What 401(k) Advisors Need to Know About Capital Preservation Options

What happens now with 401(k) capital preservation options with a stable value fund?

Stable value fund - what happens now with 401(k) capital preservation options?

The Securities and Exchange Commission (SEC) has ratified changes to Rule 2a-7, overseeing money market funds, initiating a series of structural and operational adjustments due to be implemented in October 2016. With these reforms on the horizon, numerous defined contribution (DC) 401(k) plan sponsors and consultants are carefully evaluating their options for capital preservation, considering aspects such as yield, daily liquidity requirements, stability of net asset value, and liquidity constraints. In this context, the role of stable value funds is becoming increasingly significant, offering a compelling alternative with their blend of yield competitiveness, liquidity provisions, and principal stability.

401(k) plans have typically selected between money market and stable value fund as their capital preservation option. However, recent reforms to the rules governing money funds will add administrative complexity to institutional prime funds frequently used in 401(k) plans, causing plan sponsors to reevaluate their capital preservation options. In this article, we briefly outline the new money market fund regulatory reforms and their impact on DC plans.

Summary of operational changes

The net result of money market reforms will be the creation of three distinct money market fund categories

Category 1: Retail money market funds

The new reforms limit access to retail money market funds to “natural persons.” Under the reform, the definition of a natural person was expanded to include individual investors in DC plans, individual retirement accounts (IRAs), educational 529 plans, health savings plans and ordinary trusts. The new reforms allow DC plans to invest in retail funds that will not be subject to the floating NAV.

Considerations that must be addressed related to retail money market funds include:

Category 2: Institutional prime money market funds

Institutional prime funds are drawing much attention from DC plan sponsors, as they consider whether a floating net asset value prime fund meets suitability requirements as a capital preservation option. While withdrawal fees may not be palatable for plan participants, redemption gates could be more problematic with today’s DC plans, where daily valuation and unrestricted trading have become the norm.

There are several issues that plan sponsors must consider in making such decisions, including:

Category 3: Government money market funds

Government money market funds will retain the most-desired traits for a capital preservation option — a stable $1.00 net asset value, same-day liquidity, no required liquidity fees or redemption gates. These traits will most likely be appealing to DC plan sponsors. The level of demand for securities that meet the requirements for government money market funds, as well as the impact on yield, are still yet to be determined.

Stable value funds

Stable value funds, which are available only to DC plans, are a fourth capital preservation alternative. Stable value funds are designed to provide plan participants with a positive daily return, as is the case with money market funds.

While money market yields reflect rates available in the cash market, stable value funds have historically produced returns that are comparable to high-quality, short- to intermediate-term bond funds over full market cycles. Stable value funds consist primarily of investment contracts issued by a financial institution that are paired with portfolios of fixed income securities, i.e., bonds.

The investment contracts smooth the volatility of the underlying fixed income investments, resulting in a positive return that gradually tracks changes in market interest rates. While bond prices fluctuate based on changes in interest rates, the investment contracts allow participants to transact at contract value (principal plus accrued interest) without experiencing principal fluctuations.

Plan participants have daily access to their stable value balances under normal plan operations to make investment transfers or to take distributions allowed under the plan. Stable value funds are subject to different regulations than money market funds and are therefore not impacted by the recent SEC money market fund reforms.

Evaluating performance

An important consideration in evaluating the capital preservation options are their return characteristics. Stable value and money market funds have produced positive daily returns without the volatility typically seen in bond funds.

While bond funds immediately recognize gains and losses resulting from changing market interest rates, stable value funds amortize gains and losses through the crediting rates of the investment contracts. Stable value has not experienced the monthly return volatility that is typical of bond products.

While the Fed’s accommodative monetary policy has driven the return difference between money market funds and stable value funds to historically wide levels, stable value investments have outperformed money market investments over the last two decades, creating more wealth for DC plan participants.

Plan sponsor considerations

While your plan-sponsor clients are free to continue to offer institutional prime money market funds within their DC plans, the introduction of floating NAVs and liquidity restrictions pose several administrative and communication issues worthy of consideration. Sponsors wishing to avoid floating net asset values, redemption gates and liquidity fees will most likely focus on stable value and government money market funds. It’s an important fiduciary decision that entails having a healthy understanding of the new rules and the impact they may have on participants.

Jennifer Gilmore, CFA, is head of stable value portfolio management and senior portfolio manager with Invesco. Andy Apostol, CEBS, is head of stable value client service with Invesco.

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