The Role of Stable Value Funds in Your 401(k)

During periods of market turbulence and low-interest rates, many investors struggle to find investment alternatives that aren't getting hammered. But people saving for retirement may be pleasantly surprised to discover a unique breed of mutual fund known as stable value funds.

These funds, which are typically offered in 401(k) plans, are somewhat similar to money market funds, except they post higher yields with relatively little risk. If you're considering a stable value fund, here's a look at how they work so you can weigh their advantages and disadvantages before deciding if they are a good choice for your retirement portfolio.

Stable Value Funds Explained

As the name implies, stable value funds are a type of cash fund that resembles a money market fund by offering protection of principal while paying stable rates of interest. Like their money market cousins, these funds maintain a constant share price of $1.

Stable value funds have typically paid twice the interest rate of money market funds. Even intermediate-term bond funds tend to yield less with considerably more volatility. Stable value funds used to invest almost exclusively in guaranteed investment contracts (GICs), which are agreements between insurance carriers and 401(k) plan providers that promise a certain rate of return.

However, a number of insurance carriers that invested heavily in junk bonds in the 1980s suffered heavy losses and defaulted on some of their agreements. Retirement plan participants of other providers, such as the now-defunct Lehman Brothers (which declared bankruptcy during the financial crisis of 2008), discovered that their GICs became invalid in the event of corporate insolvency. Subsequently, GICs fell largely out of favor as funding vehicles for stable value funds.

These funds now invest primarily in government and corporate bonds with short- to medium-term maturities, ranging from approximately two to four years. Stable value funds are able to pay higher interest than money market funds, which usually invest in fixed-income securities with maturities of 90 days or less.

How Risk Is Managed

The holdings within stable value funds are more susceptible to changes in interest rates than money market holdings because of the longer maturities of the bonds in which they invest.

This risk is mitigated by the purchase of insurance guarantees by the fund that offset any loss of principal; these guarantees are available from banks and insurance carriers. Most stable value funds will purchase these contracts from three to five carriers to reduce their default risk.

Usually, the carriers will agree to cover any contracts defaulted upon in the event that one of the carriers becomes insolvent.

Disadvantages to Consider

As mentioned previously, stable value funds pay an interest rate that is a few percentage points above money market funds. They also do so with substantially less volatility than bond funds.

However, these funds also charge annual fees that cover the cost of the insurance wrappers, which can be as high as 1% per year in some cases. Furthermore, most stable value funds prevent investors from moving their money directly into a similar investment, such as a money market or bond fund. Participants must instead move their funds into another vehicle, such as a stock or sector fund, for 90 days before they can reallocate them to a cash alternative.

Perhaps the biggest limitation of stable value funds is their limited availability. They are generally only available to 401(k) plan participants of employers who offer these funds within their plans.

Another key point to remember is that these funds are stable in nature, but not guaranteed. Although the chance of losing money in one of the funds is relatively slim, they should not be categorized with CDs, fixed annuities, or other investments that come with an absolute guarantee of principal.

When Stable Value Funds Are a Good Fit

Stable value funds are an excellent choice for conservative investors and those with relatively short time horizons, such as workers nearing retirement. These funds will provide income with minimal risk and can serve to stabilize the rest of the investor's portfolio to some extent.

However, they should not be viewed as long-term growth vehicles, and they will not provide the same level of return as stock funds over time. Most advisors recommend allocating no more than 15% to 20% of one's assets into these funds.

The Bottom Line

Stable value funds serve as a happy medium between cash and money market funds, which have low yields, and bond funds, which have higher risk and volatility. These funds provide higher rates of interest with little or no fluctuation in price.

But this stability comes at a price in the form of annual fees and lower returns than stock funds. In addition, transfers into other cash instruments can only be made under certain conditions.