How Stable Are Stable Value Funds?

By Kevin J Cress

401k Forum Analyst

Does your 401(k) plan offer a fund with Stable Value, Income Fund or Stable Return in the title? If so, you’ve probably got access to a stable value fund. This type of fund, available in two-thirds of all employee-directed 401(k) plans, can be an attractive alternative to money market funds and bond funds.

Stable value funds are not necessarily the conservative investor’s road to Shangri-La, however. There is a slim chance of losing money with a stable value fund investment, although the market risk is generally less than with a stock or bond fund. What’s more, in a period of rising interest rates and increasing inflation, your return may decline, possibly becoming lower than the inflation rate.

Stable value funds are available to participants in defined contribution savings and profit-sharing plans, and Individual Retirement Accounts (IRAs), and they are beginning to show up as mutual funds available to individual investors. They are included in two-thirds of employee-directed 401(k) plans, and represent approximately 15% of assets in those plans, according to the Employee Benefit Research Institute.

Here’s a look at stable value funds and how they work:

What is a stable value fund?

A stable value fund invests in — ta daaa! — stable value contracts. Here’s how it works. The fund pools your money together with that of other investors, and uses it to buy a number of contracts from insurance companies or banks (issuers). Under the terms of each contract, the issuer guarantees a regular rate of return for the length of the contract, and takes on all investment risk.

The issuer then invests your money in a portfolio of fixed income investments, such as government bonds or mortgages. If the returns on this investment are lower than what the contract issuer is paying you, the issuer still pays you the specified amount and takes the loss. If investment returns are higher, the issuer pockets the extra profit.

What is a typical stable value return?

Over the past year the average stable value fund returned 6.4%. However this rate may fluctuate as longer-term interest rates change.

Can I lose money in stable value funds?

Yes, but the chances are very slim.

If your main goal is safety (a low chance of losing money) and/or income, a stable value fund is a compelling choice. These funds are generally most suitable for investors approaching retirement, or already there. But they may also be appropriate as an alternative to cash for younger investors seeking to reduce the overall risk of their portfolios.

Are stable value funds available to me?

Probably, if you have a 401(k) or profit-sharing plan. Remember, around two-thirds of 401(k) plans offer a stable value fund. Availability of stable value funds outside of pension plans is very limited, but growing.

Why are the returns on stable value funds so stable?

A typical stable value fund return fluctuates less than one quarter of one percent a year. Now THAT is consistent! How do they do it? The answer is book value accounting.

Book value accounting means that the fund is valued based on what it paid for each contract, not on what each contract might be worth at any given time if it were sold on the open market.

Book value accounting keeps the price of stable value funds steady despite changes in the market value of the underlying securities. This makes it possible for the fund to pay interest rates similar to bonds, with minimal fluctuations in the visible price of the fund.

What securities are contained within stable value funds?

The most frequent are guaranteed investment contracts (GIC), buy & hold synthetic contracts, and managed synthetic contracts. Despite their similar sounding names, they have very different risks, returns and accounting methods. All of these (and more) may be found in a single stable value fund.

What factors most commonly cause rates on Stable Value funds to change?

A stable value fund contains a number of contracts. Each time a contract matures, the principal sum is paid back to the fund and the fund must then reinvest it in a new contract, at whatever interest rate is prevailing at the time. If rates are going down, the current rate will be lower than the rate that was being earned previously, and the return to the stable value fund will gradually decline. Similarly, if current rates are higher than the rate on the matured contract, the stable value fund’s return will gradually increase (all else being equal).

Most stable value managers ladder, or vary, the maturity of the contracts held within the stable value fund to smooth these changes.

In general, a stable value fund becomes more sensitive to interest rate changes as it increases the portion of the fund invested in managed synthetic contracts.

The timing of cash flows in and out of the Stable Value fund also affects the fund’s return.

How do cash flows affect the returns on a stable value fund?

If large sums of money flow into a stable value fund when interest rates are high, and small sums of money flow into a Stable Value fund when interest rates are low, everyone in the fund enjoys higher-than average returns because more money is invested in contracts that continue to pay high rates until their maturity date. The reverse is also true. Also, if the fund holds a large proportion of managed synthetic contracts, it will be more heavily affected by cash flow timing.

To cushion these effects, most stable value funds maintain a cash buffer. If net withdrawals can be paid out of the cash buffer instead of through liquidation of synthetic contracts, the crediting rates on the contracts remain much more stable.

How can I lose money with a Stable Value fund?

Credit risk (the risk that the borrower won’t be able to make interest payments or pay back your principal) is the largest threat to the principal in a stable value fund. This risk is highest with traditional GICs as they are all issued by a single industry — insurance companies.

If a stable value fund invests in GICs issued by insurance companies that default on their guarantee it will suffer a loss. Most insurance companies today are financially strong; however, long periods of rising interest rates could weaken the entire industry. Widespread insurance company bankruptcies are unlikely, but possible.

Most stable value managers have attempted to minimize credit risk by diversifying into synthetic investment contracts that are not issued by insurance companies and by spreading the fund’s assets across 15-30 different contract issuers.

If one or many of the bonds underlying a managed synthetic contract defaults, losses may result.

While it is important to be aware of these potentially dangerous scenarios, remember that the chances for loss on a stable value fund are very slim.

Outside of losing money, are there risks with stable value investing?

Yes. Investment risk is not solely the potential of losing money. It is the risk that you won’t achieve your goals. If inflation and interest rates rise and the yield on stable value funds declines, you may receive a return that is lower than the inflation rate. This means you will be falling behind in your investment savings.

Interested in learning more? www.dwight.com has an entire library of great articles on stable value funds and numerous links to more information.