Remember the days when employees sat down with their HR/benefits representative to decide which of the available investment funds to include in a 401(k) retirement portfolio?
One fund looked like a sure thing — conservative and boring, but safe. Thinking they couldn't go wrong, they may have allocated 50% or more of 401(k) savings to that fund, also known as the "stable-value fund."
Despite the comforting name and generally strong track record, stable-value funds aren't entirely stable anymore. Employee-investors can lose money, and the funds also carry a credit risk. While stable value fund managers try to maintain a stable $1 unit price, they can't guarantee it because the yield and underlying investments fluctuate.
For example, in 2005, the Trust Advisors Stable Value Plus fund declared bankruptcy. And in December 2008, Invesco's stable value fund available to Lehman Brothers employees lost 1.7% in value "because bond prices fell and the insurance backing, called a 'wrap' in financial parlance, ended after Lehman's mid-September bankruptcy filing," according to the Wall Street Journal. Today, the market value of many stable value funds is below their book value. And more of these funds could be impacted as bankruptcies increase in the current financial mess.
WHAT WENT WRONG?
Until the mid 1990s, stable value funds actually lived up to their name. Most were rock solid — 95% invested in the most conservative products held in insurance companies' general accounts. Offered by solid companies like New York Life, MetLife, Principal Financial Group, the Hartford and Prudential, they could be counted upon to provide a small but steady return — kind of a bank account for our golden years. They emphasized preservation of principal.
Then, Wall Street brokerages and private stable-value firms got into the act. Thinking they could provide a much richer return through their superior "investment intelligence," they started offering their own "synthetic" contracts. But, rather than investing in boring old insurance products or Treasury bonds, they decided to spice things up and base the funds on riskier investment assets with the promise of healthier returns.
To protect against possible losses, they bought mortgage bonds with financial guarantees by firms with triple-A credit ratings. But many of the guarantors that provided those ratings — MBIA, Ambac and others — have defaulted, so the "wrappers" they provided are virtually worthless.
And if that weren't bad enough, the insurance company they sometimes teamed with for the wrapper is one whose name is now synonymous with our current economic crisis — AIG. AIG wraps roughly 10% of the stable-value fund assets tracked by Hueler Analytics, a company that studies stable-value funds.
Needless to say, the risk of default or underperformance of the assets behind stable-value funds has increased significantly.
To complicate the matter, among the "riskier" investment vehicles the fund managers chose were mortgage-backed securities, including those sub-prime mortgages that are now in default. So there's a chance that a plan's stable-value fund might currently be invested in only 10% safe insurance products, with the rest in residential and commercial mortgage-backed securities, asset-backed securities, auto loans and maybe even credit-card debt. Consequently, it could be deteriorating because of the liquidity, pricing and credit risk in its underlying portfolios.
The problem is plan sponsors and investors may not even know it. Due to chasing yield instead of being focused on safety of principal, many of these funds were recently underwater with below-par investments. Some would have had to liquidate assets at a loss to cover payouts. However, new 401(k) participants came to their rescue. As the stock market tanked in 2008, participants seeking a safe haven from the market meltdown started flooding stable-value funds with cash. In fact, research shows the allocation of 401(k) assets to stable value is at a historic high as 401(k) participants continue to transfer out of equities and into fixed-income investments.
Wait a minute. New money paying off old investors? Isn't that a Ponzi scheme?
The stable value firms' trick doesn't exactly qualify as a Ponzi scheme, but it certainly tiptoes close to the line. At the very least, it places the stable-value fund managers in the same rogue's gallery with other accomplices in our current financial plight: banks (for approving bad mortgages), ratings agencies (for selling out to the investment banks), and our dear old Uncle Sam (for lack of oversight).
ALL IS NOT LOST
Investors and plan sponsors can both perform due diligence to determine a stable-value fund's risks. Here's how.
First, determine who manages the stable-value fund. If it's a private stable-value fund manager or a brokerage firm, ask the 401(k) vendor for the fund's fair value or "mark to market" value (not the "book value," which can be misleading). This value will reveal the fund's exposure to securities that are trading significantly below amortized cost. Investors are within their rights to demand this information, and the vendor is legally obligated to provide it under the Financial Accounting Standards Board position that investment contracts held in a defined-contribution plan are required to be reported at fair value.
If the fair value is less than 95%, it may be time to consider a change — or at least request the most recent audited financial statements of the fund, together with a listing of its holdings.
Could there be a stampede to exit stable-value funds? Maybe. Worst case, the funds could limit or suspend withdrawals. Under this scenario, plan administrators would be required to provide a blackout notice under Section 101(i) of ERISA and participants would be temporarily unable to transfer out. Another option would be for the fund to pay out a plan's fund balance utilizing a market-value formula to account for the underlying fund losses.
All investors should review the condition and operation of their stable value funds and identify risks and issues. Also, review your contract's cash-out provisions. Many funds have a 12-month "put" option for plan-level withdrawals due to the negative impact of market-value losses to the fund. The safest alternative for 401(k) investments in today's economy seems to be laddered insurance company window GIC contracts, which guarantee principal and interest for all deposits received during a 12-month period.
The market meltdown has revealed the soft underbelly of our financial system and has shown us once again the importance of serious due diligence in financial matters. The good news is we're getting smarter all the time. EBA
Gary Mink is the executive vice president of HR Benefit Advisors, a United Benefit Advisors member firm. Based in Rochester, New York, Mink can be reached via e-mail at gmink@hr-benefit.com.
DC overtakes DB
It's too soon to know where the current economic crisis will rank in the history of recessions, but a recent study by the Employee Benefit Research Institute confirms one thing for sure: The stock market slide is affecting retirement accounts like never before. That's because approximately two-thirds of workers identify a defined contribution plan as their primary retirement plan.
Of the survey participants in a retirement plan, 67.1% had a 401(k)-type plan as their primary plan in 2006, more than double the number found in a 1988 survey. Meanwhile, the number of workers with a defined benefit retirement plan as their primary plan dropped more than 25% from 56.7% in 1988 to 30.9% in 2006.
"As defined contribution plans have become more important - and as defined benefit (pension) plans continue to fade in the private sector - it is likely that workers' contributions to these plans will need to grow even faster if they expect to be able to afford to maintain their current lifestyle in retirement," says Craig Copeland, EBRI senior research associate and author of the study.
The increased dependence on defined contribution plans over traditional pensions is evidenced through further breakdown of the data. Of nonagricultural wage and salary workers age 16 and older, 30.1% had a salary reduction plan, such as a 401(k) plan, as their primary retirement plan in 2006, compared to 7.5% of 1988 participants.
Additionally, EBRI's research includes statistics on 2006 retirement participation and sponsor levels based on the U.S. Census Bureau's Survey of Income and Program Participation, which show that less than half of American workers participate in a retirement plan.
The percentage of workers participating in a retirement plan decreased four percentage points in three years from 48% in 2003 to 44% in 2006. The 2006 data is similar to the participation levels found in 1979-1993, and identical to the 1998 level.
The average employee contribution to salary reduction plans, such as 401(k) plans, increased gradually from 7.1% in 1993 to 7.5% in 2006.
