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Stable Value Investing, Post-2008

A recent Russell Investments paper, “Guidelines for Investing In Stable Value Post-2008,” provides a comprehensive overview and an excellent picture of what the stable value landscape looks like after the financial crisis.

The question on many plan advisors’ minds is whether to offer stable value at all. Why not just go with a money market fund and avoid the credit risk as well as the risk of not maintaining a $1 net asset value (NAV)?

The big advantage of a stable value fund over a money market fund is the ability to benefit from the term premium by extending the duration (typically 2.5 years) and thus take advantage of the normal (positive) yield curve. For this reason, the Hueler Analytics Stable Value Pool has outperformed the Lipper Money Market index during every 12-month period since the end of 1995.

While there is less credit risk in a money market fund, during the 2008-2009 financial crisis the stable value wrap providers proved to be “quite resilient” with “no providers needing to cover losses,” the Russell report notes. As recent history attests, if a stable value fund is sufficiently diversified and well managed, the chance of experiencing a loss is a rare event. Additionally, a stable value offering carries the value of the portfolio at book value even if the market value of the portfolio as a whole is below its book value.

Separate or Commingled?

It is best to not spend a lot of time analyzing all of the permutations of stable value vehicles and, instead, to focus on the main stable value options from which the majority of plan sponsors typically choose. Plan sponsors generally fall into one of two camps: (1) having their own stable value separate account; or (2) participating in a commingled stable value pooled fund. (A third option is to invest in a single contract issued by a single insurer, a practice that’s very much alive in the small plan market but is not the subject of either the Russell paper or of this post.)

The advantage of the separate account is that the portfolio is managed for the exclusive benefit of one plan sponsor, creating an opportunity for increased customization and duration flexibility. The biggest area of flexibility is not having to provide a one-year put option — that is, the ability, at the plan level, to withdraw funds at book value with one year notice. This is a contract feature that is found in most commingled stable value funds. Generally, not requiring a put option results in an overall higher quality among the underlying issuers of the contracts, assuming the same guaranteed rate of return over the same time period. This creates an opportunity to take greater advantage of the term premium by stretching out a little further on the yield curve without experiencing any degradation in credit quality.

Furthermore, to meet the liquidity demands of all investors in the fund requires that the stable value manager maintain a larger cash position (thus a lower return on assets) than would otherwise be required of a separate account.

The Case for Commingled Funds

The challenge of offering separate account stable value funds is that most plan sponsors do not have sufficient assets (scale) to support a separate account structure. The Russell paper reports that the typical account size required to support a separate account is $100MM. This is an amount that is out of the reach of most plan sponsors. Some would argue that this number is even higher given the need to have sufficient assets to create a well-diversified portfolio. This means that most plan sponsors must turn to the commingled pooled stable value fund, an option that is not all that bad.

One advantage of the commingled structure is that the pool of assets is typically greater than that found in a separate account. This allows for a larger number of guaranteed contracts, thus increasing the diversity of wrap providers.

The biggest disadvantage of commingled offerings is that, up until 2008 at least, nearly all of them had a one-year put option. Since 2008, this has changed somewhat, with some commingled providers extending the put from one year to 18 or 24 months and others removing it altogether. This is a positive development given that, while the perceived need for a one-year put is prevalent, it is rarely, if ever, required. Consequently, return is being sacrificed for a feature that few plan sponsors actually need.

Conclusion

A stable value option is an attractive alternative to a money market fund. This is illustrated by how well stable value held up during the financial crisis and the long history of the outperformance of stable value funds compared with money market funds. If a plan is sufficient in size to support its own stable value separate account, it should do so, and thus benefit from the greater flexibility in terms of duration management and control over credit quality. If a plan sponsor does not have sufficient assets to support a separate account, they should consider a commingled stable value fund.

When choosing a stable value fund manager, there should be a focus on the management of credit quality and the effectiveness of duration management. However, it would not be wise to default to funds that offer a one-year put. Instead, it would be prudent to consider whether this feature is really required and if the return trade-off is really worth it.

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