During periods of market turmoil and low interest rates, many investors struggle to find investment alternatives that will not come under pressure. But people saving for retirement may be pleasantly surprised to discover a unique type of mutual fund known as stable value funds.
These funds, which are typically offered in401(k) planer, somewhat similarmoney Market funds, except that they provide higher returns with relatively little risk. If you are considering onestable value fundHere's how they work so you can weigh the pros and cons before deciding whether they're a good fit for your retirement portfolio.
Key learning points
- Stable value funds are typically only offered in defined contribution plans, such as a 401(k).
- They are conservative investments that provide a stable income with relatively little risk, because your principal amount is guaranteed.
- However, lower risk also means lower returns.
- Stable value funds are a good choice for conservative investors, workers nearing retirement, and anyone looking to stabilize their portfolio during times of market volatility.
Stable value funds explained
As the name suggests, stable value funds are a type of cash fund that is similar to a money market fund in that it provides principal protection while paying stable interest rates. Like their money market cousins, these funds maintain a constant share price of $1.
Stable value funds typically pay twice as much as money market funds. Even intermediate-term bond funds tend to generate lower returns with significantly higher volatility. Stable value funds that used to be almost exclusively invested inguaranteed investment contracts(GICs), which are agreements between insurance companies and 401(k) plan providers that promise a certain promiseyield.
But a number of insurance companies invested heavily in itjunk bondssuffered heavy losses in the 1980s and failed to honor some of their agreements.Retirees from other providers, such as the now defunct Lehman Brothers (thatdeclared bankruptduring the 2008 financial crisis) found that their GICs became invalid in the case of corporationsinsolvency.Subsequently, GICs largely fell out of favor as stable value funds.
These funds now mainly invest ingovernmentIncorporate bondswith short to medium maturities ranging from approximately two to four years. Stable value funds may pay higher interest rates than normally invested money market fundsfixed income securitieswith a term of 90 days or less.
How the risk is managed
Investments in funds with a stable value are more sensitive to thischanges in interest ratesthan money market positions due to the longer duration of the bonds in which they invest.
The stock price of stable value funds does not have the potential to grow over time, but these funds will also not lose value, which is not the case with typical mutual funds.
This risk is mitigated by the fund's purchase of insurance guarantees, which compensate for any loss of principal; these guarantees are available from banks and insurance companies. Most stable value funds will buy these contracts from three to five airlines to reduce their contractsStandard risk.
Normally, carriers will agree to cover any breach of contract in the event that either carrier becomes insolvent.
Cons to consider
As mentioned earlier, stable value funds pay an interest rate that is several percentage points higher than money market funds. They also do this with significantly less volatility than bond funds.
However, these funds also charge annual fees that cover the cost of the insurance packaging, which in some cases can be as high as 1% per year. In addition, most stable value funds prevent investors from moving their money directly into a similar investment, such as a money market or other investmentsbond fund. Participants must instead move their money into another vehicle, such as a stock orsector fund, for 90 days before they can reallocate it to a cash alternative.
$902 billion
Assets in stable value funds in defined contribution plans, according to the Stable Value Investment Association, as of December 2020.
Perhaps the biggest limitation of stable value funds is their limited availability. They are generally only available to 401(k) plan participants of employers who offer these funds within their plans.
Another important point to remember is that these funds are stable but not guaranteed. Although the chance of losing money in any of the funds is relatively small, they should not fall under the categoryCD's,fixed annuitiesor other investments with an absolute principal guarantee.
When stable value funds are a good fit
Stable value funds are an excellent choice for conservative investors and investors with a relatively short horizontime horizons, such as employees nearing retirement. These funds will provide income with minimal risk and can serve to stabilize the rest of the investor's portfolio to some extent.
However, they should not be seen that waylong-term growthinvestment funds and will not provide the same return as equity funds in the long term. Most advisors recommend allocating no more than 15% to 20% of one's assets to these funds.
In short
Stable value funds serve as a middle ground between cash and money market funds, which have low returns, and bond funds, which have higher risk and volatility. These funds offer higher interest rates with little or no price fluctuation.
But this stability comes at a price in the form of annual fees and lower returns than stock funds. In addition, transfers to other cash instruments can only take place under certain conditions.
