Investors flock to stable value funds, despite their risks
Last year’s stock market turmoil sent a lot of 401k investors running for cover. According to industry sources, the most popular investment options for those who pulled money from the stock market were stable value funds.
Also known as capital preservation funds or fixed-interest funds, these funds promise to pay a fixed interest rate without fluctuation in share price.
Most stable value funds delivered average returns of about 4 percent last year, making them far and away the top performing choices in many 401k plans. Workers responded by boosting assets in these funds by 25 percent in 2008.
However, retirement savers shouldn’t be lulled into a false sense of security. In order to deliver such interest rates—which were above market interest rates on short-term investments– stable value funds have to take bond market risks. And the insurance contracts that guarantee share price stability are themselves subject to risk.
Safety in… AIG?
Should investors feel safe in stable value funds knowing that 10 percent of their holdings nationwide are insured by American International Group, the failed insurance giant that is struggling to survive on the government dole?
AIG’s involvement in this market is one of several reasons the government continues to prop up the insurer, Federal Reserve Bank Chairman Ben Bernanke told Congress in late March.
“Workers whose 401k plans had purchased $40 billion of insurance from AIG against the risk that their stable value funds would decline in value would have seen that insurance disappear,” Bernanke testified.
How they work
Stable value funds invest in diversified bond portfolios in order to generate the interest they pay to investors. They attempt to avoid the daily fluctuations in bond prices by backing their holdings with insurance contracts that protect against market swings.
This strategy has generally worked well over the years, but when markets are in turmoil and insurers are hurting stable value funds can end up declining in value and can even become insolvent.
That’s just what happened to one fund, the Trust Advisors Stable Value Plus, back in 2005. It held investments from 1,500 retirement savings plans when excessive risks in its holdings caused it to fail. Investors had to wait more than a year to recover their money from the fund.
Chrysler workers who invested in the firms’ Stable Value Fund B were shocked when the fund went belly up earlier this year. They received only 89 cents on the dollar as reimbursement.
The failure was caused by a rush to the exits by Chrysler workers who lost their jobs. The massive withdrawals meant that the fund had no time to make up for recent market declines.
Indeed, industry experts say that company failures pose the biggest risk to stable value investors.
One expert, David Merkel, chief economist at Finacorp Securities, says he “won’t be surprised” to see a stable value fund fail this year.
The Stable Value Investment Association, an industry trade group, says the funds continue to pose low risk and that it takes “a perfect storm” to cause a failure. However, experts say the failure of major financial institutions and continued credit market problems have posed just such a storm.