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Stable Value Funds.

Byline: John Keefe

Summary paragraph: More complicated investments than some realize

Art by David Jien

After spending their careers scrimping and saving, many participants are all too happy to pull their retirement funds out of volatile equity markets and trade the prospect of high returns for the safety of capital.

Money market funds used to be a logical choice, but these have offered no return to speak of since the financial crisis. Another option for capital preservation is stable value funds-one of the first investments available in defined contribution (DC) plans, going back to the 1970s.

Stable value funds build steadily over time, much like an old-school savings account, earning a return that approximates the yield on short-term bonds but-under normal circumstances-with no downside volatility. They provide valuable diversification and are popular with more mature and conservative cohorts of participants. Still, the stability has its costs: Besides the usual fees and challenges of portfolio management, the stable value structure includes a bank or insurance company guarantee against declines, adding fees for participants and a further layer of complexity for sponsors.

Stable value funds promise to deliver a steady return in line with short-term bond yields and have performed as advertised. Returns have indeed been more stable than their closest market analog, the Barclays Capital 1-5 Year U.S. Government/Credit Bond Index. The accompanying chart shows the bond index and the median return among 35 stable value funds in the manager universe of eVestment, Marietta, Georgia. From 2007 through 2014, returns on both fell-to about 1.5% in the latter year-though stable value's decline has been more gentle.

Manager skill is as important to stable value funds' total return as it is to any other asset class. Among the 35 stable value products tracked by eVestment, the annualized spread between first- and third-quartile performance was 80 basis points (bps) for the three years ended in March, and 97 basis points over five years-a considerable difference on a median return stuck in the low single digits.

The appeal of stable value is more than just the steady return: The funds' net asset value is designed to keep rising, no matter what happens in the surrounding financial markets. According to the latest surveys from the Employee Benefit Research Institute (EBRI), stable value funds are offered to about 22% of 401(k) plan participants and in those plans had attracted 15.5% of portfolio assets through year-end 2013. They seem to be an acquired taste, however: Participants in their 50s held 15% of their portfolios in stable value, while those 60 and older allocated 25%. Investors in their 20s devoted just 5%.

Counteracting the potential downside requires a complicated financial machine, composed of a portfolio of short-term bonds, a crediting method for allocating returns to participant accounts and an insurance contract that keeps investors whole in the event that portfolio assets fall short.

So, in addition to monitoring the performance of the underlying portfolio, sponsors also have to keep an eye on the insurers. "The complexity of these products is something we've discussed with our clients for a long time," says Kim Gillett, investment consultant at Towers Watson, in New York City. "They have to understand the investment guidelines and insurance contracts, and the fees and just what those pay for."

Stable value has benefited from two crises: The stable value industry fell into turmoil in the early 1990s, but emerged with an improved product structure. In the 2008 financial crisis, stable value got in to trouble again; although most investors came out in good shape, plan sponsors and providers of the asset class learned important lessons.

The problems began with the underlying portfolios of bonds of certain funds, supposedly short-term and investment-grade. Like many bond investors, some stable value portfolio managers took as gospel the rating agencies' high marks on subprime residential and commercial mortgage-backed securities, as well as other bonds apparently offering a bit more return. Losses were extensive, and managers and guaranty providers that had believed stable value could not go wrong were saddled with large losses.

"The industry hasn't engineered new products since 2008, but there have been big improvements in getting a better understanding of stable value by managers, insurers and plan sponsors," notes Henry Kao, senior vice president in the defined contribution practice at PIMCO, in Newport Beach, California.

One reaction, insisted on by insurance contract providers, was tightening portfolio guidelines to restrict investments to higher credit quality and shorter duration-and thus lower price sensitivity to swings in interest rates.

Another was the exit of many banks from writing stable value portfolio guarantees. The remaining banks and insurers hiked their fee rates, from 6 to 8 basis points annually to between 20 and 25 bps. "Before the crisis, prices of guarantees were too low," observes Nick Gage, senior director at Galliard Capital Management, Minneapolis, a stable value manager handling $72 billion for defined contribution clients. "Now, at 25 basis points, they're too high," he adds. "But we have a more diverse insurance issuer base, so supply and demand are in better balance. Managers are able to negotiate wider guidelines and more streamlined contract terms, and recently we're seeing fees come down a bit."

"Since the financial crisis, the industry is 15 pounds leaner, we have a more durable product, and sponsors are able to evaluate managers with 20/20 hindsight," notes Antonio Luna, co-portfolio manager of the Stable Value Fund of T. Rowe Price Group, Baltimore. He points to new interest in stable value from sponsors reviewing their conservative investment options. "One factor is the low returns on money market funds, which could continue well into the future. Another is the SEC [Security and Exchange Commission]'s proposed reforms to money market funds, which could place restrictions on participants' ability to redeem their holdings."

Despite its renewed health, stable value likely faces an important challenge in the form of probable higher interest rates, which work against bond prices. "The best defense against rising rates is active management," says Kao. "It's not enough to know that rates are going up. You need a view on how high they'll go, and how fast, and how bumpy the road will be from point A to point B. We think the front of the yield curve will be more volatile, so we've been underweighting the short end and overweighting intermediate securities."

But shorter bonds pay lower coupons. "We also have rotated into corporate bonds, which pay a yield premium over Treasurys, focusing on sectors that traditionally outperform when rates are rising, such as the cyclical industries," Kao explains.

At T. Rowe Price, Luna points to purchases of high-quality asset-backed securities as well. "Stable value can be contrary to other fixed-income products," he says. "Higher rates can increase yield without adding much risk to the portfolio, so that rising rates could be a positive."
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Date:Jul 1, 2015
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