With greater frequency, stable value managers are enforcing their contractual right to restrict redemptions by plan sponsors. Plan sponsors should be aware that this may result in a delay of 12-24 months to redeem these assets. However, these restrictions do not impact participant trade activity.
Stable value funds are essentially fixed income portfolios supported by insurance “wraps” or guarantees. This structure is employed to protect against market losses and to create a participant experience that shields against the market value fluctuations of interest rate changes. Stable value funds are traditionally viewed as one of the safest investment options that can be offered to participants of defined contribution plans. Unsurprisingly, the vast majority of 401(k) plans hold this investment product in their plans.
Due to their protective structure, stable value funds hold the right to restrict redemption requests made by plan sponsors. The managers of these funds choose to exercise this right when the conditions are such that allowing an immediate wholesale redemption could have an adverse impact on the remaining investors of the fund. These requests most commonly occur during a plan conversion, possibly as a part of a merger and acquisition, or when the existing stable value fund is being replaced or eliminated.
The factors that are contributing to the enforcement of plan level redemption restrictions have mainly been market driven. These products have been negatively impacted by the recent rise in interest rates. At the start of 2017, many stable value funds had a market value greater than 100% of its book value. Throughout the year, the Federal Reserve raised rates which increased interest rates on the short end of the yield curve, which in turn has had a negative effect on the market value of the stable value fund’s underlying fixed income portfolios. Consequently, the market to book value ratio for many stable value funds has declined and is now in the 98-99% range. Some managers have shared with PEI that they expect a continued rising rate environment to further drop this range by another percentage point or two.
Participant trade activity has also somewhat contributed to the enforcement of plan level redemption restrictions. Typically, when stable value funds are experiencing continuous positive net cash flows, managers can relax restrictions and use those assets to meet any termination requests. However, to some extent, plan participants have been shifting their allocations away from stable value due to what has been a prolonged equity market rally. Unpredictable cash flows have inhibited managers from permitting this option.
In response, managers have continued to maintain their portfolios’ tighter duration positioning to protect against further interest rate movements. Currently, most funds have a duration between two and three years, whereas historically many of these same funds had a duration in excess of three years. Lower yields on the underlying portfolios are a direct consequence of this shift, which leads to a reduction in the rate credited to participants. Crediting rates across most stable value funds today is between 1.50% and 2.00%. As the underlying portfolio’s holdings are reinvested at higher interest rates, the yield on the fund and the rate credited to participants is anticipated to increase as well.
PEI continues to believe that stable value funds are very suitable capital preservation vehicles to offer to participants. However, due to current market conditions, plan sponsors should be aware that they may face restrictions on any redemption requests.