The Safe Haven in Your 401(k)

by Barbara Bedway | Mar 16, 2009 | Comments

Key Stats

• Name: Stable value funds
• What they are: Pools of short-term bonds whose value is protected by one or more insurance contracts, typically known as wrappers
• How they’re valued: The insurance wrappers allow these funds to use “book value” accounting, which effectively prevents the prices from fluctuating with the underlying bonds.
• Where to find them: In your 401(k)
• Expected 2009 yield: About 3 percent
• Pluses: The price stability of a money market fund and the higher yield of a bond fund
• Pitfalls: The guarantee is only as good as the insurance contract standing behind it.

Until stocks turned around a few weeks ago, just about every investment in your 401(k) had let you down — except one. The so-called stable value fund has continued to deliver on its promise to combine the safety of a money market fund with the higher returns possible from an intermediate bond fund.

Your 401(k) may call its stable value option something else, like a capital preservation fund or fixed-interest fund, but whatever the name, it’s essentially the same thing: a portfolio of bonds and other low-risk investments guaranteed against loss by a collection of insurance companies. Last year, the average stable value fund returned 4.58 percent, compared with 2.89 percent for money markets and 5.07 percent for intermediate bond funds. Investors fleeing stock funds in their ravaged 401(k)s transferred more than $5 billion into stable value funds last year; these funds now make up more than 36 percent of 401(k) plan assets, according to Hewitt Associates.

Lately a few cracks have appeared even in these pillars of safety. But despite the cracks, stable value funds probably remain the safest haven in your 401(k). Still, if you’ve learned one thing in the past few years, it’s that you need to know what you’re getting into.

Built for Safety

Stable value funds invest in high-quality corporate and government bonds, with a twist: The funds back up the bonds with contracts from banks and insurance companies, typically known as wrappers. The wrappers guarantee the principal and accumulated interest even if the bonds in a fund’s portfolio decline in value. If a stable value portfolio falls below the rate of return set by the wrapper, the insurer pays the difference. If the portfolio earns a return beyond what the wrapper guaranteed, the insurer keeps the difference. That way, you get a stable return no matter when you decide to cash out of the fund. Cashing out is dubbed a “participant-initiated event.”

Now hold that thought.

And Then Came Lehman

A low-risk bond portfolio backed by an insurance company contract would seem to be a more or less bulletproof investment. And it is. But “more or less” is the operative phrase here, as investors in Lehman Brothers’ 401(k) stable value fund learned last December. The problem? The fine print in wrap contracts can void the protection in the case of “employer-initiated” events, such as bankruptcy. And Lehman Brothers was one hell of a bankruptcy: More than 13,000 employees, half the company’s workforce, lost their jobs immediately and took their money out of the plan. With so many withdrawals, the insurers could not guarantee principal and the fund was forced to sell bonds at a loss; the $235 million fund fell 1.7 percent in December 2008.

It’s no secret that many stable value funds are now underwater, with their underlying bond portfolios worth less than the guarantees, as Lehman’s fund was. If your company were to go bankrupt with an underwater fund in its 401(k), a Lehman-like loss is theoretically possible.

Why Lehman Redux Is Unlikely

Although it is possible, a replay is pretty unlikely. Not only was Lehman’s demise the largest bankruptcy in U.S. history, it also happened at breathtaking speed. “Typically in a bankruptcy, the plan sponsor will work with the wrap providers to come up with a way to continue coverage,” says Gina Mitchell, president of the Stable Value Investment Association. “A corporation usually comes out of bankruptcy in some form, hopefully as a stronger entity. Lehman was very different because of how quickly it happened and its size.” The fact that it was liquidated also figured in. “You don’t typically have a bankruptcy and fire half your workforce,” Mitchell adds.

In practice, stable value funds have survived other sponsors’ bankruptcies without a hitch. Even Enron employees who invested in their 401(k)’s stable value fund did not lose a cent. And remember that despite the dip in December, the Lehman fund gained 2.2 percent overall in all of 2008. Not too shabby, considering the spectacular dives in nearly every other investment option.

State Street Steps Up

Another provision in wrap contracts can allow the wrappers to terminate the guarantee if they deem the underlying investments to be too risky. In December 2008 and January 2009, State Street elected to provide support − a total of $610 million − to the bond portfolio in stable value funds the company managed. State Street was not contractually obligated to do this. As the company’s 8-K filing (a report filed with the SEC to notify investors of any events that could be of importance to shareholders) stated, “liquidity and pricing issues in the fixed income markets” so affected the accounts that the wrappers “considered terminating their financial guarantees.” State Street’s action to bolster its portfolios kept the wrappers in place.

State Street is one of those good-news/bad-news stories. “State Street is to be commended for doing the right thing,” notes Chris Tobe, a CFA who works with stable value investments at Breidenbach Capital Consulting — although it’s safe to say that State Street acted to preserve its business reputation, not out of altruism. In this market environment, other funds may find themselves in a similar situation, and it’s not clear they’ll have the wherewithal to make investors whole.

It’s a Wrap

One more concern is the financial health of those insurers wrapping the funds, and the need for more of them to provide guarantees. There are about seven active wrappers now — not counting the insurance behemoth AIG, which is not exactly the picture of financial health. AIG wraps roughly 8 percent of the stable value fund assets tracked by Hueler Analytics, a stable-value research firm. Kelli Hueler, the firm’s CEO, acknowledges that there is a need for more contract providers.

For now, though, Hueler points out that stable value funds are typically not dependent on a single wrapper or type of contract. Losing one wrapper means the fund manager would reallocate those dollars to a different wrap or contract provider. Worst-case scenario: If a fund lost a wrapper and couldn’t get a replacement, the fund’s manager would swap the previously wrapped bonds for ultra-safe cash investments, getting a money market-like return until another book-value contract could be put into place. The upshot: The fund’s yield would drop, but its value would not suddenly become subject to bond market fluctuations.

Still the Safest Harbor

All in all, the chance that you’ll lose money in a stable value fund is not zero, but it’s pretty small. And the extent of possible losses is nothing like what you’ve seen in your 401(k)’s unwrapped bond funds, let alone its stock funds. David Babbel, professor of insurance and finance at the Wharton School at the University of Pennsylvania and the author of the only academic study on the long-term performance of stable value funds, sums up: “Stable value funds in most forms are in pretty good shape. [Among investments in retirement plans,] I’d still put them on top for safety and delivering [better than money-market returns]. But nobody is completely escaping this meltdown.”