While investigating the bond options in my wifes 401(k), I noticed that the only safe option in her account was a Stable Value fund. I have noticed this label before, but never really paid them much notice. What is a stable value fund?

The pitch: Cash with better interest. You get the safety and stability of principal found in a money market fund, but with the higher returns of an intermediate bond fund. Here is a graph from 1990-2006 via the Stable Value Investment Association website (yellow is money market, blue is stable value, and red is bond fund):

How? In essence, stable value funds invest in intermediate-term bonds and similar investments, but the usual day-to-day fluctuations are smoothed out by the guarantee of an insurance company. For example, the insurance company guarantees that a certain amount of interest will be paid. If the actual return from investments fall short, the insurance company makes up the difference. If the actual investments outperform, then the insurance company keeps the difference.

This insurance guarantee also keeps the per-share price (NAV) at $1, much like a money market fund, even though the assets being held are riskier. Because they are limited to qualified retirement plans like a 401(k) or 403(b), they are allowed to use book value accounting instead of the more strict daily market value accounting required of most retail mutual funds.

What are the risks? In most cases, even if investments perform poorly, the insurance company will eat the loss rather than face the bad publicity. This is similar to money market funds. However, the danger is when things go so bad that the insurance company goes bankrupt. An example is the Trust Advisors Stable Value Plus fund which failed, as outlined by this NY Times article. Although technically the investors eventually recovered all their principal, it took over a year for everything to settle. There have been other isolated instances where investors have lost a portion of their principal.

To invest or not? Stable value funds are pretty popular, and found in 2/3rds of all 401(k) plans. Who wouldnt want a fund with hardly any volatility that pays high interest? The fund in my wifes 401(k) is guaranteed to earn 4.55% for all of 2008. Be careful though, because they are not all made the same. According to this study by JP Morgan Chase, returns from good/bad stable value funds can differ by up to 2% per year.

As for safety, I would treat it like a money market fund in that you should only buy if you trust the insurer and learn about the actual holdings. Otherwise, buy a bond fund somewhere else if you smell something fishy. Unfortunately, if you really want a safe holding place inside your 401(k), many times you dont have much choice. Finally, I would also point out that in the end they are still bonds, and are subject to the risk of having their modest returns eaten up by inflation. If you are a young investor, stocks still provide the best long-term growth prospects.

Last updated: March 14, 2014