Investing February 23, 2022

The Role of Stable Value Funds as QDIAs or Otherwise

Though stable value funds might not be appropriate as the qualified default investment alternative for a defined contribution plan, they have an important role to play in retirement savings portfolios.
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Art by Carol Rollo

Prior to the passage of the Pension Protection Act of 2006, it was not uncommon for defined contribution plan participants who failed to select their own investments to see their deferrals defaulted into a stable value fund. Stable value—a relatively low-risk asset class that focuses on capital preservation and liquidity—seemed to be a “safe” option.

The final regulations on qualified default investment alternatives, published by the Department of Labor’s Employee Benefits Security Administration in 2007, addressed the savings previously defaulted into stable value funds, saying they are grandfathered under the protections of the QDIA regulation. And stable value funds were approved as a capital preservation product for an employee’s first 120 days of participation—an option for plan sponsors wishing to simplify administration if workers opted out of participation quickly.

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But, during a press conference at the time the final regulations were published, Bradford Campbell, then-assistant secretary for EBSA, stated that stable value funds would likely still be a very big part of QDIAs as underlying investments.

Stable Value Funds and QDIAs

After having some time to see if that prediction would come true, David O’Meara, director of investments at Willis Towers Watson in New York City, says the firm hasn’t seen commonplace use of the QDIA regulation’s 120-day rule.

He adds that he cannot think of a situation where such a conservative investment would be the appropriate default for the majority of a plan’s participants. “We tend to favor multi-asset portfolios designed to best aid participants in growing and preserving retirement assets, so that requires an element of growth investments,” he says.

Still, O’Meara notes, stable value funds have a place in DC plans, and possibly in target-date funds, because research has shown the funds have the ability to generate positive returns, generally, in excess of money market funds, yet at relatively low levels of risk. “So it’s a pretty attractive asset class for participants looking to mitigate the loss of capital, and it’s been very effective in doing so,” he says.

O’Meara says stable value as an investment in DC plans has undergone a lot of evolution over the past 20-plus years. “In the ’90s, stable value funds were primarily insurance-dominated solutions, but they have migrated to short-term bond portfolios with insurance wrappers—or synthetic solutions,” he says. “In addition, increased oversight of the investments, as well as the insurance companies that provide the wrappers, has brought more sustainability to the stable value marketplace. Stable value funds have remained resilient over a number of years, and we expect it to be a strong investment asset class going forward.”

One thing that makes stable value investments unique and valuable is that they are only available in tax-qualified plans such as DC plans, says Tom Schuster, senior vice president and head of MetLife’s stable value business in New York City.

“It’s the best-kept secret in the world of investments from retail investors because they don’t have access,” he says. “And [stable value funds] are uniquely structured to maximize returns while preserving principal.”

Looking objectively at the 45-year track record of stable value funds, they have performed well, offering a reasonable return no matter the market conditions, while preserving principal, Schuster adds. “Even during the Great Recession, periods of rising and falling interest rates, and a pandemic, stable value has performed as designed,” he says.

Though he wouldn’t promote investing 100% of retirement portfolios in stable value funds, Schuster says the asset class does allow for a more tailored risk profile for plan participants. 

The “2022 MetLife Stable Value Study” found that more than two-thirds of DC plan sponsors are concerned about the impact of market volatility on retirees (70%), and a similar number are worried about plan participants within 10 years of retirement (67%).

The study also shows there is great interest among advisers and plan sponsors in the potential of stable value to improve participant outcomes. Nearly nine in 10 plan sponsors (89%) and 97% of plan advisers would be interested if a TDF provider could use a solution, such as stable value, that generates net returns four times more than the cost associated with delivering those additional returns (e.g., 60 basis points enhanced net returns for a cost of 15 basis points) while keeping volatility constant. Eighty-six percent of plan sponsors and 94% of plan advisers favor a solution that could maintain comparable returns, net of fees, while reducing volatility by approximately 40%.

“We conduct these studies because we like to rely on what plan sponsors are telling us,” Schuster says. “We asked plan sponsors whether, if stable value was approved as a QDIA, they would use it, and 26% of plan sponsors said they would be very or somewhat likely to use it as QDIA for near-retirees, within 10 years of retirement. In addition, 61% of advisers said would be somewhat or very likely to recommend stable value as a QDIA for near-retirees.”

“The discussion on QDIAs as it relates to stable value is that, as a standalone QDIA, it might be valid for only near-retirees, but the discussion evolves when thinking about what stable value does well as part of other QDIAs,” says Warren Howe, national sales director of stable value markets at MetLife in Wallingford, Connecticut. “It can help optimize returns and lower volatility for certain participants in TDFs, balanced funds and possibly managed accounts.”

The Role of Stable Value Overall

The MetLife “Stable Value Study” found a large majority of DC plan sponsors (82%) offer stable value and nearly all DC plan sponsors (98%) say they are not planning to make any changes to their stable value offering. More than nine in 10 stable value fund providers (91%) say plan sponsors chose stable value because its returns are better than those of money market funds and other capital preservation options.

Howe notes that Investment Company Institute data shows that assets in DC plans top $7 trillion, and stable value investments hold more than $900 billion of that, so the asset class plays a significant role in the lineups of DC plans. “Stable value is used in a variety of ways; almost every plan sponsor uses a capital preservation investment option,” he says.

While stable value can play a role in investment portfolios for plan participants of all types, depending on individual needs, it may be even more important as participants get closer to retirement and for those in retirement, Howe says. He notes that studies show more participants are keeping their assets in plans after retirement, and he points out that even among younger participants, individuals have different risk tolerances.

Primarily, investors in stable value funds happen to be those closer to retirement, which O’Meara says is most appropriate and where he would expect to find the majority of stable value assets. “Within five or 10 years from retirement is when we see participants starting to gravitate to conservative options within DC plans, and we think that’s about right,” he says.

However, he notes that for those who are a decade out from retirement, assets are not necessarily expected to be spent right at retirement, so only a portion of their portfolios need to be in a low-risk investment option in case money is needed in the short term regardless of market environment.

For younger, newer or mid-career participants, stable value funds might have a place in DC plans to the extent participants are not using their savings only for retirement, O’Meara says.

“We have to recognize that the number of participants who tap into their savings during their career is not insignificant,” he says. “For those with more acute near-term needs, putting assets into a conservative investment might be beneficial—though one can argue whether it’s their best option and that they need a long-term vision for their savings.

“[Stable value] certainly deserves a place in DC plan investment lineups, and if you look at the glide paths of TDFs, it makes sense that there is very little in fixed-income investments for people with longer time horizons, but as people get closer to retirement, stable value becomes a bigger part of the portfolio,” he says.

Investing February 23, 2022

Why Have Balanced Funds Been Given the Short Shrift?

Their performance only matches that of TDFs for a certain age cohort, but there are other circumstances for which they might be considered a good QDIA fit.
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Art by Carol Rollo

Of the qualified default investment alternatives approved by the Department of Labor, target-date funds have grown to be the most popular. According to the 2021 PLANSPONSOR Defined Contribution Survey, 75.6% of respondents overall use a TDF as their default investment for automatic enrollment.

By comparison, only 1% of DC plan sponsors indicated that they use a stable value fund or guaranteed investment contract as the default for automatic enrollment; 2.3% said they use a risk-based asset allocation fund; 3.4% reported they use a professionally managed account; and 5.1% use a balanced fund. Stable value funds are only protected by the QDIA safe harbor for the first 120 days of participation, so those plan sponsors that reported they use a stable value fund as the default might be moving those participants who remain in the plan longer into another QDIA option, such as a TDF.

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The argument against using a stable value fund as a default is that it is much too conservative for retirement savings. Managed accounts haven’t taken off because they’ve been criticized as too costly or because studies have shown participants don’t provide the level of personalized information for them to be of optimum use. But why aren’t balanced funds more common—is it performance, cost, something else or a combination of these factors?

Amy Arnott, a portfolio strategist at Morningstar in Chicago, recently did a comparison of TDFs and balanced funds for an article on the firm’s website, and she updated it to January 31 for PLANSPONSOR.

Arnott explains that the equity allocation of TDFs’ 2030 vintage is about 62%, a bit higher than the average balanced fund, but it’s the closest comparison.

“The performance numbers are pretty close depending on the time period,” she says. “For the past three, five and 10 years, TDFs are slightly ahead, but balanced funds are ahead over the past 15 to 20 years.”

Performance for Balanced Funds Versus TDFs

Balanced funds
TD 2030 funds
3 years
11.10%
11.40%
5 years
8.91%
9.50%
10 years
8.16%
8.74%
15 years
6.44%
6.01%
20 years
6.74%
6.32%
Source: Morningstar Direct data as of 1/31/22

Performance for Balanced Funds Versus TDFs (continued)

Worst 3-month return since inception (%)

Balanced funds
TD 2030 funds
-19.69%
-18.91%
Source: Morningstar Direct data as of 1/31/22

But, Arnott says, plan sponsors might want to consider the risk side as well. “In terms of downside risk, TDFs held up a bit better because of their broader range of asset classes,” she says.

Arnott says another important consideration is expense. “There’s a pretty significant gap there,” she says. “The expense ratio of the average balanced fund is 1%, compared with close to 0.55% for TDFs. And, since fees have been under so much scrutiny, that’s a compelling reason to favor TDFs.”

Arnott notes that TDFs have a few other advantages, including that their broader asset allocation provides greater diversification in one fund, and most TDFs follow a glide path that automatically de-risks portfolios as employees get older.

“If participants are defaulted into a balanced fund, they might have less equity exposure than ideal when they are young or too much when they reach retirement age,” she says. “With TDFs, there’s a dynamic adjustment to risk level changing over time.”

Matthew Eickman, Omaha, Nebraska-based national retirement practice leader at Qualified Plan Advisors, who works as a 3(38) fiduciary investment manager but is also an Employee Retirement Income Security Act attorney, says he’s “come to believe the greatest reason for the wide use of TDFs [as QDIAs] is the financial incentive for companies that make them available.

“That’s been lessened by the lower use of recordkeepers’ proprietary funds but, still, recordkeepers will offer reduced prices if plan sponsors use their proprietary funds,” he continues. “To be fair, they are very transparent about this.”

Eickman says plan sponsors are typically given up to three to five quotes: one for a pure open architecture fund lineup, one for a lower cost if the plan sponsor puts the recordkeeper’s stable value fund in the lineup, one for a lower price if the plan sponsor uses the recordkeeper’s passive TDFs, perhaps an even lower price if the provider’s active TDFs are used, and potentially the best price if the plan sponsor does a re-enrollment into a recordkeeper’s proprietary QDIA.

“I appreciate the transparency of it,” he says. “It puts plan sponsors in a position of knowing what their choices are, but it also explains why there is a preponderance of TDFs as QDIAs.”

Balanced Funds’ Valuable Role

Plans in which participants are automatically enrolled could benefit from having a balanced fund as the QDIA if plan sponsors want to encourage participant engagement, Eickman says.

“Often, auto-enrollment or re-enrollment into a QDIA tends to lead to a disengaged participant population. It’s an incentive for people to not take action,” he says.

Eickman says a plan re-enrollment can be treated with little fanfare, or it can be an event that encourages proactive elections. “We don’t do a re-enrollment without a roadshow or education about ways employees can engage with the plan,” he says.

A balanced fund can work better during a re-enrollment when a plan sponsor says, “‘We’re going to automatically put you in this safe [investment] vehicle where you will be treated like everyone else, but we assume that’s not what you’d like. We’d like you to learn about your options and make an engaged choice,’” Eickman explains.

Research seems to support his theory that auto-enrolling into a fund other than a TDF will lead more participants to make a proactive choice. The TIAA Institute’s “Investment Defaults and Retirement Savings Allocations” study compared the behavior of participants who were defaulted into a money market fund with that of participants who were defaulted into a TDF. The research found the money market default was less “sticky” than the target-date default. Only 2% of participants allocated exclusively to the money market fund six months after joining the plan.

But there are other reasons that might make balanced funds the right TDF for a plan.

“Plan sponsors can look at the costs of funds and look at their participant demographics and determine the right default investment for them, and it could very well be a balanced fund,” Eickman says. “Looking at performance comparisons, if a plan sponsor’s participant population skews older, one can argue a balanced fund would be best. If the population skews younger, it might be that a TDF performs better. The youngest participants have a 20-year run before a ‘60/40’ allocation would be appropriate for them.”

Arnott agrees that a balanced fund could come out on top if the participant demographic skews older. A balanced fund might also be a good choice for a small plan sponsor that isn’t equipped to research funds.

“Balanced funds are more straightforward,” she says. “Plan sponsors have to do a bit of digging for TDFs because of the wide range of equity exposure, as well as asset class exposure.”

Plan sponsors might  also consider putting a balanced fund on the investment menu, but not as the QDIA, Arnott adds. “It’s reasonable to put a balanced fund on the menu for investors looking for a straightforward option that’s easy to understand,” she says.

Eickman says he has found that the growing reliance on QDIAs has led plan sponsors to pay less attention to default investments because of the DOL’s safe harbor, but “when 70% to 75% [of plan investments are] in the default, then that investment needs more attention.

“I really believe that the prevailing thought in the [DC plan] marketplace is that TDFs are an easy choice that plan sponsors don’t have to put much thought into, but good fiduciaries take the time to consider what’s right for participants, taking into account the age demographic of participants and how the plan sponsor wants to present the plan to them,” Eickman continues. “Those considerations should help plan sponsors choose what’s right rather than what’s easy.”

Eickman adds that he and his colleagues have spent a lot of time thinking about the pros and cons of TDFs, managed accounts and balanced funds, and they still struggle with whether there is any one perfect solution.

“We’ve thought about whether a dynamic QDIA has merit,” he says. “The idea that younger participants who do not make a proactive investment decision should have higher equity allocations for a period of time is good so accounts grow as much as they can. Then as people’s lives have more complexity—they have more assets and have to think about competing savings needs—the solution should be more customized for them.”

“TDFs tend to attract a lot of criticism, described as cookie-cutter because they are not tailored to individual investors, and that’s true in a way,” Arnott says. “But we have always thought that for the majority of participants, they are a solid investment option, especially as a QDIA. It’s hard to think of another alternative that would be more compelling.”

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