Without a doubt, stable value is experiencing a resurgence of sorts in the wake of money market reform and recent volatility. With this in mind, four major stable value managers were recently interviewed about trends they are seeing in the marketplace, as well as its overall strenght.
Key questions asked were:
- What major trends did you notice in 2015?
- What are the largest anticipated challenges for stable value funds?
- What trends do you see in terms of fees, duration, market value-to-book value ratios, wrap capacity and type of wrap (such as global)?
- Do you expect increased usage of stable value within target date funds or retirement income solutions?
Reasons for including stable value funds in DC plan menus
Historically plan sponsors included stable value funds in their investment menus because of their more attractive return profiles (between 1% and 3% over the past several years) relative to money market funds. The underlying portfolio within a stable value fund is a short- to intermediate-term bond portfolio, therefore over most periods the fund will provide a term premium over a money market fund. The use of insurance wrappers to create a stable net asset value (NAV) makes the vehicle attractive for plan participants. Many plan participants are partial to investments with a stable market value where the variable is the interest rate earned.
Key reasons for not including stable value as an investment option generally have been that some products impose strict exit provisions (related to plan sponsor-initiated events), restrictions on the addition of certain other fixed income funds (i.e., competing funds) to the plan menu, equity wash rules and lack of transparency.
Prudential and MetLife each released a study in 2015 which polled plan sponsors, managers and consultants on the topic of stable value[i]. Both studies found that the key reason plan sponsors offer stable value is capital preservation. Other important reasons for offering stable value include steady returns, guaranteed returns (if applicable), and higher returns than money market funds. MetLife found that the main reason for not offering a stable value option was that the plan sponsor’s advisor had not recommended it. Secondary reasons were the perceived complexity, strict contract terms and lack of transparency.
Money market reforms—Money market mutual funds have been popular options in DC plans. Near zero short-term interest rates and recent Securities Exchange Commission (SEC) money market reforms, however, have plan sponsors reviewing the role of money market funds in a DC plan menu. In 2015, the SEC released new requirements for money market (MM) mutual funds. Only retail MM mutual funds classified as government funds will be able to maintain a stable NAV and be exempt from liquidation restrictions. Non-government retail MM mutual funds may be subject to liquidation restrictions but will have a stable NAV. Institutional MM mutual funds will have a floating NAV and be subject to liquidation restrictions.
Improved wrap capacity—Wrap capacity for stable value funds continued to improve in 2015. Stable value asset growth has been flat to down, so demand for insurance wrappers has dropped. At the same time, wrap providers have sought to grow their businesses. Wrap providers that had previously demanded managing a part of a stable value portfolio as a condition of providing wrap insurance, are now open to wrap-only business. The improved capacity has provided greater leverage for wrap fee negotiations. Expectations are that wrap fees will decline up to 0.05% from the current level of approximately 0.25%. Managers generally believe that it is unlikely for wrap fees to drop to the pre-2008 level of around 0.15%
Litigation—There is an increase in the number of lawsuits involving DC plans overall and stable value funds are not immune.
1) On December 11, 2015, a lawsuit was filed against Fidelity Management Trust Company (Fidelity). The lawsuit involves Fidelity’s stable value fund called the Fidelity Group Employee Benefit Plan Managed Income Portfolio Commingled Pool (MIP).
The suit alleges that:
Fidelity’s actions led to low returns and high fees for MIP; following the market crisis of 2009, Fidelity positioned the portfolio in an overly conservative manner and agreed to allow wrap providers to charge high fees; and, Fidelity attempted ‘to conceal’ MIP’s conservative strategy and low returns by using an improper benchmark (money market), which made MIP’s relative returns look better.
On January 20, 2016, Fidelity filed a motion to dismiss the lawsuit. In support of its motion to dismiss the suit, Fidelity claims that MIP met Employee Retirement Income Security Act (ERISA) and Department of Labor’s (DOL) ‘safe’ option criteria as MIP was diversified, preserved capital and provided consistent returns. In responding to the allegations about paying high wrap fees, Fidelity states that it paid the market rate for wrap fees and did not breach its fiduciary duty. Fidelity cited that effective December 2010, the DOL selected the 3-Month U.S Treasuries Bill Index as the model benchmark for stable value funds. The firm claims that there was nothing improper about its use of the 3-Month U.S Treasuries Bill Index as the usage was consistent with DOL guidance.
2) On December 29, 2015, a lawsuit, Bell et al. v. Anthem Inc. et al., was filed in the U.S. District Court for the Southern District of Indiana, Indianapolis division. This lawsuit involves the Anthem, Inc. 401(k) Plan, which has about $5 billion in plan assets. While the lawsuit is centered on not using lower-cost CITs over mutual funds, it also alleges that in 2006, the plan replaced the stable value product with a money market fund which cost participants $65 million in lost earnings from 2010 through September 30, 2015.
Largest challenges for stable value funds
Stable value fund managers summarized their largest challenges as relating to the potential for rising interest rates and aging demographics. The concern is that in a rising rate environment, market-to-book ratios could dip below par. While stable value products are designed to withstand decreases in market value below par, the ability of managers to navigate a rising interest rate environment will depend on how much interest rates rise and how quickly. Small and gradual interest rate increases are manageable with lower crediting rates. Sharp interest rate increases could drop market values below book values quickly. If market-to-book ratios fall below par, it will be more challenging for plan sponsors to execute large scale plan events, including re-enrollments. Managers also expressed concern about managing cash outflows related to aging participants who may need to withdraw funds for retirement or withdraw from their company’s plan at retirement.
Plan sponsors have questioned whether stable value funds provide inflation protection. Historically, stable value returns have outpaced inflation and has been consistent in producing positive real returns. However, we note that fixed income returns historically were much higher while inflation remained low. The gap between stable value returns and inflation has shrunk considerably.
Stable value in target date funds
Many stable value managers view target date funds (TDF) as a potential growth engine, hoping that stable value will be included within a TDF. Some of the leading TDF managers we interviewed were less receptive to using stable value funds. Logistical and legislative hurdles pose barriers for including stable value in off-the-shelf TDFs. Many TDF managers believe that the cost of using stable value in TDFs outweigh the benefits. For example, they believe that short term bond funds likely will generate returns similar to stable value and having principal protection on just that portion of a target date sleeve is of less value when the TDF is exposed to fluctuations in the equity market. Custom target date fund solutions were most likely to incorporate a stable value fund.
Preet Prashar, CFA, is senior research analyst with Pavilion Advisory Group Inc.
[i] Prudential polled more than 400 plan sponsors and 300 advisors/consultants, while MetLife surveyed 205 plan sponsors, 20 stable value managers and nine consultants.
[ii] Hueler takes a straight average of the monthly book value returns of the funds participating in the Hueler Analytics Stable Value Pooled Fund Universe for the month identified. The monthly indeces are linked to calculate the index values for the designated periods. The Hueler Universe currently represents the investment strategies across 15 stable value pooled funds.