Stable Value Funds in Your 401(k) Account
What Are Stable Value Funds and How Do They Work?
If you work for an employer which sponsors a 401(k) or Roth 401(k) plan, you might notice when looking over the roster of available mutual fund investments that one of your options is what is known as a stable value fund. Unless you've encountered such a thing before, it might seem confusing because it often won't have a ticker symbol, Morningstar information sheet, expense ratio data, or other common things you might expect when analyzing your potential retirement investments.
Don't worry! It's normal. Let's take a moment to examine what a stable value fund is and why you might opt to own one when establishing your asset allocation.
What Is a Stable Value Fund?
In a 401(k) or 529 college savings plan, a good stable value fund is designed with a capital preservation investment mandate, meaning its primary objective is to avoid losing money, reduce volatility, and generate modest interest or dividend income from a portfolio of high-quality securities tailored to the job. This portfolio can either be managed as a separate account specific to the plan sponsor or as part of a larger, co-mingled portfolio in which multiple plan sponsors participate.
In past generations, the return was generated by a "guaranteed investment contract" with an insurance company. These days, it's more common for the stable value fund to accumulate a portfolio of high-quality fixed-income securities then sign an insurance contract that causes the insurance company to make up any short-fall should the portfolio not provide a pre-determined lower threshold return, while requiring the portfolio managers to turn over any out-performance to the insurance company if the portfolio does better than expected.
For example, one recent retirement portfolio I reviewed for a family member offered a stable value fund tied to a major insurance underwriter that promised capital preservation and a 1.20% tax-free yield. It effectively served as a place to park what were intended to be cash reserves while generating some offset to inflation.
If the portfolio that backs the stable value fund doesn't generate 1.20%, any shortfall is being made up by the insurance group.
What Types of Investors Might Take Advantage of a Stable Value Fund?
There are many reasons someone might want to opt for a cash-like investment in their retirement portfolio. It isn't necessarily a bad idea for people retiring within five or ten years to keep a minimum of 10% to 20% of their holdings in cash to serve as a buffer in case of a major stock market crash or recession, That way, they aren't forced to sell off their stocks, bonds, or real estate when prices are severely undervalued, leading to a risk of so-called "portfolio failure"; a risk that can be mitigated by keeping the withdrawal rate at less than 3% or 4% per annum (to learn more about this topic, read What Is a Safe Retirement Withdrawal Rate?). It works because the early year withdrawals are funded by the cash reserves as the passive income from the other portfolio holdings replenish them throughout the year.
Alternatively, it isn't uncommon for some workers to have built up substantial assets outside of their 401(k) plan. When this happens, they may want to use the retirement account to get any free matching money their employer might offer without dealing with what are often sub-par investments selections or increasing their equity exposure.
Instead, they bide their time until the funds are eligible to be rolled over into an outside IRA, the stable value fund serving as a temporary home for the cash until the employee can put it to work elsewhere.
What Are the Risks of a Stable Value Fund?
The ability of the stable value fund to remain exactly that - stable - without suffering major losses is largely dependent upon a combination of the underlying portfolio itself and the contracts that are in place with the financial institutions responsible for backing the product. Ultimately, stable value funds aren't FDIC insured so you're relying on that counterparty to have the resources to meet its obligations should something go catastrophically wrong. If the portfolio suffers severe decline and the financial institution can't cover the losses, it could get ugly.
This is similar to a money market mutual fund "breaking the buck" in a sense. It's not necessarily likely based upon historical experience but it can happen so you should account for it in your risk analysis.
Abusive pricing is another risk of investing in a stable value fund. Due to the nature of the asset, it's possible for the sponsors to charge a lot more in fees, few of which are clearly visible, to the point there have been class action lawsuits filed over them. On the upside, this might not be a concern if you are still satisfied with the return you're being offered and it's the best you have on the table; that is, in a world of near zero-percent interest rates, if your stable value fund is offering 1.50% and you're happy with it, who cares as it still offers the best risk/reward trade-off until you can liberate your money from the confines of the plan? It's better than the alternative of taking on duration risk for a bond fund or adding to your stock holdings when you should be focusing on liquidity, instead.