The average crediting rate for stable value funds was about 2.73% as of March 31, 2012, according to the Stable Value Industry Association. Interest rates on high-quality U.S. bonds reached new lows this year, after falling steadily for decades. Inflation has averaged around 4.5% since 1970.
So why do so many 401(k) plans feature a menu of fixed income options that starts with a stable value fund and ends with a core bond fund? A fixed income portfolio allocated among these two popular fund options guarantees that real returns will be negative for as long as the inflation rate exceeds the high quality bond yields comprising these funds — resulting in a corresponding loss of wealth.
In a low or rising interest rate environment, plan participants are likely to be disappointed in their quest for steady income and perhaps capital gains. This frustration will be magnified for participants who begin to reduce their equity allocations beginning at around age 45 and continue reductions right up to retirement age, when maximizing income while protecting purchasing power is paramount.
Adding international exposure to the core fixed income allocation can help solve this problem. International bonds can offer higher yields than domestic bonds. Securities issued in foreign currencies can provide a potential hedge against the import price inflation caused by rising demand for overseas products and upward pressure on foreign wages. And with their low correlations to the Barclays Capital U.S. Aggregate Bond Index — the typical benchmark for the core bond funds used in most DC plans — international bonds offer deep diversification benefits.
Sponsors of 401(k) plans and their advisors who climb out of the stable-value-plus-core-bond rut and include exposure to the world’s fixed income markets can offer meaningful opportunities for participants to generate real income.
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Fixed income investing entails credit risks and interest rate risks. When interest rates rise, bond prices generally fall, and a Fund’s share prices can fall. It is possible to lose money by investing in stable value funds. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and political and economic uncertainties. Emerging and developing market investments may be especially volatile. Diversification does not guarantee profit or protect against loss.
