During periods of market turbulence and low-interest rates,
many investors struggle to find investment alternatives that aren’t getting
hammered. But people saving for retirement may be pleasantly surprised to
discover a unique breed of mutual fund known as stable value funds.
These funds, which are typically offered in 401(k) plans,
are somewhat similar to money market funds, except they post higher yields with
relatively little risk. If you’re considering a stable value fund, here’s a
look at how they work so you can weigh their advantages and disadvantages
before deciding if they are a good choice for your retirement portfolio.
Key Takeaways
Stable value funds are typically only offered in defined
contribution plans, such as a 401(k).
They are conservative investments that provide steady income
with relatively little risk as your principal is guaranteed.
However, less risk also means lower returns.
Stable value funds are a good choice for conservative
investors, workers nearing retirement, and anyone looking to stabilize their
portfolio during times of market volatility.
Stable Value Funds Explained
As the name implies, stable value funds are a type of cash
fund that resembles a money market fund by offering protection of principal
while paying stable rates of interest. Like their money market cousins, these
funds maintain a constant share price of $1.
Stable value funds have typically paid twice the interest
rate of money market funds. Even intermediate-term bond funds tend to yield
less with considerably more volatility. Stable value funds used to invest
almost exclusively in guaranteed investment contracts (GICs), which are
agreements between insurance carriers and 401(k) plan providers that promise a
certain rate of return.
However, a number of insurance carriers that invested
heavily in junk bonds in the 1980s suffered heavy losses and defaulted on some
of their agreements. Retirement plan participants of other providers, such as
the now-defunct Lehman Brothers (which declared bankruptcy during the financial
crisis of 2008), discovered that their GICs became invalid in the event of
corporate insolvency. Subsequently, GICs fell largely out of favor as funding
vehicles for stable value funds.
These funds now invest primarily in government and corporate
bonds with short- to medium-term maturities, ranging from approximately two to
four years. Stable value funds are able to pay higher interest than money
market funds, which usually invest in fixed-income securities with maturities
of 90 days or less.
How Risk Is Managed
The holdings within stable value funds are more susceptible
to changes in interest rates than money market holdings because of the longer
maturities of the bonds in which they invest.
The share price of stable value funds doesn’t have the
potential to grow over time, but these funds won’t lose value either, which is
not the case with typical mutual funds.
This risk is mitigated by the purchase of insurance
guarantees by the fund that offset any loss of principal; these guarantees are
available from banks and insurance carriers. Most stable value funds will
purchase these contracts from three to five carriers to reduce their default
risk.
Usually, the carriers will agree to cover any contracts
defaulted upon in the event that one of the carriers becomes insolvent.
Disadvantages to Consider
As mentioned previously, stable value funds pay an interest
rate that is a few percentage points above money market funds. They also do so
with substantially less volatility than bond funds.
However, these funds also charge annual fees that cover the
cost of the insurance wrappers, which can be as high as 1% per year in some
cases. Furthermore, most stable value funds prevent investors from moving their
money directly into a similar investment, such as a money market or bond fund.
Participants must instead move their funds into another vehicle, such as a
stock or sector fund, for 90 days before they can reallocate them to a cash
alternative.
$810 billion
Assets in stable value funds in defined contribution plans,
according to the Stable Value Investment Association.
Perhaps the biggest limitation of stable value funds is
their limited availability. They are generally only available to 401(k) plan
participants of employers who offer these funds within their plans.
Another key point to remember is that these funds are stable
in nature, but not guaranteed. Although the chance of losing money in one of
the funds is relatively slim, they should not be categorized with CDs, fixed
annuities, or other investments that come with an absolute guarantee of
principal.
When Stable Value Funds Are a Good Fit
Stable value funds are an excellent choice for conservative
investors and those with relatively short time horizons, such as workers
nearing retirement. These funds will provide income with minimal risk and can
serve to stabilize the rest of the investor’s portfolio to some extent.
However, they should not be viewed as long-term growth
vehicles, and they will not provide the same level of return as stock funds
over time. Most advisors recommend allocating no more than 15% to 20% of one’s
assets into these funds.
The Bottom Line
Stable value funds serve as a happy medium between cash and
money market funds, which have low yields, and bond funds, which have higher
risk and volatility. These funds provide higher rates of interest with little
or no fluctuation in price.
But this stability comes at a price in the form of annual
fees and lower returns than stock funds. In addition, transfers into other cash
instruments can only be made under certain conditions.
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