Third in a series of articles exploring diversifying asset strategies, including fixed income, real assets, capital preservation and equities.
If Mark Twain were a defined contribution (DC) participant, chances are he would keep some of his savings in a capital preservation strategy. “I’m more concerned with the return of my money than the return on my money” is one of his most famous (and oft-misattributed) aphorisms.
It is a common sentiment, and it explains why capital preservation strategies are among the most popular offerings in DC plans. As their name implies, these approaches seek to help participants preserve invested principal; return is a secondary priority. They also can serve an important role in portfolios by potentially generating income, providing liquidity or offsetting riskier investments.
These are important attributes, so much so that virtually all consultants concur that plan sponsors should offer capital preservation strategies. In the U.S. in 2012, 58% of DC plans offered stable value, 48% offered money market funds (MMFs) and 19% offered both, according to the most recent data from the Plan Sponsor Council of America.
But plan sponsors face a conundrum in selecting capital preservation strategies.
For more than three decades, stable value funds have been designed to provide money-market-like liquidity and investment risk, while aiming to deliver returns over time similar to intermediate-maturity bonds. Yet stable value funds come with unique risks and obligations, making them less attractive for some plans.
MMFs, in the meantime, seek to provide a constant net asset value (NAV) but in recent years have yielded less than inflation. Moreover, the MMF reforms announced by the SEC in July will likely compound structural pressures on yields and set up the potential for the imposition of liquidity gates or fees on MMFs in DC plans.
For details, please see the July 2014 Viewpoint, “Money Market Reform: Reflections on This Critical Inflection Point for Cash Liquidity Investing,” by Jerome M. Schneider.
Bottom line: MMFs may generally preserve capital, but in today’s low-yield world, they also may erode participants’ purchasing power.
Other options to consider include short-term, low-duration and low-risk bond strategies. Unlike MMFs and stable value, bond strategies lack a constant asset value. That is a key consideration. Nonetheless, depending on the needs of
a particular plan, these strategies may present a viable and possibly more attractive solution. Whether stand-alone or blended with other strategies, these bond strategies may provide more return and potential to keep ahead of inflation. Active management has the potential to further increase both the nominal and real return opportunity.
In evaluating options, we believe plan sponsors should consider potential nominal and real return, volatility, risk of loss and other factors. Weighing trade-offs among these elements will guide prudent decision-making.
Our analysis suggests that short-term, low-duration and low-risk bond strategies warrant careful consideration, particularly as an MMF alternative. We believe bond strategies rank second only to stable value among options geared toward preserving capital within DC plans.
Money market versus stable value
Typically, plan sponsors evaluating capital preservation strategies begin by contrasting money market and stable value funds. After all, both seek to deliver a constant NAV to participants. But they achieve it in different ways: MMFs follow extremely conservative credit guidelines and invest in bonds with very short average maturities; stable value strategies use insurance contracts, or wraps, that help to assure the return of invested principal, albeit with conditions, and smooth the returns of intermediate-duration fixed income investments, through book-value accounting. When it comes to performance, stable value funds have been the clear winner.
Over the 10 years ended 30 June 2014, stable value outpaced MMFs by 196 basis points (bps) (see Figure 1). Importantly, stable value stayed 113 bps ahead of inflation as measured by the Consumer Price Index (CPI). By contrast, MMFs failed to keep pace with inflation, losing ground in purchasing power by around 80 bps each year.
For an individual participant, the difference could have been consequential. A $100,000 investment in a stable value fund over the 10-year period could have grown to $140,516, compared with $116,054 in an MMF – a difference of $24,462. On an inflation-adjusted basis, the variance is even starker: The stable value investment could have grown a participant’s purchasing power to $112,225, while the money market investor could have lost ground and been left with only $92,282 in real terms.
Based on current yields, stable value also looks better on a prospective basis. On 30 June 2014, money market yields (based on the yield to maturity of the BofA Merrill Lynch U.S. 3-Month T-Bill Index) were near zero, while the Hueler Stable Value Index crediting rate was 1.7%, according to Hueler Analytics.
However, some plan sponsors may find preconditions associated with stable value contracts unworkable. For instance, if sponsors are at risk of bankruptcy or have a participant population with unattractive underwriting demographics and cash flows, then they may be unable to secure sufficient or attractive wrap capacity. Sponsors also may be concerned with the potential risk that mergers, acquisitions, spinoffs or other corporate actions could contravene provisions in the wrap contract. Some plan sponsors may object to possible prohibitions against managed accounts, income solutions or other competing strategies that many sponsors view as desirable. Any of the above may be sufficient for a plan sponsor to look for alternatives to stable value.
Finally, some plan sponsors have expressed concern that a rising rate environment could produce unattractive short-term returns in the portfolios that underlie stable value contracts, potentially delivering returns below even those of MMFs. We believe sponsors should not be overly concerned with this. Indeed, we believe higher rates over the long term should provide more attractive returns and help offset any short-term decline in crediting rates. And,
regardless of changes in interest rates, wrap contracts allow participants to withdraw their invested principal and accrued earnings at any time.
As Figure 2 shows, a hypothetical 200 bps rate rise within one year could produce a temporary decline in stable value returns, yet both the crediting rate and the longer-term return for stable value could stay significantly ahead of money market returns. Over five years, a $100,000 investment in a stable value fund could grow to $116,051, while a money market investment could rise to just $108,928 – or $7,123 less. (Note that our model shows an extreme, yet
highly unlikely, one-year rate jump. PIMCO believes that when rates rise, they are likely to do so far more gradually over a longer time frame.)
Plan sponsors also should consider the manager’s ability to manage volatility and risk of loss in the underlying portfolios of capital preservation strategies.
When we compare the risks of money market and stable value funds, they may appear low and roughly equal given the constant NAV. As shown in Figure 3, the Lipper Money Market and Hueler Stable Value Indexes report low volatility as measured by standard deviation (0.5% and 0.3%, respectively) and zero negative return days. However, these low volatility numbers reflect the constant NAV shield that helps mitigate risk.
Looking under the hood at the underlying money market and stable value portfolios reveals a different story. An MMF, for instance, may hold a portfolio including Treasuries. As shown in Figure 3, the 0.6% volatility of Treasury bills (as represented by the BofA ML 3-Month U.S. T-Bill Index) was higher than that of the Lipper Money Market Index – but not by much. The T-Bill Index also had 397 negative return days, with the most extreme at -0.3%. Plan sponsors
also should be aware of important, if highly unlikely, risks – namely, that MMFs can and have lost value (or “broken the buck”).
Stable value portfolios, typically comprising low- to intermediate-duration bonds, generated volatility as high as 2.6% – more than four times that of Treasury bills. Moreover, the number of negative days and the magnitude of daily volatility were higher than those for MMFs. Stable value also can be affected by poor investment returns, potentially pushing a contract’s market value below its book value. Although an investor’s principal is assured by the
wrap guarantee, if market value falls and stays below book value, crediting rates for participants could be reduced over time. There is also the risk, however remote, that the wrap provider could become insolvent.
So while the risks of MMFs and stable value funds may appear about equal due to the constant NAV, the underlying portfolios differ and hold much different – although still relatively low – levels of risk. For plan sponsors with attractive plan characteristics and who are comfortable with wrap-issuer-imposed restrictions, stable value will likely continue to be the more attractive capital preservation strategy.
Short-term, low-duration and low-risk bond strategies warrant consideration
Short-term, low-duration and other low-risk bond strategies warrant consideration for the capital preservation DC seat. Unlike current money market and stable value funds, these bond strategies do not have constant NAVs. Rather, their holdings are marked to market (i.e., the underlying bonds are priced at the end of each trading day).
Without a doubt, it is the price volatility and risk of loss – particularly the risk of a negative day return – that may give plan sponsors pause. Yet DC plan sponsors are under no obligation to provide a constant NAV option to participants (see the June 2013 DC Dialogue with ERISA attorney Marla Kreindler).
Therefore, we suggest plan sponsors carefully consider nominal and real return, volatility and risk of loss for bond strategies. As shown in Figure 3, over the last 10 years, index returns for a short-term, low-duration bond portfolio and a low-risk bond blend outpaced MMFs in nominal returns, yet only low-duration kept ahead of inflation. Moreover, the volatility, negative day returns and maximum drawdown for the low-duration strategy exceeded those of the other investment choices.
PIMCO believes that an actively managed low-risk bond strategy specifically designed for the unique return, volatility and liquidity demands of DC participants may offer a better solution than other shorter-duration strategies without those objectives, whether active or passively managed. Active bond managers have the potential to reduce volatility, minimize the number of negative days and increase return in low-risk bond strategies. This may be accomplished by investing in a broad range of fixed income sectors including investment grade credit, mortgages and Treasuries. Of course, moving beyond MMFs by embracing investment opportunities in the short-term space engenders additional risk, particularly interest rate risk and management risk, but it also provides participants the potential to realize improved risk-adjusted returns, particularly in today’s environment of low yields.
In the end, a DC-tailored short-term bond strategy is likely to fall short of stable value returns, even in today’s historically low interest rate environment, but it would likely generate returns closer to inflation than those of MMFs. As shown in Figure 4, stable value has handily won on a nominal and real return basis for the past decade. What’s more, stable value has excelled on a risk-adjusted-return basis given its constant NAV-enabled low volatility. Over long-term investment horizons, we expect stable value’s relative risk-adjusted return advantages to continue.
Plan sponsors may conclude stable value is optimal, so long as they can accept the covenants of wrap contracts. For those who do not, a DC-oriented low-risk bond strategy may provide a better alternative for participants than money market funds (see Figure 5).
Brett Gorman, Henry Kao and Paul Reisz contributed to this article.