Stable Value in Today’s Defined Contribution Plan

Academic study sheds new light on importance of stable value to defined contribution plan portfolios

Written in collaboration with Andrew Cohen, Doris Fritz, Brian Murphy, and Victoria Paradis of the Stable Value Association.

Stable value has been a mainstay investment in qualified retirement plans since the introduction of 401(k)s. Stable value continues to be a popular fixed income option within many defined contribution plans even as regulators focus on the benefits of equity-focused asset allocation strategies such as target date funds. 

But what is the role of an investment that pairs the power of principal preservation with the return of intermediate term bonds in a world focused on building a nest egg for retirement? Has stable value become somehow less important as the retirement industry adapts to the defined contribution plan’s newfound role as the primary pension plan for millions of Americans? 

Today, stable value accounts for $413 billion in retirement plan assets. Despite stable value’s importance to investors, it remains an understudied asset class within the defined contribution arena. Intuitively, many in the financial services industry have long been aware of the important role stable value can play in portfolio asset allocation. But until now, rigorous study of the appropriate role of this asset class has been light. 

To address this academic knowledge gap, the Stable Value Investment Association sponsored an independent research study conducted by Professors David Babbel, PhD and Miguel Herce, PhD. Doctor Babbel is a Professor of Insurance and Risk Management and a Professor of Finance at the Wharton School at the University of Pennsylvania and a Vice President and Senior Advisor at Charles River Associates International (CRAI). Prior to joining CRAI, Doctor Herce served as a professor of econometrics at the University of North Carolina at Chapel Hill. 

The study examines the risks and net returns of various assets. Stable value net returns were developed from data supplied by twelve stable value managers who manage commingled funds, separate accounts, and full service funds representing $189 billion in assets. The study looked at stable value funds over the period of time beginning January 1989 and ending December 2006. The result of this work is the recently released academic research paper, A Closer Look at Stable Value Funds Performance — the first rigorous analysis of stable value from an investor’s point of view. The conclusions of this analysis are compelling — by enabling greater returns for a given level of risk, stable value greatly enhances the likelihood of defined contribution plan participants meeting their retirement goals. 

Overview of the Analysis
Since the inception of the contemporary stable value fund almost 35 years ago, stable value funds have provided attractive fixed income returns with very low volatility. As a result, defined contribution plan participants have come to rely upon stable value to protect assets from risk of loss, to diversify their portfolios, and to blunt the risk of higher volatility investments like stock funds. But are these appropriate uses of stable value? 

A Closer Look at Stable Value Funds Performance is the first study to closely evaluate stable value from an investor’s point of view. It carefully compares stable value performance to other common investment alternatives such as U.S. large and small stocks, long-term government and corporate bonds, intermediate bonds, and money market investments. 

Before the release of this study, plan providers debated the relative merits of offering stable value versus other fixed income options such as money market funds or intermediate bonds. Now, through state-of-the-art statistical techniques such as mean-variance analysis, stochastic dominance analysis, and multi-period utility analysis, the answer is clear. Offering stable value as the core fixed income option in a defined contribution line-up provides a significant benefit to plan participants. By delivering investment performance characteristics of intermediate bonds with money-market-like stability, stable value provides superior return per unit of risk. As illustrated in Exhibit 1, stable value shifts the efficient frontier leftward, outperforms money market funds over time and in nearly all market conditions, and provides a better risk-adjusted return than intermediate bonds over time and in nearly all market conditions.

Exhibit 1: Mean-Variance Analysis
Mean Net Returns and Volatility Jan 1989 – Dec 2006

As a result, stable value plays an important role in a portfolio context. It allows plan participants to increase the return of his or her portfolio for any given level of risk or decrease the risk of their portfolio for any level of return. This finding has important implications for asset allocation strategies such as target date and target risk. The central reason for using a target date or a target risk fund is to effectively tailor participants’ asset allocation to an appropriate measure of risk tolerance. The wisdom of such an approach is beyond question. Since stable value favorably shifts the efficient frontier, it naturally follows that it should serve as an important part of all target date and target risk strategies that include a fixed income component. Please see Exhibit 2 which illustrates how well the stable value funds as a stand-alone investment option compares to lifecycle funds over time.

Exhibit 2: Simulation of Lifecycle Funds Without Stable Value Component Compared to Stable Value Funds

	Contributions Start at Age 30		Contributions Start at Age 40		Contributions Start at Age 50
Averages	Lifecycle	Stable Value	Lifecycle	Stable Value	Lifecycle	Stable Value
Across 10,000 Paths	$365,713	$199,974	$203,278	$135,868	$100,348	$79,544
Top Decile	$813,534	$266,189	$393,717	$173,745	$165,485	$96,136
Middle Decile	$318,414	$196,802	$186,463	$134,353	$95,988	$79,050
Bottom Decile	$136,798	$147,529	$93,987	$105,576	$56,200	$65,268
Worst Case	$37,600	$88,594	$43,999	$83,332	$27,718	$52,108
Total Real Contributions	$130,980		$99,630		$65,280
Number of Cases with Real Losses	351	71	589	145	1,063	404
Average Shortfall	$19,375	$6,599	$13,660	$3,951	$8,567	$2,729
Percent of cases SV > Lifecycle	17.8%		22.2%		27.7%
Source: CRA International

The Power of Staying in a Qualified Plan
Participants that elect to roll out of their defined contribution plan lose two important advantages: institutional pricing and access to stable value funds. The high fees often associated with retail investing are detrimental to participants who rollover their defined contribution plan balances to IRAs. The availability and performance of stable value provides another compelling reason for participants to keep their money in a defined contribution plan. 

Stable value also serves as a powerful investment option in an individual’s retirement years, providing steady, predictable income while insulating a portfolio from the shock of a market correction that could dramatically reduce a retiree’s nest-egg. As such, stable value has an important role to play in meeting a retiree’s need for steady income during retirement. 

Conclusion
As the study shows, stable value can greatly enhance the likelihood of defined contribution plan participants meeting their retirement goals. Even as defined contribution plan designs change to meet the needs of a shifting retirement landscape one thing seems clear — stable value has an important role to play. Plan sponsors should consider investment line-ups that employ stable value as the core fixed income fund and seek pre-mixed asset allocation strategies that naturally incorporate stable value into their design as well as provide that stable value is an investment option for all participants.