Insights


The Effect of Rising Rates on Stable Value Accounts

The Federal Reserve has raised the effective benchmark interest rate three times since the end of its unprecedented accommodative monetary policy. The rising inflationary pressures in the marketplace since the U.S. presidential election could hint at a more aggressive policy and higher U.S. interest rates in the future. The steepening of the yield curve in the fourth quarter resulted in negative returns for core bond portfolios, as the Bloomberg Barclays U.S. Aggregate Bond benchmark returned the worst quarterly result in 35 years.  

In this environment, stable value products could provide a smoother ride than traditional bond funds. These lower-risk accounts can be a smart choice for the conservative fixed income portion of a portfolio, as they avoid the losses likely to hit bond funds, while delivering higher returns than money market funds. These accounts are specifically designed to protect principal in defined contribution (DC) plans, regardless of interest rate fluctuation.

Like traditional bond funds, stable value funds generally invest in short and intermediate bonds (for purposes of this article, we will not focus on insurance company general or separate account products). However, unlike bond funds, these fixed income instruments are “wrapped” with a promise from insurance companies or banks that investors will not suffer from a decline in their principal and will receive the crediting rates, even if rising interest rates push down bond prices. Under normal circumstances, a plan participant in a stable value account can transfer money out of the fund at the contractual value, also known as book value (original principal plus accumulated credited interest), without suffering from the principal loss associated with a market-valued, unwrapped bond portfolio (market value drops as yields rise). Book value wrap contracts use a standard formula for crediting returns to participants, taking into consideration the yield-to-maturity, duration, and total returns of the underlying portfolio. In effect, it amortizes bond price changes into the crediting rate, smoothing the impact on investors. 

There has been increasing focus on the market-to-book value ratio, and an account with 100% or greater ratio is considered to be a healthy stable value fund. However, this ratio should be evaluated relative to the prevailing market environment.  Low interest rates in recent years have pushed these accounts’ market-to-book values above 100%.  Rising interest rates will apply pressure on the ratio; however, it should not be a basis for undue concern. As the investment contracts amortize the losses through the crediting reset process, the portfolios will continue to move towards parity. Since stable value crediting rates follow interest rate trends with a lag, when interest rates rise, the underlying bond portfolio’s cash flows can be reinvested at higher rates, ultimately translating to higher crediting rates for stable value investors. 


Source: Stable Value Investment Association

While stable value funds are low volatility options, they do not come without risk. Rising rates make stable value accounts attractive for investors, but they may increase the financial burden on the wrap provider, especially in periods of heavy outflows from participants. Should the market value of the stable value fund’s underlying assets be insufficient to meet the benefits for covered withdrawals at book value, the contractual protection kicks in to ensure that participants continue to transact at book value (benefit responsive). In periods of heavy participant cash outflows, insurers and guarantors must continue to meet their obligations. While unlikely, situations like the large outflows of the 2008 market could force insurers into liquidity crisis. Since the 2008 financial crisis, tighter regulations have been introduced to the asset class. These accounts are now invested in higher credit quality securities, and excess reserves have increased on the balance sheets.

Stable value funds can account for a large portion of a plan’s total assets. Therefore, it is important to follow ERISA best practices, and review and evaluate the funds at regular intervals. It is equally important to conduct due diligence on the fixed income manager and the financial strength of the wrap provider. Areas for review include:

  • Credit ratings of the wrap providers (financial strength)
  • Market-to-Book value ratio
  • Performance of fixed income manager(s)
  • Net crediting rate
  • Portfolio characteristics (average yield, duration, and credit quality)
  • Crediting frequency and consistency 
  • Liquidation provisions (e.g., equity wash provisions) 

Conclusion

In this prolonged low interest rate environment, crediting rates for stable value funds have remained low, compared to historical averages. These accounts have typically credited within a range from 1.0% to 3.0% depending on the type of product, liquidity provisions, and duration.  In 403(b) plans, which require a minimum crediting rate (or floor), most stable value products have been crediting at this floor. 

In general, stable value crediting rates have outpaced returns for money market funds and short-duration bonds.  For the stable value investor, the duration impact on underlying bonds is neutralized by the wrap feature that smooths the price volatility of the underlying portfolio. Since the underlying portfolio’s market value fluctuates with interest rates, the stable value investors do not experience price volatility at the participant level.  Raising rates will eventually translate into higher crediting rates for investors, which may outpace inflation, a welcome change for stable value funds.

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

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