Defined contribution plan executives — and their managers — are holding firm on stable value investment options, despite the concern of higher interest rates based on recently rising Treasury yields.
“No one is panicking,” said Bryan Ward, a partner at consultant Hewitt EnnisKnupp, Lincolnshire, Ill., referring to DC clients, stable value bond managers and firms that provide the wrap insurance to guarantee the book value of the investments.
Defined contribution consultants say they're hearing questions from plan executives, but they don't see them deciding to shift, change or remove stable value options based on rising rates. Among his firm's clients, “for the most part they are sitting tight,” Mr. Ward said.
“There is a heightened concern (from DC clients), leading to questions about how stable value managers are positioning themselves,” said Constantine Mulligan, senior investment analyst at Blue Prairie Group LLC, Chicago. “But we have not had any requests to evaluate alternative options.”
Blue Prairie has detected “asset outflows in general from stable value since the beginning of the year,” Mr. Mulligan added. “But the providers are attributing these flows to strong equity markets, and a heightened risk appetite from participants, as opposed to interest rate fears.”
Pensions & Investments' annual survey of the largest U.S. retirement plans shows stable value accounted for 12% of DC plan assets in the year ended Sept. 30, 2012, vs. 16.8% three years earlier.
According to annual Aon Hewitt client surveys, stable value/guaranteed investment contract accounted for 14.3% of DC plan allocations in 2012, vs. 19.5% in 2009.
Investment consultants and stable value providers say today's portfolios are better equipped to deal with rising rates because strategies such as shorter bond duration, higher quality bonds and larger cash allocations have been in place for several years.
”I don't see rising rates having a significant effect on allocation,” said Cynthia Mallett, vice president, industry strategies and public policy for MetLife Inc., New York. “Our recently issued business is in the 2- to 2.5-year (bond duration) range, which we believe is generally consistent with new wrap business being written or renewed across the industry.”
The crash of 2008 “made it easier for sponsors to understand risk and see how stable value portfolios reacted,” said Toni Brown, director of U.S. client consulting and DC segment leader for Mercer in San Francisco. “As a result, everyone really scrutinized stable value.”
Although some of her firm's clients switched to money market funds or to a combination of money market funds and short-term bond funds after the crisis, many stayed with stable value.
“Most plan sponsors would not make a decision for a tactical reason,” Ms. Brown said. “Most plans have a long-term strategy.” She hasn't seen any Mercer clients leaving stable value because of concerns about rising interest rates.
Absorb the impact
Stable value providers say they have built portfolios to absorb the impact of rising rates and to offer flexibility in a changing rate environment.
“It wasn't a question of if — but when,” said Karl Tourville, managing partner at Galliard Capital Management Inc., Minneapolis, referring to the anticipation of higher interest rates.
Over the past two to three years, he said, Galliard has been reducing the duration of its stable value bond portfolio by about six months. The range is typically between two and three years, depending on the client. Prior to 2008, duration of the “typical” Galliard portfolio was 2.75-3.5 years, he said.
In recent years, the Galliard stable value portfolio has had an allocation of 70% to 75% in cash equivalents and securities backed by the federal government because “we've always been conservative on the quality front,” Mr. Tourville said.
A survey by Hewitt EnnisKnupp of 20 stable value collective trusts and separate accounts showed the average bond portfolio duration was 2.5 years by year-end 2012.
The potential impact of rising rates on stable value portfolios is “the No. 1 question at every client meeting and every consultant meeting,” said Stephen LeLaurin, a Louisville, Ky.-based managing director and senior client portfolio manager at Invesco (IVZ) Ltd.
“The basic design of stable value is to cope with rising rates,” he said. “This has been the mantra in the stable value world for 30 years.”
Mr. LeLaurin said Invesco's stable value bond portfolios — for both pooled funds and separate accounts — have average durations of 2.5 to 3.5 years with a midpoint of three years depending on client circumstances. The typical portfolio has an AA+ rating from Standard & Poor's Financial Services LLC and Fitch Ratings Inc., and an Aa1 rating from Moody's Investors Service Inc., he said.
Mr. LeLaurin said his firm's strategy of higher-quality and shorter-duration bonds has been in place “before, during and after” the economic crisis.
Dwight Asset Management, a subsidiary of Goldman Sachs Asset Management, has trimmed the duration of bonds in its stable value portfolios to a median of 2.3 years vs. a median range several years ago of 2.5 to 2.75 years, said Josh Kruk, managing director and head of stable value portfolio management in Burlington, Vt.
The decision was based on the company's evaluation of the market and interest rate trends as well as the requirement by wrap providers that bond firms offer a more conservative portfolio, he said. Since the economic crisis of 2008, the Dwight portfolio has stayed away from high-yield bonds and emerging markets debt, a practice that is “not unique” to his firm, he said. That's because “wrap guidelines now generally prohibit these investments for all managers,” Mr. Kruk said.
Blue Prairie consultants believe shorter-duration portfolios “will benefit, overall, from gradual rate increases, because managers will be able to reinvest coupons and principal at higher rates as their securities mature and generate income,” said Mr. Mulligan.
“However, a sudden spike in rates could cause a steep decline in market-to-book ratios that, if coupled with participant outflows, could cause longer-term crediting rate declines, as managers are forced to sell securities to meet redemptions,” he said. The crediting rate is the effective annual yield on the book value.
In addition to shorter-duration bonds, stable value managers also are using cash in their portfolios to give them more flexibility in a rising rate environment.
Among DC clients of NEPC LLC, cash positions in stable value portfolios were in the 5% to 10% range prior to the economic crisis of 2008, said Ross Bremen, a partner in the Cambridge, Mass., firm. In the following years, the cash allocations have ranged from 10% to 20%, he said.
Although some separate account clients have raised their cash positions “to mitigate interest rate risk,” others added more cash because wrap capacity had been tight. “Increasing cash lowers the overall duration of the stable value account,” he said. “Cash positions are immediately responsive to interest-rate increases.”
Aaron M. Cunningham, director of research and analytics, contributed to this story.
This article originally appeared in the July 8, 2013 print issue as, "Plan execs, managers stick with stable value".