A primer on stable value funds for retirement plan advisers

Retirement plan advisers should not set and forget stable value funds.

These funds can be an excellent supporting character in a diversified global portfolio for the right defined-contribution-plan clients. But good advisers take nothing for granted. It’s important to look under the hood of investments, even those considered to be the “safest” components of a portfolio.

Stable value funds resemble money market funds. They are designed to pay a stable rate of interest and protect principal. They are looked upon as a substitute for a short or intermediate-term bond fund without the corresponding volatility.

These funds are usually invested in high-quality government and corporate bonds of low to intermediate duration. According to the Plan Sponsor Council of America, around 53% of 401(k) plans offer this product.

(More: Plan advisers give stable value another look)

Unlike most bond funds, stable value products can shield investors in a rising-interest-rate environment. This is accomplished by the purchase of “wrap protection.” This insurance keeps interest and principal stable despite the underlying value of the investments.

“Wraps” are purchased mainly from insurance companies and banks. Stable value funds can purchase “wraps” from more than one source to provide greater safety.

So, which clients are prime candidates for stable value funds?

Conservative investors who are approaching retirement are ideal clients for stable value funds. A large fear for advisers regarding clients’ retirement plans is sequence risk, or receiving low or negative returns when clients begin to take withdrawals from their accounts. A stable value fund can be deployed to help offset some of this risk.

Many advisers like to keep three years’ worth of spending in a separate bucket for their clients. In today’s low-rate environment, stable value funds should provide a significantly higher interest rate than a money market fund. Stable value might be the ideal home to deposit these funds when deploying this strategy.

Who should not be using stable value funds?

The adviser’s job is to make sure stable value funds are not used to provide capital appreciation.

Many workers are defaulted into this product, but they may be decades away from retirement. This will virtually assure a low overall return compared to a diverse global portfolio of stocks and bonds. This mistake can have a catastrophic effect on their chances of funding a lengthy retirement.

In this case, a so-called “safe” investment is anything but.

How should advisers evaluate stable value funds?

Stable value funds are not insured by the Federal Deposit Insurance Corp. as are money market funds. They may have attached insurance wrappers. This is vastly different than being guaranteed by the federal government. Wrappers are only as solid as the financial institutions providing them.

When choosing a stable value fund, advisers should look at the financial strength of both the provider and company issuing the wrap insurance.

Advisers should consider the current interest rate offered by the fund. It would be a big red flag if the rate is significantly higher than the average intermediate-bond-fund rate. This could mean the investments underlying the fund are not high-quality bonds, which would be completely inappropriate for the scenarios for which this product was designed.

Advisers should examine the liquidity provisions of the fund. Unlike most money market funds, many stable value funds do not give investors immediate access to their cash.

They often employ something called an “equity wash” provision. Investors cannot switch money into a similar investment like a money-market or short-term-bond fund; they may have to move funds to a stock fund and wait 90 days before a cash conversion. This is designed to reduce arbitrage and prevent chaotic withdrawals.

Advisers should look at fees closely, because unnecessary high fees cannibalize performance. As a guideline, if the underlying investment fees are 1% or more, caution is warranted. Also watch out for some funds claiming 0% fees; the fund sponsors might be making huge spreads between the interest they pay out and the return on the underlying investments. Again, it is simply a way to mask the fact that the client is being charged more than is necessary.

The 2007-09 financial crisis led to big problems in a small portion of these products. There are no guarantees for investors, and there are many nuances involved in selecting a stable value fund.

Advisers, choose wisely.

Anthony Isola is head of the 403(b) group at Ritholtz Wealth Management.