Not All Stable Funds Are Created Equally

Knowing the differences is a matter of fiduciary prudence

In turbulent markets, stable value investments can be an attractive choice for retirement plan participants worried about fluctuations in the marketplace. And with all the volatility we’ve experiencing recently, some participants may be evaluating their options to preserve capital. 

Like any investment option, stable value funds have advantages and disadvantages. There are circumstances in which stable value funds can be a great fit, and those in which they are not the best solution for plan participants. 

Adding a stable value product to a plan’s investment lineup brings on fiduciary liability for plan officials, who are responsible for the prudent selection and monitoring of the options. Understanding the unique aspects of stable value funds is the first step in an effective evaluation and assessment process that, when documented, can help mitigate fiduciary liability under the Employee Retirement Income Security Act (ERISA) of 1974.

Types of stable value funds

Organizations offer a diverse array of available stable value-type products. The differences between products are attributable to the different laws that govern the offering organizations. However, these vehicles share at least one commonality: Each is only as secure as the organization or organizations backing it up.

Insurance company stable value products, commonly called “guaranteed investment contracts” (GICs), are backed by the financial strength of the insurance carrier. If the carrier were to become insolvent, potentially no assets would be available to pay participants.

Bank or trust company stable value products, commonly structured as “collective investment trusts” (CITs), are often referred to as synthetic GICs, because one or more outside entities are contracted to insure all or a portion of the stable value product for a fee, commonly called a “wrap fee.”

What are the underlying investments of a stable value product?

It depends. For example, insurance carriers generally do not have an earmarked portfolio of assets backing their stable value products. Instead, the stable value product is, in effect, invested in the insurance company itself. Sometimes this fund is referred to as the “general account.” Other stable value products, such as those issued by banks or trust companies, may have a specific underlying bond portfolio associated with the fund.

Are there restrictions on distributions?

There could be. Again, doing homework is critical when it comes to understanding possible limitations on when and how distributions can occur. Many stable value products have a distribution limitation commonly known as a “put” option. A put option can limit the amount of a distribution or its timing (for example, a 12-month wait might be imposed), or even face a “market value adjustment.”

Market value adjustments to distributions are not well understood, but these are an important factor to consider when selecting a stable value product as a plan investment option. Essentially, a market value adjustment is a reduction in the amount available to be distributed in certain circumstances. A market value adjustment may occur if the present value of the underlying investment pool is less than the book or face value of the investments.

The following simplified example illustrates how market value adjustments work:

Stable Value product “SV” has a $10,000,000 bond portfolio. From an accounting perspective, X is valued at $10,000,000 because this was the original purchase price of the bonds. However, the underlying bonds may not be worth $10,000,000 today. Perhaps their current market value is $12,000,000, or maybe it’s $8,000,000. 

If the market value of the portfolio has dropped to $8,000,000 and SV’s terms impose a market value adjustment, the amount available to satisfy an immediate distribution may be lower than what the investor expects. The rationale is that, if the participant wants their money immediately, the provider must sell bonds at a loss, which is passed on to the participant.

Often the market value adjustment will not apply if the distribution is postponed for a specified period, commonly 12 months. If the participant waits 12 months, it’s likely some bonds would mature during that time at face (or book) value, and the extra cash could then be used to pay the participant the full expected distribution.

Put options and their limitations can be complex and require close analysis by plan officials before decisions can be made regarding stable value product selection. Some products allow immediate distributions for participants who have separated from service, others do not. Other products impose a market value adjustment only if the book-to-market value ratio is below a certain percentage.

Do stable value products offer a guaranteed rate of return?

Some stable value products, specifically those offered by insurance carriers, offer a guaranteed rate of return. Non-insurance carrier products, typically, do not have a guaranteed rate of return.

What fees are associated with stable value products?

As with other features, fees can vary by the product. Some products do not charge a fee, but instead the net amount paid under the contract is reduced by a certain number of basis points, reducing the yield.

What do plan sponsors need to know?

Not all stable value products are created equally. Before committing to an option, plan fiduciaries are encouraged to explore the significant differences in how the funds are structured, backed and credited, and the possible limitations on distributions. Conducting periodic due diligence on the capital preservation options offered to participants is also a prudent move in evaluating such funds. All of these factors impact which stable value product would be in the best interest of plan participants.

Source : Retirement Learning Center