Why Participants Like Stable Value So Much

Stable value offers both "preservation of capital," as does a money market fund, and also an attractive return significantly in excess of inflation, unlike money markets. Moreover, since stable value is carried at book value, unlike company stock and the wide variety of equity options and bond funds, participants are insulated from the market volatility caused by movements in interest rates, changes in credit ratings, stock earnings, economic forecasts, corporate scandals, and the many other factors which cause interim price volatility for these other options. Stable value permits a participant to reduce the anxiety of sudden changes in his/her retirement assets. Participants can preserve their earnings from riskier investments, especially as retirement looms, by increasing their commitment to stable value.

Moreover, as illustrated by the performance charts, with returns comparable to bond funds but without the interim volatility, a well-laddered stable value portfolio with regular dollar cost averaging into the market will produce consistent and predictable returns.

Nevertheless, many participants still view stable value, money market and bond funds at the same end of the risk spectrum. How do they decide which is best for them? Clearly the performance of money market funds, with annualized returns currently in the 1.30% to 1.75% range, has been much less attractive than stable value. But recently, bond portfolios have been producing the most attractive returns of any of the 401(k) options available. However, in the long run a bond portfolio will produce total returns equal to the income return on the portfolio plus (or minus) the value-added by the manager. Most fixed income managers under-perform the unmanaged indices, even before the imposition of fees, and the only other elements of total return are the capital gains and losses due to changes in interest rates. In the long run, capital losses due to interest rate rises have to cancel out capital gains due to interest rate declines or else we would experience negative interest rates! And so when investing in bonds, it is important for a participant to be mindful of where we happen to be in the interest rate cycle. Since 2002 could be the third consecutive year of fixed income returns near 10%, bond funds may appear quite attractive. However, with the general level of interest rates at 40-year lows, participants need to remember that the lower interest rates fall the greater the probability that the next significant change will be an increase in rates, possibly resulting in significant capital losses in bond portfolios.

In light of the performance disadvantage of money market funds, and the market risk of bond funds, it is not surprising that stable value has grown to be the low risk favorite of participants. So how does a stable value manager achieve the results that have become so popular? By taking advantage of all the investment alternatives available, FCM can opportunistically select investments that will produce attractive relative values. FCM uses liquidity and duration management to improve a portfolio's tracking efficiency and to manage cash flow distortions, and combines the variety of buy and hold products with "evergreen" wrapped bond portfolios to produce superior performance.

FCM purchases buy & hold fixed maturity products opportunistically to provide internal portfolio liquidity through well-laddered maturities. Due to their historic 0.40% yield premium, low default rate and very high recovery rate; FCM has employed a higher allocation to traditional GICs than wrapped bonds in light of their relative value, while being mindful that the GIC segment must be well diversified. But the insurance industry has been experiencing some stress recently. In the wake of unprecedented non-insurance corporate bond defaults, such as Enron and WorldCom, and depressed equity markets over the past year, insurers have seen their earnings cut and capital positions softened. Nevertheless, the industry still remains one of the very highest rated by the agencies, with an average financial strength rating of AA-, defined as "very strong." This rating reflects the industry's solid capital levels, consistent profitability through diversified revenue sources, and high quality, well-diversified investment portfolios. Moreover, GIC issuers are industry leaders with strong market positions in their core business lines and even higher quality than the insurance industry at large.

Consequently, the asset quality of GIC issuers is still solid with over 90% of their bond portfolios in investment grade bonds and good diversification amongst individual credits and industries. And GIC issuers have demonstrated sound asset/liability management capabilities, along with the ability to manage the risks of their product portfolios. Nevertheless, given the overall economic downturn, credit ratings for most industry sectors have been pressured with downgrades. Although additional downward notching may be experienced over the next few months, we fully expect that the insurance industry, and particularly the GIC issuing segment of the industry, will continue to demonstrate its historic strength relative to other industries over time.

Including wrapped fixed income "evergreen" portfolios in a stable value fund, offers industry and securities diversification, improved liquidity of the underlying securities and the possibility of increased credit quality. But, it is critical to employ fixed income managers who have a demonstrated ability to outperform the unmanaged benchmark indices. Consequently, FCM serves as a manager of managers for the evergreen sector in our portfolios, by drawing upon our investment consulting heritage, carefully selecting out-performing fixed income sub-advisors, monitoring them closely, and replacing them when necessary. FCM's goal is to select sub-advisors with distinctly different fixed income management styles which in turn have different market cycles, so that the fund can achieve less volatility for the evergreen wrapped bond component in total than would otherwise be the case with just one sub-advisor.

Designing the stable value fund to take advantage of the strengths of both the buy & hold and evergreen components yields results that provide participants with the attributes highlighted in a new book by David Wray, President of the Profit Sharing/401(k) Council of America. In his book entitled, "Take Control With Your 401(k): An Employee's Guide to Maximizing Your Investments," David opens his chapter devoted to stable value with the following observation, "One of the advantages of participating in a 401(k) plan is the possible presence of a stable value investment option….For the fixed income aspect of your 401(k) asset allocation, stable value funds are an important investment choice because they provide a high rate of return with virtually no risk." David continues, "While the stable value option has been likened to bond funds and money market funds, stable value funds have the positive attributes of both kinds of investments with few drawbacks. Replacing the fixed income aspect of your asset allocation (such as bond funds) with stable value choices allows you to devote more of your assets to equity investments, which increases your return, without increasing your risk….If a sudden downturn [in the stock market] has made you feel insecure, having some of your money in a stable value fund may provide you with more confidence in the stability of your portfolio because the value of your original investment amount does not change."