Risk of Rising Interest Rates on Stable Value

While retirement plan sponsors will find the market for getting into stable value funds has improved, the threat of rising interest rates poses a risk they need to keep in mind.

An article from Portfolio Evaluations, Inc. (PEI) explains while most of the concern pertaining to the potential rise in interest rates has been focused on fixed income funds, stable value funds have been significantly impacted as well. Pooled stable value funds are essentially fixed income portfolios supported by insurance wraps or guarantees, so they carry a significant level of interest rate risk. The market value of the underlying fixed income portfolio will decline as interest rates rise. Participants do not experience these market value fluctuations due to the products’ insurance component; however, last year’s rise in interest rates had a potential negative impact on the liquidity for stable value funds at the plan sponsor level.

Marc Lescarret, senior investment analyst at PEI in Warren, New Jersey, and author of the article, tells PLANADVISER if plan sponsors use a fixed income instrument and interest rates go up, that will generate a negative return, but stable value funds are a way to protect against negative return. Stable value funds are capital preservation vehicles.

He explains that stable value funds usually impose liquidity restrictions—if a plan sponsor wishes to terminate a pooled stable value product, they may be required to wait in a put queue which is typically 12 or 24 months depending on the ratio of the fund’s market-to-book value of assets. According to Lescarret, currently many investment managers still have a market value of 100% or just slightly above book value, so they are keeping a loose policy on sponsor liquidity. Many are letting investors out within months now, he says.

However, as interest rates get higher, market value can drop below book value, and managers may have to pay if funds leave, so they are beginning to enforce the puts.

One thing this means for plan sponsors is it is a good time to review their stable value products because if they are unhappy and want to make a switch, now is their opportunity, according to Lescarret. If a plan sponsor adopts a stable value product and becomes dissatisfied, the window for getting out is narrowing.

In addition, he notes in the article, in order to protect against potential rising interest rates, most stable value managers have shortened the duration of their portfolios. These actions lowered the yield on their portfolios, which reduced the crediting rate offered to participants. When deciding whether to get into a stable value product, or when monitoring their current offering, it is important for plan sponsors to understand how stable value funds have been affected by the recent rise in rates in addition to what steps managers have taken to adjust portfolios.

Greg McCarthy, principal and director of the Investment Consulting Group at PEI, tells PLANADVISER, just because market-to-book values have improved and products are opening up doesn’t mean plan sponsors can lower their due diligence efforts. “It is important for plan sponsors to remember they have to carry out the same prudent process and due diligence for stable value investments as with any other asset class,” he concludes.

Lescarret’s article is here.