The Capital Preservation Conundrum

One of the critical factors in maintaining compliance with ERISA Section 404c hinges on providing a low volatility option where plan participants can preserve capital in the next market correction. While money market funds (or “MMF”) and stable value funds (or “SVF”) offer a solution, the differences between the two for plan participants are significant. For the sake of this article, we will use SVF as a placeholder to represent all guaranteed income vehicles as the principles discussed remain applicable. Given the amount of plan assets MMF and SVF vehicles typically garner, it is no wonder they have become targets of recent fiduciary litigation. As a plan sponsor, it is paramount that you know what vehicle is being used in your plan, what alternatives are available and the plan level constraints associated with this selection.

Historically, stable value funds have been able to generate returns exceeding typical money market funds with similar volatility characteristics (see chart). While the portfolio of bonds is managed just like any other short duration bond fund, stable value funds use an insurance wrapper to account for the fluctuations in bond prices. This characteristic creates the stable and predictable return profile participants covet but adds complexity for plan sponsors. In times of economic recession or stock market volatility, stable value funds can be one of the most valuable investment options available. While many other investment returns are much lower in hard times, stable value funds remain just that, stable. That said, the insurance protection has a price. The costs of the insurance wrappers went up following the financial crisis of 2008, a period during which the market values of stable value funds were well below book values and some insurers exited the market. From pre-crisis levels of lower than 0.10%, post-crisis levels reached as high as 0.25%. Moreover, stable value funds are not FDIC insured or registered with the SEC which results in limitations in terms of transparency and makes comparative analysis challenging.

Late last year, the SEC pushed through sweeping changes to the way money market funds are managed and regulated, creating a challenge for managers. At the same time, money market funds have been plagued with paltry returns amid today’s low interest rates, a problem that has caught the attention of attorneys who are suing retirement plans over fees. Since December 2015, at least three lawsuits have been filed alleging certain 401(k) plan fiduciaries breached their duty under the Employee Retirement Income Security Act of 1974 by retaining money market funds as an investment option rather than stable value funds. The recent likelihood that the low yields provided are not sufficient to cover plan expense, resulting in a principal loss for the participant, has added to concerns.

Many plan sponsors and participants like the idea of an investment that doesn’t lose value and provides a solid return. Stable value funds are designed to do exactly that, help preserve capital while generating returns that are consistent with what is expected from fixed-income investments. Available to most investors only through employer-sponsored retirement plans, stable value funds offer an attractive combination of income generation and share-price stability that stands in stark contrast to riskier assets that are also widely available options. That said, these vehicles are not without risks. The risks could involve the credit quality of the company running the fund, the insurer offering the “wrapper,” or a substantial company investing in the fund. Even though stable value funds typically outperform money market funds, fiduciaries may find stable value overly complex due to the need to evaluate additional layers such as the guarantees involved. Some also consider stable value funds to be riskier than money market funds, and the funds may contain restrictions on transfers and withdrawals.

We have identified five key terms to help you make an informed decision about stable value funds:

Ultimately, your process for supporting one vehicle over the other can weigh on a number of factors, such as the needs of the plan and participants and cost relative to value. ERISA requires a prudent fiduciary process in selecting investment options and a diversified range of investment offerings. Documenting the steps taken is vital (see Tibble vs. Edison), regardless of which selection you make for you plan. Know what you have selected for your plan, monitor the selection for prudence and keep easily referenced records of your decision.