Saturday, January 9, 2010

When Stable Value Isn't So Stable

A lot of uproar was generated last week because of an article posted on Zero Hedge titled This Is The Government: Your Legal Right To Redeem Your Money Market Account Has Been Denied.  The crux of the article is the proposed change to money market rule 2a-7, which specifies that fund managers can suspend redemptions to allow for the orderly liquidation of fund assets.  In other words, if the markets freeze like they did in the fall of 2008, holders of money market funds may not be able to withdrawal their money.

Who exactly is surprised by this?  The proposed change in law merely reflects the blunt truth that money market funds as a whole can hardly withstand a run on the bank scenario.  Liquidity is an illusion that is swept away during a panic.

Besides, for those looking for a story with real teeth, I suggest examining the current rules governing stable value funds and what has already happened to those who invested in these funds.  Stable value funds are similar to money market funds but are somewhat less known because they are only available in retirement accounts.  According to the Stable Value Investment Association, stable value funds are defined as follows:

Stable Value Funds deliver safety and stability by preserving principal and accumulated earnings. They are similar to money market funds but offer considerably higher returns. Their returns make them comparable to intermediate bonds minus the volatility. They are the largest conservative investment in defined contribution retirement plans with over $642 billion in assets

Tell that to the workers at Chrysler. This story seems to have been buried by the financial crisis of 2008 but it is one of the most important:

An unnerving new crack emerged in the $520 billion stable-value fund market as an offering for workers at Chrysler LLC dropped 11%, highlighting strains in yet another supposedly safe investment.  The loss at the fund, which is part of the retirement program for white-collar workers at Chrysler, is the latest sign of trouble for these products.

Stable-value funds, available only in tax-deferred savings plans such as 401(k)s, are designed to provide capital preservation and smooth, positive returns. But Chrysler Stable Value Fund B, offered to certain Chrysler employees and retirees through company savings plans, paid out only 89 cents on the dollar when the fund was liquidated earlier this year. Chrysler declined to say how much money was in the fund.

"They advertise it as being basically guaranteed. That's why I put money into it," says Johnnie Johnson, a 63-year-old retired Chrysler electrical engineer in Plymouth, Mich. "I'm pretty frustrated with this whole thing." He says he had nearly $80,000, roughly 20% of his total retirement savings, in Chrysler Stable Value Fund B.

Problems in stable-value funds can become particularly acute when many investors make withdrawals at once, which is what happened in the Chrysler fund this year.

Employer-initiated events that can cause mass withdrawals, such as a plan termination or the employer's bankruptcy, generally aren't covered by stable-value contracts. Typically, these events are known in advance and the employer and stable-value manager can negotiate coverage that lets investors withdraw their money without taking a loss.

Investors in Chrysler Stable Value Fund B say there was no sign that the fund was in trouble until they received their distribution checks, which were far smaller than they expected.

These workers were taken to the cleaners and the best part is that it was all perfectly legal.  Stable value funds are supposedly backed by insurance wrappers that pay out in the event of investment losses but the legal loopholes allow for the screwing of investors, as we saw in this case.  The amount of payout by the wrappers is even under dispute, so in the event of failure investors might not be made whole.

Going back to the Stable Value Investment Association definition, stable value funds are "similar to money market funds but offer considerably higher returns."  How exactly are these considerably higher returns generated?  In 2008, the average stable value fund returned 4.58 percent, compared with 2.89 percent for money markets.  Risk and return are directly correlated.  If you are garnering higher return, by definition you must be either (1) taking on higher risk or (2) committing fraud.

Unfortunately, for any specific fund, investors have no way to find out which of these two scenarios apply.  This is because, unlike money market funds or mutual funds, stable value funds are not required to disclose their holdings in any way whatsoever.

I attempted to contact Prudential about getting either the specific holdings or the market-to-book-value ratio for one of their sizable stable value funds.  Prudential refused to disclose this information and was rudely dismissive of the request.  This despite the Stable Value Investment Association's claim that the market-to-book-value ratio must be disclosed at least once a year by stable value fund managers.  This fund is currently generating a guaranteed 4.59% return per year.

And what of the insurance companies themselves that wrap these funds?  Who are they and how healthy are they?  Well, by one metric AIG wraps nearly 8% of stable value fund assets, so that should tell you about all you need to know.

We look at the stable value funds as a potential black swan event that could hit sometime in the next few years.  As the baby boomers retire, funds will be withdrawn from stable value funds.  This will make these funds increasingly fragile going forward, and a general market panic of any kind could produce fund failure.  A couple of high profile fund collapses will generate a "who could have predicted" response from the usual big shots.  With stable value funds currently comprising 36% of all retirement fund assets, this would be no small scale event.  We have no way of knowing what the government's response to the above scenario would be, but after the cold shoulder given to the Chrysler workers, investors should not assume that the government will step in and make these funds whole.  Protect yourselves accordingly.
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