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Stable value funds, with over $560 billion in collective assets, have long been a dominant fixture within the 401(k) marketplace. Unfortunately, the information available on the underpinnings of these funds poles in comparison to that available regarding the registered products they accompany within the investment menus of many qualified plans.

While it is tempting to think that stable value funds (SVFs) are all the same, the reality is that they come in all shapes and sizes with significantly different underlying portfolios, expenses, and risk profiles. It is difficult to compare SVFs on an apples-to-apples basis because of some noteworthy variations, such as pooled versus separate account structures, the credit quality of the underlying portfolio, cash flow, wrap coverage via external insurers or via the sole insurer sponsoring the find, participating versus nonparticipating contracts and, finally, 12-month put versus market value adjustment exit policies.

One aspect of the Financial Reform Bill (the Bill) still pending in Congress categorizes the wrap insurance used to prop up SVFs as a swap (http://www.washingtonpost.com/wp-dyn/content/article/201007/15/AR2010071500464.html). Wrap insurance, which is applied to the underlying sleeves of bonds in a SVF, is purchased to ensure that the SVF cannot produce a negative return (with a zero return as a worst case outcome if the hedging is done correctly). One goal of the Bill was to clean up the uncollateral¬ized swaps without anything to back them up that could cause harm to investors expecting no reduction in principal. The Bill then takes reform one large step further by stipulating that the firm that issues the insurance contract would then have a fiduciary duty to the plan (and both the buyer and the seller in the transaction). The Securities and Exchange Commission (SEC) has been charged to review purchase decisions and, ultimately, to implement what it sees as the remedy for any harm suffered. While many think or hope that no action will ultimately come out of the SEC's review, there is still a chance that the SEC's action will ultimately unwind the SVF industry. In any case, the likelihood that the SVF industry will emerge from this evaluation unchanged is slim to none.

SVF Versus Money Market Funds

Given the implications of the huge sums invested by 401(k) plans in stable value funds, a comparison to their typical competition--money market funds--may be instructive.

Different Risks, Returns, and Volatility

Money market funds are invested in short term, high quality, highly liquid investments, such as certificates of deposit and T-bills. They have an average maturity that is 60 days or less courtesy of recent changes to SEC Rule 2a-7. Stable value funds, on the other hand, are invested in a range of short-to-intermediate bonds, as well as the general accounts of insurance companies, with average maturities typically in the four-to-five year range.

By purchasing short-term investments with the highest ratings, money market funds take significantly less risk than SVFs, which usually means a lower return than SVFs over the long haul. SVFs, which invest primarily in the intermediate term bond market, take more risk and, hopefully, provide higher returns.

As short-term investments, money market funds are immediately affected by changes in interest rates. Not long ago, four to five percent interest rates on money market funds were common; as of this writing, the return is about 0.10 percent. SVFs purchase insurance "wrap" contracts to protect against losses and credit today's rate based on a blend of past and present interest rates.

When interest rates plummet, as they did recently, money market fund rates reflect 100 percent of the decline. The opposite is also true: money market funds paid double-digit returns when rates spiked in the 1980s. SVFs, on the other hand, smooth out the peaks and valleys of interest rate changes through the use of the insurance wrappers and crediting techniques. Cash flows also have a direct impact on rates of SVFs.

Availability and Information Disclosure

Money market funds and SVFs may both invest in bonds offered by the U.S. government, but neither offers a guarantee of principal, although there are a few exceptions on the money market side of the equation. Neither type of investment is guaranteed by the federal or state government. While many providers have tapped into fear by offering "FDIC insured" money market products, the reality is that the FDIC is so unstable that a massive failure of money market funds would not have the assets/backing to live up to their guarantees. While neither type of fund is designed to lose principal, it has happened on rare occasions.

Money market funds are offered to the general public, as well as to retirement plans. They are mutual funds and, as registered products, can be purchased in any type of account. SVFs are not mutual funds. They are collective investment trust products offered only within qualified retirement plans, such as a 401(k).

As a result of the public registration of money market funds, information on such funds is publicly available. On the other hand, investors in a SVF can only receive information on the fund directly from the offering company. That information is sometimes sparse.

In short, SVFs and money market hinds have more differences than similarities. These differences do not necessarily make one superior to the other, but it is fair to say that over the long haul, the average SYF should provide a higher rate of return than the average money market fund. However, neither is designed to meaningfully outperform inflation. They are parking spots for money that offer less risk and significantly less return than the other options within a plan's investment menu.

SVF Comparisons

Net rate of return. With the correct software and data feeds, it is possible to compare the net return of competing SVF products. Unfortunately, net returns are not innately helpful as the data can be driven dramatically by other elements, such as cash flow and duration.

Expenses. The stated expense is another element of comparison among SVFs. The right cash flow at the right time can make an expensive SVF temporarily outperform a low-cost version.

Market value (MV) vs. book value (BV) ratio, SVFs make payments at their unit value, also called book value, which is typically $1. On the other hand, the market value, which is what the underlying bonds within the fund are worth, may be more or less than the book value. Why should investors care about MV? During the throes of the 2008-2009 downturn when declines in the value of corporate bonds dramatically reduced their MV, it was not unusual to see a SYF with a MV of 92 percent of its BY. In practical terms, this meant that a SVF with less than 100 percent MY vs. BY could not afford to pay all of its obligations. In the fourth quarter of 2010, these ratios rebounded and most healthy SVFs now have a MV above 102 percent.

Duration. Much like a traditional bond fund, SVFs have durations. In a declining rate environment, duration can help estimate the potential gains or further declines in short-term rates. In a rising rate environment, duration can point to the amount of losses a portfolio would suffer as rates climb.

Credit quality. Prior to the 2008 collapse, it was not all that unusual to see some exposure to high yield or emerging markets debt within a SVF. Lately, overall credit quality has become somewhat homogenized due to the newer, tighter requirements of the wrap insurance provider community.

Number of clients/size of the largest clients as a percentage of the fund. In a pooled environment, it is worth noting not only how many others share the same pool but also the size of their position versus everyone else. A departure from the fund by an investor that holds 25 percent of a pool is a major event. Even more significant for those remaining in the pool is where rates are during liquidation of their portion of the portfolio.

Pooled vs. separate account structure. A pooled product is similar to a mutual fund where the assets of all investors are gathered in one pool. A true separate account is a completely different approach where the assets of one client are managed separately. In a true separate account the cash flows of other clients have no impact. As these are two distinct approaches it's not possible to compare them on an apples-to-apples basis (more information on the separate account structure is found in the next section).

Pooled funds take in cash and upon termination pay out in cash. It is not safe to assume, however, that a true separate account SVF (belonging to only one client) will offer the ability to purchase an individual basket of securities that can later be moved to another manager. Some separate account managers actually utilize a building block approach, in which each client buys a vertical slice of the underlying funds. Notwithstanding this approach, upon termination, the investor in a fund using a building block approach will still typically receive cash and not a basket of securities, just as they would have under a pooled environment.

Management. The management structure of SVF products is nearly as diverse as their mutual fund brethren. Some vendors, such as Schwab, utilize a manager-of-managers approach to gain exposure to the various parts of the bond market through use of external managers who are, in turn, overseen by an internal team. Other vendors, such as T. Rowe Price, rely on internal management to build and run the portfolios. Several years ago, prior to the market collapse and dearth of wrap coverage, the manager-of-manager and internal management approaches could have distinct differences in their styles and underlying holding. Those differences are now being muted by the conservative terms of the existing wrap providers, which eliminates significant variances in holdings and duration, and the fact that most stable value funds have had to turn to a small group of insurers that are willing to manage new contributions under separate accounts that they also then guarantee (this is another way to handle cash flow in an environment where wrap insurance is difficult and expensive to obtain).

SVF Comparison Impediments

Home cooking. Some bundled 401(k) providers offer different sleeves of a single SVF product: their own. In particular, there simply are no SVF options available in many of the bundled products offered in the small plan market. In the mid-market (defined loosely as plans of up to $500 million in total assets) the home cooking theme still dominates, depending on the vendor selected. For example, Vanguard currently offers only its Retirement Savings Trust SVF, and, in an effort to stem cash flows, even that is offered on a case by case basis. Other vendors have gone in the opposite direction, liquidating their proprietary SVF in favor of an extremely limited menu of nonproprietary products and, of course, proprietary money market funds.

Cash flows. Many vendors consider details regarding cash flow to be proprietary information. This is unfortunate, as this single factor can serve as the primary driver of the crediting rate. A given SVF fund might reflect a one year rate of return that is .75 percent higher than the bulk of the competition. It is easy to make the assumption that the higher rate of return is attributable to the prowess of the management team. Unfortunately, the real driver of excess performance may be the fact that cash flow within the SVF turned negative in a falling interest rate environment. Conversely, a fund that appears to be underperforming its competition in a falling interest rate climate may be the victim of too much positive cash flow. The chart below explains the nuances.

Separate accounts within pooled products. Insurers, such as New York Life and Prudential, have made significant inroads into the stable market over the past few years with separate account products managed and custodied by some or all of the staff that manages the general account of the insurer. There is no external wrap coverage, only a promise to pay that is tied to the general health of the insurer. How does a product that utilizes--and pays for--a traditional array of wrap providers compare with one where the "insurance" is a charge that is passed to another business unit of the same insurer? In short, it does not. The profitability of the separate account backed by the insurer has a significant advantage over competitors that have to find and pay for external wrap coverage. The insurer running the separate account also has the corresponding advantage of not being bound by external limitations as to the cash that it can accept (and underwrite). This is the reason many traditional funds are seeking out relationships with the insurers to establish separate accounts to handle additional flows. The insurers, particularly when offering their own bundled 401(k) products, use their increased profitability to their advantage when pricing a plan.

Even within the context of comparing two traditional SVFs, the size and impact of expenses can be difficult to determine. The use of proprietary fixed income or cash management products can aid the underlying profitability of a SVF, masking fees and allowing the offeror to understate the true extent of its fees and profitability. In many cases, the single biggest driver, cash flow, can make what would ordinarily be considered an expensive product look extremely competitive when compared with peers with significantly lower fees.

Participating vs. nonparticipating contracts. In a participating contract, the client and its participants get exposure to the performance of the underlying portfolio in the form of a fluctuating return. Nonparticipating contracts (now somewhat rare) offer a fixed rate of return that is typically lower than that available from a similar participating contract.

Separate account SVF managers. This is a true, independent separate account for a single client, not a separate account offered by an insurer that is tied to its general account. Many managers willing to establish a separate account SVF for a single client now prefer at least $100 million in assets prior to agreeing to propose their services. The ability of this structure to offer upside versus a pooled environment depends on many factors, including expenses of the manager and the external wrap providers, manager skill, limitations imposed by the external wrap providers, and, of course, cash flow.

Three Paths

Given an understanding of SVFs and the attempt to differentiate them, let me frame our analysis using an analogy.

Suppose that there are three sets of hike-and-bike trails along the bayou near my home. Lest you think me ostentatious, I should point out that the word "bayou" is a local euphemism for what would be known elsewhere as a drainage ditch.

Trail 1 is paved and serves as the conduit for spandex-clad individuals who want the illusion of the Tour de France minus the requisite training or the Alps. With the exception of a close encounter with a Lance Armstrong devotee, this is a fairly safe, uneventful trail.

Trail 2 mirrors the first but is unpaved and sits above the berm that theoretically keeps the adjacent neighborhoods from a close encounter with the bayou. Trail 2 does have an occasional bout of elevation and a stray rock or two, but the main danger comes in the form of unattended proof of prior dog walks.

Trail 3 actually winds within the banks of the bayou. It twists and dives, and is choked with vegetation and mosquitoes. Portions of Trail 3 are frequently washed away when the bayou floods. In short, Trail 3 is a lot of fun for the mountain bike enthusiast--until it is not.

While this description might mistakenly give the impression that a huge range exists in the risk levels of these three trails, the reality is that even Trail 3 can be successfully navigated by a rank amateur or weekend warrior. It takes longer, and likely involves a few more bumps and scratches, but it is not something that someone who hails from a state with mountains or even hills would think about twice.

If we juxtapose our trails against the financial world, I submit that fans of Trail 1 prefer safety and predictability of returns. Many of these folks are currently sitting in money market accounts, earning next to nothing in the way of interest but finding solace in the safety.

SVFs, on the other hand, historically resemble Trail 3. Unlike money market funds, they invest in intermediate-term bonds that have a fair amount of play in their market value. Some SVFs have, in the past, placed small amounts in subprime mortgages, high yield bonds, and emerging market debt.

In our post-2008 financial meltdown world, the insurers that provide wrap coverage on the bond portfolios within an SVF have tightened their restrictions to the point where many will only back investment in treasuries and the highest grades of the corporate bond market. To some extent, insurers have asked SVFs to look like Trail 1 while at the same time increasing the rates for coverage far in excess of what they previously charged for Trail 3. With the departure of SVF managers who were either poor stewards or excessively risky and the institution of new requirements by the wrap insurers, it is fair to say that nearly all of the SVF universe now fits squarely on Trail 2.

While SVFs have become centered on Trail 2, it is worth noting that the transparency of the underlying components discussed earlier varies widely from one product to another. Almost none-- sans a separate account SVF run for a single client--has anything close to the transparency of a money market fund/Trail 1. Even within a single client separate account, there are techniques such as the building block structure that add vagary to the equation.

Trail 3 and the lure of higher returns still exist, but it does so primarily via a SVF tied to and insured directly by a single insurer. In these products it is still possible to find significant excess allocations to corporate, mortgage-backed securities, and longer-term maturities. It all depends on the risk appetite of the insurer offering the SVF. It is also reasonable to categorize a more generic SVF that refuses to divulge basic data as something that belongs on Trail 3.

How to Choose

In choosing a SVF, it is best to determine first whether there exists an option. It may well be that the recordkeeping solution chosen for a plan has but one homegrown option when it comes to SVFs. If other options exist, then it is probably best to frame the process by the three trails and by the time available to devote to the effort.

Those who want the clarity and predictability of a Trail 1 and who do not wish to spend a fair amount of time reviewing MVs, credit quality, and management structures should probably stick with a money market option.

Those who are willing to devote time and effort to the evaluation, but who need to identify and understand all of the points that were previously raised, will want to stay with the minority of the SVF universe on Trail 2 that supplies this level of information. There is no simplistic scoring system that will provide a reliable outcome and it is best to seek a seasoned outside resource for this analysis. Those with assets in excess of $100 million in this category may want to pursue their own separate account SVF for the benefits this structure has in the way of control and exit terms.

Trail 3 still exists, but it serves as a resource primarily for those who seek higher returns without the desire to understand how those returns are achieved. On one hand, it is comforting to note that the insurers in business today survived the cataclysmic downturn of 2008-2009. On the other hand, it is probably unwise to assume that any firm is truly too big to fail.

Choose your path carefully.

Marshall J. Cobb, CRSP, is president and founder of Cobb Retirement Solutions, LLC., an independent, fee-only firm offering qualified plan analysis and oversight exclusively to corporations and organizations. Cobb’s first-hand knowledge as a veteran representative of retirement plan vendors beginning in 1990 gives him a unique perspective as he advises his clients. Cobb runs his office -- based in Houston, Texas -- with employees and clients across the country.

Posted from the Journal of Pension Benefits, Spring 2011, with permission from Aspen Publishers, a Wolters Kluwer Company, New York, NY, 1-800-638-8437, www.aspenpublishers.com.

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