Investors piling into stable-value funds — but not reading the fine print

Galliard Capital Management Inc.'s stable-value funds, designed to preserve principal in tumultuous times, drew more than four times the usual inflows in August as market volatility increased, said managing partner John Caswell. Investors in retirement plans administered by Wells Fargo & Co. (WFC) moved $850 million into the funds that month, while at Aon Hewitt, a benefits manager, about $1 of every $5 transferred by plan participants was put in a stable-value fund. While the funds recently have outperformed the stock market, investors should realize they're riskier than money funds, and may contain restrictions on transfers and withdrawals, said Jeff Elvander, chief investment officer for Aliso Viejo, California-based 401(k) Advisors Inc., a consultant to employers that offer defined-contribution retirement plans. “Some of those restrictions may not be clearly communicated until a participant tries to make a transaction, and then they're prevented from making it,” Elvander said. Stable-value funds are viewed by many investors as a higher yielding alternative to money-market funds, said Pamela Hess, director of retirement research at Aon Hewitt, a unit of Aon Corp. (AON) In August they returned 0.22 percent, compared with the 5.68 percent decline in the Standard & Poor's 500 Index. They achieve those returns in part by purchasing insurance contracts, which come with restrictions. The funds are riskier than the typical money-market fund, meaning they aren't really comparable investments, said Donald Stone, president of Chicago-based Plan Sponsor Advisors. No Guarantees “There's a reason why they call them stable value, not guaranteed,” Stone said. “I don't think participants understand that. They understand if they put a dollar in they'll get a dollar back, and some interest.” There was about $540 billion invested in stable value products as of December, according to the Stable Value Investment Association. The funds are more complicated than most investors realize, said Hess. Although they're often called “funds,” stable-value can refer to funds that pool one or more retirement plan's assets, and to insurance contracts, in some cases annuities, that are offered within defined-contribution retirement plans such as 401(k)s. The funds generally invest in short- to intermediate- term bonds and buy insurance on their portfolios. The contracts are issued directly to a retirement plan sponsor or to its participants, and offer an interest rate that resets periodically. Smooth Ride By buying insurance on their portfolios, the funds can allow investors to redeem shares at principal plus interest, even though the underlying bonds may be lower or higher in price. The insurance is meant to cover a potential shortfall should a fund have to sell bonds to meet redemptions. “The insurance smoothes out the returns of the underlying portfolio,” said Gina Mitchell, president of the Washington- based Stable Value Investment Association, a membership and trade group for the stable-value industry. The insurance also comes with restrictions. The companies that provide the contracts, including Prudential Financial Inc. (PRU) and JPMorgan Chase & Co. (JPM), generally limit the circumstances under which they'll pay out and may also restrict how or when savers may transfer or withdraw their money. “The insurance company is willing to guarantee this book value, but they're only willing to do that up to a point,” said Stone of Plan Sponsor Advisors. Investors usually can't move their money to competing investment options such as short- to intermediate-term bond funds for 90 days after withdrawing from a stable-value option, said Caswell of Galliard, which is a subsidiary of Wells Fargo and oversees about $68 billion in stable-value assets. Surrender Charges The insurance contracts can be even more restrictive. Savers in a stable-value annuity issued by TIAA CREF may only withdraw or transfer funds over a set schedule of 10 payments during nine years. Workers who quit a company that uses the product in its retirement plan may take a lump sum within their first 120 days of leaving, during which they would pay a 2.5 percent surrender charge. Retirement-plan administrators such as Boston-based Fidelity Investments said these restrictions are disclosed in investment literature, even if participants don't always read it. Those limitations allow TIAA CREF to offer a higher interest rate than it would be able to otherwise, said Phil Maffei, director of product management for the New York-based insurance and mutual-fund provider. The TIAA CREF annuity yielded 4 percent in August. Insurance Caveats Insurers also generally stipulate that they won't be liable under certain circumstances, which can leave savers with losses. Major layoffs, mergers and bankruptcies at the employer usually nullify a portfolio's insurance. That's because large outflows from a fund increase the likelihood that an insurer would have to pay out on the contracts they've issued. Employees of Chrysler LLC received 89 cents on the dollar, or a loss of 11 percent, when a stable-value fund the company offered in a supplemental savings plan liquidated in January 2009. Insurance on the fund, which was managed by Dwight Asset Management Co. LLC, didn't cover the shortfall because of restrictions on the insurance contracts. Kristel Garneau, a Dwight spokeswoman, declined to comment on the Chrysler fund citing client confidentiality. Lehman Brothers A stable-value separately managed account offered to Lehman Brothers Holdings Inc. (LEHMQ) employees lost 1.7 percent in its liquidation in December 2008, because the portfolio's insurance stipulated it wouldn't pay in a bankruptcy. Lehman Brothers filed for bankruptcy under Chapter 11 on Sept. 15, 2008. After accounting for that drop, the Lehman Brothers fund returned 2.2 percent total during 2008, said Bill Hensel, spokesman for Atlanta-based Invesco Ltd. (IVZ), which managed the fund. Such losses are rare, said Galliard's Caswell. Often companies have no need to liquidate a plan in a bankruptcy, and if they do they generally have more time to plan and are able to pay out participants' assets without losses, he said. “Stable value's been a safe haven,” said Mitchell of the trade association. “It's not risk free, but it is one that has continued to perform throughout the financial crisis and even in today's volatile market.” Bond Funds Stable value is a conservative investment option and participants should think of it as similar in risk to a short- term bond fund, rather than as a cash-equivalent, said Kristi Mitchem, head of global defined contribution for State Street Global Advisors, a unit of State Street Corp. (STT) The funds returned 2.9 percent on average for the 12 months ending in August, compared with the 1.8 percent average return for short-term taxable bond mutual funds, according to data from Hueler Companies Inc. and Morningstar Inc. (MORN) The average stable- value fund yielded 2.55 percent on Aug. 31 compared with the average taxable money-market fund yield of 0.02 percent on Aug. 30, according to data from Hueler and from iMoneyNet, which tracks money-market funds. “Defined-contribution plan participants tend to be a conservative group, often citing preservation of principal as a major factor in fund selection,” said Christopher Rowlins, a consultant to plan providers with Fiduciary Investment Advisors LLC in Windsor, Connecticut. “That is one reason stable-value funds are and remain popular.” Investors, for whom losses in stable value have been rare events, may not have realized that in some cases fund managers were propping up their own products during the financial crisis. Terminating Guarantees State Street voluntarily contributed about $450 million of its own capital to the stable-value funds it managed during the fourth quarter of 2008, and purchased about $2.5 billion of debt securities from the funds, because the investments the funds held had fallen significantly in value, according to its annual report from that year. “During 2008, the liquidity and pricing issues in the fixed-income markets adversely impacted the market value of the securities in these accounts to the point that the third-party guarantors considered terminating their financial guarantees with the accounts,” the report said. The Boston-based company is in the process of exiting the stable-value business, said spokeswoman Alicia Curran Sweeney. Some insurance contracts allow the issuer to terminate for any reason provided the company gives notice, such as 90 days, Stone said. ‘All Bets Off' “If we went into some kind of world calamity here, it could be all bets off,” Stone said. “You can imagine an instance where the guarantee might be difficult for a company to honor.” After the financial crisis, the cost of the insurance has more than doubled to 15 basis points to 25 basis points of fund assets from 4 basis points to 8 basis points, said Mitchell, of the Stable Value Investment Association. A basis point is 0.01 percentage point. “Insurers had priced this business on the idea that they would never have any claims,” Stone said. During the 2008 to 2009 financial crisis, “they were really staring into the face of having to pony up quite a bit of money.” Those costs reduce fund yields and aren't generally disclosed to participants, according to Galliard's Caswell. That may change in 2012 when a U.S. Department of Labor rule requiring comprehensive fee disclosure for 401(k)s takes effect. Management fees, which generally range from 10 basis points to 55 basis points depending on the size of the retirement plan, are disclosed to investors, according to Mitchell. Rising Rates The insurance contracts also depend on the strength of the underlying insurer. Prudential holds an a- long-term rating from A.M. Best Co., which rates the financial strength of insurers. JPMorgan is not rated by A.M. Best and has an Aa3 long-term rating from Moody's Investors Service and an A+ rating from S&P. Even though the funds generally invest in longer-dated debt than money-market funds, they could lag behind money funds' yields if interest rates rise rapidly because they generally take longer to adjust to rate changes, Caswell said. “Right or wrong, there are plenty of disclosures that participants receive that nothing is guaranteed,” with stable- value funds, said Jon Upham, principal of Irvine, California- based SageView Advisory Group, a consultant to plan sponsors. “From a practical standpoint, participants think that if they put their money in a money-market fund or a stable-value fund, they think it is guaranteed,” he said. --Bloomberg News--