Faced with erratic stock markets, some 401(k) plan participants are shifting to what they once considered a dull alternative–stable-value funds. But are investors pursuing the illusion of safety at the cost of long-term growth?
Experts worry that might be the case. Over the past 18 months of market tumult, there has been a significant shifting of 401(k) assets into stable-value funds and away from equities. In fact, according to Hewitt Associates, the allocation to equities in all 401(k) plans dropped to 67% from 74% between October 2000 snd February 2002, while the allocation to stable value funds climbed to 21.1% from 17%.
No doubt, part of the decline in equities is attributable to poor stock market performance and the consequent diminution in value of the stock portion of any investment portfolio. Still, the decline seems excessive to experts, given that many professional pension managers have been using the past downturn to buy stocks to rebalance portfolios. "There's been a pretty dramatic shift in overall allocations, and it suggests that participants don't yet understand the idea of rebalancing," says Lori Lucas, a defined benefit consultant with Hewitt.
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Admittedly, stable-value funds are hardly the kiss of death. Many have been able to match the results of intermediate-term bond funds while reporting only a fraction of the volatility–a compelling record. But experts fret that many 401(k) plan participants have no clue what stable-value funds really are. For instance, according to a study by John Hancock Financial Services, most participants did not know the difference between stable-value funds and money-market investments. On average, the employees expected stable-value funds to deliver annual returns of 9.3% during the next five years, an extremely optimistic outcome for a fixed-income option that is currently yielding around 6%.
It's not surprising that stable-value funds might be the alternative that would come to mind when 401(k) investors are looking for safe havens. In the 1980s, when 401(k) plans offered few investment alternatives, it was not uncommon for plans to have 70% of their assets in stable-value funds, which provided fixed-income returns while protecting participants from ever losing any principal. Back then, many stable-value funds–mostly called guaranteed investment contracts (GICs)–had double-digit yields. As the yields dropped and equities soared, many participants shifted away from the relatively tame instruments. The exodus accelerated when several GIC issuers suffered credit downgrades and eventually collapsed during what resembled a run on the bank, as plans withdrew assets to avoid uncertainty.
In recent years, stable-value funds have developed a record for providing reliable returns. Some credit for the increased safety goes to rules that now make it more difficult for panicked plans to make sudden withdrawals. Another factor is a new generation of synthetic GICs that are structured to provide extra security. In the old-fashioned contracts, a plan sponsor makes a deposit with an insurance company that guarantees a fixed return for a period of three years or so. The contract is backed by the insurer's general account. With a synthetic, the plan sponsor hires a money manager who buys bonds. Then the plan selects an insurance company to provide a wrap guaranteeing plan participants won't suffer capital losses when they make withdrawals. The synthetic arrangement provides security because the plan owns the bonds directly. While a single insurance company backing a traditional GIC can default, the likelihood of many investment-grade bonds going belly-up at once is remote.
Many stable-value funds hold a mix of conventional GICs and synthetics, offering participants a return that represents a blend of all the investments. "To have adequate liquidity and safety, it makes sense to hold a broadly diversified mix of investments," says Aruna Hobbs, director of pensions for Aegon Institutional Markets, a provider of stable-value investments.
To help participants use stable-value funds more effectively, some consultants have suggested that employers increase their education efforts or even offer professional advisors. But not everyone believes that is sufficient.
Another idea is to offer balanced or so-called lifestyle funds, which provide one-stop shopping, including a mix of equities and fixed-income allocated by professional managers. Cereal maker General Mills Inc. offers three balanced funds for 401(k) participants: a conservative choice focusing mainly on stable-value and bond investments, an aggressive selection that emphasizes stocks and a moderate version whose balanced mix closely resembles the diversified fund that is used for the company's defined benefit pension plan. "People feel very comfortable with the moderate 401(k) choice," says General Mills Treasurer David VanBenschoten, "because they figure that if it is good enough for the pension to pick, then it must make sense."
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