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Diversifying with Stable Value

In real estate, the three most important things to remember are "location, location, location." The same could be said for 401(k) plan investing. Where you decide to "locate" your assets will determine their future worth and ultimately, your financial security during retirement. But with most 401(k) plans offering a variety of different investment options, selecting the appropriate fund or funds can be challenging. Most plan sponsors provide participants with a wide selection of funds covering the risk spectrum, from stable value to intermediate duration bond funds to large cap and small cap equity funds to international funds. Each fund carries with it different risk and reward characteristics. Determining your risk tolerance is the first step in deciding where to allocate your 401(k) assets.

For a risk averse participant looking for a safe haven; money market, short-term bond funds, and stable value funds are most desirable. Of these three lower risk investment options, stable value funds are most attractive. Why? Stable value funds benefit from lower volatility than

money market funds and offer a similar yielding investment compared to bond funds of comparable quality and duration. As shown in the second chart on page 5 of this publication, the composite of FCM managed stable value accounts has comparable performance over the last 12 and one-quarter years to the 50/50 weighted composite of the Merrill Lynch 1-3 year Treasury Index and the Lehman Brothers Government/Corporate Intermediate Bond Fund. But, as shown, the standard deviation of the FCM composite is even lower than that of 91-day Treasury Bills.

For participants looking to diversify holdings with a mix of fixed income and equities, stable value is also very attractive. Stable value funds offer principal protection and have a low correlation of returns with equities. With double-digit returns during the greater part of the 1990's, a significant portion of 401(k) assets fled to the equity markets where participants were hoping for a piece of the action. It was difficult to not take advantage of one of the best bull markets in recent memory. Participants' 401(k) statements were showing that their money was working harder for them; with balances increasing in leaps and bounds. With their sudden wealth, some participants even began planning for early retirement. And then the market began its downward slide and participants, with up to 40% devalued portfolios, were forced to rethink their early retirement plans. And so began the transfer back to stable value. Suddenly, the 6.5%-7% annual return that stable value has been offering over the past several years looks very attractive, especially when most equity funds are offering negative returns. The significant downturn in the markets has provided an eye-opening lesson on the benefits of stable value funds and the importance of diversification.

During the bull market years that prevailed during much of the 1990's, a low volatility fixed income vehicle was not sought after by many plan participants. Unlike company stock, equity and bond funds, the stable value fund is carried at book value versus market value. Book value insulates the participant from the volatility of market fluctuations caused by movements in interest rates, changes in credit ratings, stock earnings, and economic forecasts that can cause interim price volatility. The low correlation of stable value returns with stocks and stable value's volatility, which is even lower than that of cash equivalents, suggest that stable value is an excellent diversifier for a participant's 401(k) plan investments. As reported in IOMA's April 10, 2001 issue of DC Plan Investing, while stable value product providers were reporting returns that were down slightly from a year ago, the difference was far less substantial than in the equity market, demonstrating the power of stable value to offer DC plan participants an investment that has relatively little correlation to the overall market.

Currently, stable value funds are included in about two-thirds of 401(k) plans, represent about 25 percent of retirement plan assets and total some $250 billion, as reported in IOMA's April 24, 2001 issue of DC Plan Investing. We expect that once the data from the first quarter is available, these figures will increase as participants continue to respond to the volatile equity market and transfer assets back to stable value funds.

With their strong performance characteristics, sector diversification, low volatility and low correlation of returns with equities, diversifying investments within the 401(k) plan to include a portion in stable value funds will help to reduce the anxiety of sudden changes in participant retirement assets. Moreover, it is expected that a greater percentage of assets will begin to shift towards stable value funds as baby boomers age and begin to seriously plan retirement, especially with the lessons learned in the last six months.