Stable-Value Funds Pose More Risks Than Anticipated

     Stable-value funds invest money in fixed-income portfolios that are protected against volatile interest rates by contracts with banks and insurance companies. One or more financial institutions provide so-called “wraps” that guarantee participants will receive the fund’s book value even if its market value falls.

     According to the Washington-based Stable Value Investment Association, individuals had about $520 billion invested in stable-value funds through 138,000 defined-contribution plans as of year-end 2008.

     In recent months, stable-value funds have become particularly popular because of the stock market turmoil. As of March 31, for instance, stable-value funds accounted for 36 percent of 401(k) plan assets, compared with 21 percent at year-end 2007, says Pam Hess, director of retirement research at Hewitt Associates in Lincolnshire, Illinois.

     Concern has been raised, however, because of payments that were less than expected by participants in a Lehman Brothers Holdings fund and a Chrysler fund, both of which had separately managed accounts.

     Other concerns include the quality of investments, the spread between the book and market value, and the available capacity for wrappers. But observers maintain that while not risk-free, stable-value funds are the safest investment option in the 401(k) plans that offer them.

     A stable-value plan offered by Chrysler as part of a supplemental savings plan paid out only 89 cents on the dollar when workers withdrew their investments early this year. In December, a fund managed by Atlanta-based Invesco for the bankrupt Lehman Brothers paid 1.7 percent below book value. Observers say both situations were unusual.

     The Chrysler payout was affected by market volatility and a high number of participants who took a January distribution, the company said in a statement. A spokesman says the automaker has not disclosed how many employees were involved.

     The situation with the Lehman Brothers account involved “a very unique set of circumstances” that were specific to the firm, an Invesco spokesman says.

     Usually matters can be worked out during a bankruptcy reorganization. But in this case, “it was such a quick dissolution of the company” that four of the seven wrap providers who underwrote the credit value of the assets canceled their policies and “we couldn’t get new coverage for that,” the Invesco spokesman says. That led to the 1.7 percent write-down for participants who withdrew their assets from the plan. The spokesman says that for 2008, the plan generated a 2 percent return.

     Despite these cases, many observers say stable-value funds remain among the safest investment options.

     “I would say they’re as safe as your employer is,” says Sheldon Gamzon, a principal with PricewaterhouseCoopers’ human resource services division in New York. If the business is one that is “getting through this economic crisis ... then I don’t think you have an issue.”

     The security of these funds is “largely a function of how they’re built,” says Randy Cusick, Philadelphia-based U.S. investment consulting practice leader for Towers Perrin. “You have some providers out there who have done a very good job” of managing the plans. Others, though, that were more aggressive “got caught in this particular environment, and those are the ones that are having liquidity issues.”

     One area of concern has been investments made by the stable-value funds.

     Many investments have come under pressure, some have performed poorly, and many include mortgages and asset-backed securities, says Ruth Falck, a senior investment consultant with Watson Wyatt Worldwide in New York.

     However, “the underlying portfolios run by these managers are very well-diversified and, therefore, the vast majority of portfolios have not been enormously impaired,” Falck says.

     Another issue is capacity to provide wrap coverage.

     “There are fewer and fewer organizations that want to be wrap providers,” says Angie Parrish, Tampa, Florida-based senior vice president and global practice leader for Aon Investment Consulting, a unit of Aon Consulting.

     Phil Suess, a Chicago-based worldwide partner who heads Mercer’s defined-contribution consulting group, says market-to-book ratios during the past 18 months have not been “as favorable as they’ve been in the past,” which has forced wrap providers “to put up capital to support this difference,” and “essentially limited their interest in writing new business or taking on new business within their existing relationships.”

     American International Group, which has been a major provider of wrap coverage, no longer is taking new business, according to reports.

     Suess says he is particularly worried that many of the banks, for which stable-value funds represent only a small portion of their business, “are going to elect not to continue” providing wrap coverage given their concerns.

     But Cynthia Mallett, vice president-products and market strategies for MetLife.’s institutional business, says, “What we’re really seeing is the quick rise and relatively quick decline in nontraditional wrap capacity” provided by non-insurance companies. “I don’t think anything fundamental has happened to core wrap capacity here, and the insurance industry doesn’t have a problem with capacity,” she says.

     Employers need to make careful choices, observers say.

     “You do need to understand what’s in the portfolio. You need to ask questions about who are the wrap providers and what is their financial condition and what have they put in place in the event of default by one of the wrappers. What agreements do they have in place by the other providers?” Falck says.

     Observers say that even if the stock market rebounds, there will be no rush to return to equities.

     “The average plan participant may be a little bit shy of going back into the equity market with the full force they were in before,” says Betsy Vary, director-investment consulting for Buck Consultants in New York.

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