If you have a 401(k) or other tax-sheltered retirement plan, one of the investment options may be a stable value (SV) fund. In today’s low interest rate environment, stable value funds have been popular as they offer the stable price of a money market fund but with a higher yield. This is due to the fact that they are basically intermediate-term bond funds wrapped in an insurance contract that guarantees it maintains a “stable value”. This means the book value that you see can differ from the actual market value.

In my case, I invest some money in them because they offer a 3% yield on previous contributions (current contributions earn 1.25% on which I passed). Compare that with a money market fund earning 0.01%, or the Vanguard Intermediate Bond fund with a 6.4 year duration and only a 1.78% yield.

However, if interest rates were to rise quickly, this would lower the market value of those bonds (as interest rates go up, bond values go down) at the same time that there may be a rush of redemptions. Would the fund be able to cash people out at the higher book value as promised? A recent Vanguard research paper ran some scenarios based on historical periods of rising interest rates (1986-1990 and 2004-2008). They used Vanguard’s pooled fund, the Vanguard Retirement Savings Trust, with an average duration of underlying investments of ~2.6 years. Read the paper for details, but the overall conclusion was that the stable value funds would survive such scenarios:

Although stable value funds in general have performed well through past market cycles and crises, in the current environment of low interest rates both stable value investors and contract providers have been concerned about the effect rising interest rates would have on the funds and the ability of the funds to continue to perform well when further stressed by cash outflows.

[…] …in our simulations, the funds’ MV/BV ratios demonstrated resiliency, and crediting rates fluctuated within a band far narrower than that of market yields, even in extraordinary scenarios.

While the paper’s findings provide some reassurance, I’m reminded that lots of people “stress tested” mortgage-backed securities in 2007 as well. Based on the Vanguard analysis, here are some additional cautionary steps to take for potential investors in stable value funds:

1. Remember the basics of stable value funds. SV funds are intermediate bonds wrapped in an insurance guarantee, so if the insurance fails then you’re just left with bonds. This isn’t the end of the world, but make sure you’re okay with that. See previous post on stable value funds risks and rewards for real-life examples.
2. Understand your specific withdrawal restrictions. There are usually some form of liquidity restriction attached, but they can vary greatly. In some cases, you have to give a full 12- to 24-month notice to withdraw at book value (guaranteed principal). In my plan, I am not allowed to transfer into any other fixed income (bond) funds at all. I can transfer at any time into a stock fund, but then I have to wait 90 days until I can transfer again to another bond fund. This Reuters article reports that some providers have been cutting back on guarantees.
3. Be aware of scenarios where your stable value fund will be under stress. Usually, this results from rapidly rising interest rates. For example, if the yield on money market funds rise, people will prefer those to stable value funds. Also, the market value of the underlying bonds will fluctuate, even though only the book value is reported on your statements. If the market-to-book ratio on your SV fund drops below 98% (see updated prospectus), people may panic and start to withdraw.

Here’s a mid-year update of our investment portfolio, including employer 401(k) plans, self-employed retirement plans, Traditional and Roth IRAs, and taxable brokerage holdings. Cash reserves (emergency fund), college savings accounts, and day-to-day cash balances are excluded.

Asset Allocation & Holdings

Here is my current actual asset allocation:

The overall target asset allocation remains the same, based on my own preferences and research:
[Read more…]

New 401(k) plan fee disclosure requirements from the US Department of Labor are coming soon. This includes defined benefit, 401(k), 403(b), profit sharing, and other retirement plans. I was getting confused myself, so I wanted to summarize some of the basic deadlines. First, there are three main parties involved:

1. Plan service providers. For example Vanguard, Fidelity, or numerous smaller local providers.
2. Retirement plan fiduciaries. Basically, your employer.
3. Plan participant. The employee.

First, there is a new requirement for fee disclosure by service providers to the fiduciaries (i.e. from Fidelity to the employer). These regulations become effective on July 1, 2012. The idea is to get fiduciaries to understand the services received from providers and to determine the reasonableness of the costs incurred. You’d think that your employer would already demand to know what they’ve been paying for all these years. Why don’t they? All too often, you, the employee are the one paying for it out of your investment balances and earnings!

Which brings up the next stage, the fee disclosure requirement from plan fiduciaries to participants (i.e. from employer to employee), which becomes effective August 30, 2012. Now, your employer is legally required to tell you what fees you’re paying, including both investment management fees and administrative fees for things like record keeping, accounting, and legal services. However, this is likely be wrapped up into just an overall percentage for each investment option, or worded as dollars charged per $1,000 invested.

The basic problem remains. Employers choose 401k plans with high fees often because they it doesn’t affect their bottom line – most are smaller companies with plans that shift the cost burden onto the employees. However, by simply shining a brighter light on these fees and allowing easy comparison between employer plans, it lets employees have more information to affect change. Indeed, it appears this forced transparency is working already, as the WSJ reports:

Employers “have been polishing up their plans in anticipation of fee disclosure, making sure the fees are appropriate,” says David Wray, president of the Plan Sponsor Council of America. He says nearly two-thirds of 401(k) plans changed their investment lineup last year, and 57% did so the year before, compared with a “normal number” of about 10%.

More reading: Department of Labor, NY Times, Employee Benefits Law Report