Even in periods of market volatility, wrap contracts seek to provide a book-value protection of the principal investment, ensuring the interest rate received is greater than zero and allowing participant withdrawals and transfers out of the portfolio at book value subject to the terms of the wrap contract. The wrap contract provides participants with the guarantee that an insurance company or a bank that issued the wrap contract will make up the difference when the market value of the underlying portfolio is below the book value. The issuers of wrap contracts are compensated for this guarantee via a wrap fee.
The goal of stable value funds is to provide the benefit of a capital preservation and accumulation with low-returns volatility through use of a crediting rate. The crediting rate of stable value funds, often thought of as the return on investment, reflects market interest rates with a time delay. This delay is the result of an accounting mechanism that amortizes gains/losses over a specified period.
Traditional fixed income funds realize market gains/losses immediately. Stable value funds, on the other hand, realize gains/losses more slowly. How? The amortization flow-through to the yield crediting of the underlying investments smooths the volatility of returns to investors. The crediting rate could be a fixed percentage amount set by the contract or could reset periodically (i.e., monthly, quarterly or annually).
Another unique aspect of stable value funds is the redemption limitation placed on plan sponsors. Due to limitations on wrap contracts, most stable value funds have a “12-month-put” feature. This means that a plan-sponsor-initiated complete redemption out of the portfolio typically requires the plan to wait 12 months for the full book value to be redeemed when the market value of the underlying portfolio is below the book value. This does not apply to plan participants who are allowed to redeem their investments at full book value at any time no matter the market-to-book ratio.
Stable value funds come in three primary vehicles: a commingled investment trust (CIT), a guaranteed insurance account (insurance general account) or a separately managed account.
The CIT has the following characteristics: a fully transparent fee schedule, a diversified set of wrap contract issuers (typically several insurance companies), a limited investment strategy universe that targets investment-grade short and intermediate bonds for the underlying portfolio, a 12-month-put limitation on plan sponsor full redemptions and an immediate redemption at a market value for plan participants subject to the contract terms. Most CITs are fully portable and available on numerous recordkeeping platforms.
An insurance general account has more complicated features than a CIT that plan sponsors need to fully understand: a fee schedule that is usually spread-based and not fully transparent, only one wrap contract issuer guaranteeing principal preservation, an investment opportunity set that includes a broad variety of asset types with longer duration and a portfolio exit that typically occurs in deferred book value installments over multiple years when the market value is below book value. Even though most insurance general accounts can offer higher crediting rates than CITs, a lack of portability and a complicated redemption schedule need to be considered when choosing a general account vehicle.
The third type of stable value fund is not actually a fund but a separately managed account. Separately managed accounts are highly customizable and can have features of either a CIT or an insurance general account, but typically are only offered to large DC or DB plans as they require a high minimum investment.
Money market funds are the primary alternative to a stable value strategy, when plan sponsors decide which stable net asset value option to offer its participants. Money market funds typically hold securities with a weighted average maturity of 60 days or less, whereas the average maturity of stable value funds is around three years. Stable value can be more attractive for pre-retirees or retirees wanting to preserve the principal while still having the ability to take advantage of additional capital accumulation through longer-dated (and usually higher-yielding) securities.
Historically, stable value returns have exceeded the returns of money market funds and inflation. Due to its longer duration and smoothing process when accruing market gains/losses to investors, a stable value investment option offers a conservative return stream with low volatility due to the smoothing mechanism. Money market funds tend to outperform stable value immediately following interest rate increases, as it takes stable value funds longer to benefit from higher market rates. The graph illustrates the comparative performance of stable value versus money market funds through several market cycles.
Sources: Segal Marco Advisors using Bloomberg Finance LP, iMoneyNet, Morningstar Inc. data as of May 31,2023 and the average Consumer Price Index for All Urban Consumers, less food and energy in U.S., seasonally adjusted from the U.S. Bureau of Labor Statistics.
There have been two notable recent developments in the stable value industry. When stable value funds were first created in the mid-1980s, wrap contracts were in a form of a Guaranteed Investment Contract (GIC), sometimes referred to as a “traditional GIC.” A traditional GIC is a contract in which a single insurance company guarantees a book value and provides the underlying investments. Currently, most wrap contracts are “synthetic GICs.” Unlike the traditional GIC, synthetic GIC investment assets that support a book value of a contract are held by a custodian bank in the name of a plan. In other words, plan sponsors have legal ownership of the underlying assets. This was a positive change in the industry, as it reduced the risk of a wrap provider being unable to guarantee a book value of the contract.
A second update is related to a definition of competing options as it pertains to DC offerings. Any investment option offered by a DC plan alongside the stable value that also has a principal preservation as its objective can be viewed as such. In the past, any investment option with a duration less than three years, such as money market funds, short-term bond funds and even self-directed brokerage, used to fall under the definition of a competing option. The insurance companies that provided wrap contracts did not want participants to move between a stable value and competing options in search of arbitrage opportunities. As a result, an “equity wash rule” was in place for stable value funds which required that any participant-directed transfer between a stable value and a competing option must first be directed to any non-competing investment option for a period of 90 days.
Recently, stable value providers have worked with the wrap providers to narrow the definition of a competing option. As a result, a self-directed brokerage is no longer considered a competing option by many stable value funds. In addition, many stable value providers shortened the duration requirements to be considered a competing option for short-term bond funds from less than three to less than two years. This was also a favorable change, as many plan sponsors want options for plan participants and prefer to include both a short-term bond fund and a stable value fund in the investment lineup.
Over the past several decades, stable value’s ability to provide a consistently strong track record while navigating market volatility has led to increases in the presence of stable value funds especially in DC plans. In turn, stable value providers continue to negotiate with wrap issuers to make competing options less restrictive, which makes it easier for a plan sponsor to add a stable value fund to the plan’s existing lineup. Going forward, as retirement income planning continues to fall more on individuals with the decreasing presence of DB plans, the demand for investment options focusing on income and capital preservation will continue to be paramount. The unique characteristics of stable value funds means they can have a role in fulfilling that need.
The information and opinions herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This article and the data and analysis herein is intended for general education only and not as investment advice. It is not intended for use as a basis for investment decisions, nor should it be construed as advice designed to meet the needs of any particular investor. On all matters involving legal interpretations and regulatory issues, investors should consult legal counsel.
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