Recent interest in principal protection options inspired a conversation between Rick Unser, the host of the 401(k) Fridays Podcast, and Steve Horner, CFA, one of the four Portfolio Managers of Putnam Stable Value Fund. Rick asked Steve, who has over 30 years of industry experience, to discuss the capital preservation landscape, vehicles, and different structures, and to highlight factors for plan sponsors to consider in the current market environment. Below are excerpts from the interview, edited for clarity.
Rick: I feel like this whole idea of cash or capital preservation might be the next thing people start talking about as a dead asset class. Agree or disagree?
Steve: As with most black and white declarations in the investment world, I would say this one is demonstrably false. While real returns for capital preservation options have obviously been negative this year due to the high inflation that we’ve experienced, capital preservation funds have really been the only segment of the market that haven’t lost principal value. For plans with older investors who are closer to retirement and consequently will be more risk averse, to not have a capital preservation option in the plan because you considered the asset class to be dead would have been disastrous this year. It potentially might have altered the retirement plans of many individuals.
One thing to keep in mind is that 401(k) lineups are generally designed for long-term performance success leading to capital growth. Therefore, capital preservation options within that context serve not only as safe havens during stress periods, but also as the best diversifier of risk in the entire lineup over a longer period.
So, while investing most of one’s 401(k) assets in a capital preservation vehicle isn’t a great long-term strategy to get anybody to retirement, we believe that not having any principal protection options within a plan to be equally damaging and precarious from a fiduciary perspective. For these reasons, I would say these options are anything but dead from where we sit.
Rick: If I’m getting a low single-digit rate of return and inflation’s running at mid to high single digits, is it right for employers — or even participants — to think about cash, not as necessarily a provider of return, but strictly as a principal protection vehicle? Is it really the value here and now, or the value going forward, that is truly principal protection?
Steve: Not necessarily. The key point here is that, despite the low single-digit real return you mentioned not being all that attractive, we firmly believe that the selection of the capital preservation option shouldn’t ever be an afterthought. It should not be subject to a thought process that assumes all capital preservation funds are basically the same, and therefore, any option chosen will suffice, as there’s a lot of different vehicles out there to choose from.
Rick: There has been an age-old debate of, “Are we better served in a money market account or a stable value option?” There are obviously a lot of different flavors of each in the marketplace. Focusing on that — money market or stable value based on the current inverted curve environment — how does an employer navigate that choice before they even get into thinking about some of the other details or nuances between the two?
Steve: It should be noted that, generally, when you look at inverted yield curve periods, they have historically been relatively short on average. The yield curve inversions that can give money market funds an advantage over stable value generally last somewhere between four and seven months, historically. Given that plan sponsors are charged with selecting 401(k) investments that will best suit their participants over much longer periods of time, this short-term advantage that money market funds now have over stable value should be discounted, in our opinion. You have to remember that when you look at longer-term returns — such as 5-year returns, 7-year returns, 10-year returns — stable value funds provide a significant annual return premium over money market funds. These long-term returns include all six of the short-term periods since 1987 when the yield curve has inverted.
Rick: What are some of the different options or flexibility that stable value fund managers have in different asset classes that aren’t available in a more traditional money market account? As you go through those, also describe what it means in terms of risk and things that employers should consider when evaluating options. What should they make sure they understand as it relates to this current market environment and rising rates and all that fun stuff?
Steve: The big differences between stable value options have mostly to do with fund structure. There are a lot of ways to structure a fund, but also a lot of ways to invest the money for it. There is a wide variety of investment strategies for stable value that encompass pretty much the full investment-grade spectrum of securities and, in some cases, other sectors.
There are funds that could have allocations to high-yield securities. There are funds in some cases that will have allocations to equity — smaller allocations, for sure, but noticeable. But certainly, I think it’s incredibly prudent for any fiduciary to look in very great detail at all the holdings of a given fund to make sure that it fits with what their plan philosophy is for their participants, the demographics, the risk tolerance, and so on. For example, stable value funds are going to have an average quality basis, somewhere between A+ and AA+. But that doesn’t mean there won’t be securities underneath that may be rated lower. Most funds will have allocations to BBB securities in the corporate space and potentially in other sectors.
So, like I said, the best course of action is to be completely aware of and evaluate fully all securities. Do not just assume that because it’s labeled “stable value,” it’s all Treasury or agency securities inside the portfolio.
Rick: I like how you described earlier the different goals that stable value fund managers have. What questions should an employer be asking their advisor, their recordkeeper, and their stable value fund manager? For example, what are we looking at? What is the strategy that fund or that manager is employing? And am I comfortable with that, or am I aligned with that as what I think is going to be best for my plan or my participants?
Steve: Several important questions need to be addressed when comparing different options across the board. Obviously, investment guidelines are a big part of it, such as asking for detailed investment guidelines, not only at the total fund level, but also if there are underlying strategies that have specific investment guidelines to their portion. That’s entirely appropriate, so that you get all the detail of what potentially the fund is investing in.
The second piece deals more with fund structure. There is a bifurcation in the stable value world of funds that are focused specifically for total return — meaning they don’t have a lot of built-in liquidity — and a smaller set of funds that is more focused on liquidity, meaning they want to make sure they have securities maturing each quarter to replenish cash if necessary. These are the two major blocks that you’ll see in in the stable value pooled fund space. There are differences between the two because obviously a total-return-oriented fund is probably going to hold slightly less cash than one that’s focused on liquidity.
One of the likely differences in outcomes of a total return manager versus a liquidity manager is that the total return manager probably will have a slightly harder time keeping pace with current movements in interest rates, because they’re not having securities mature as often as a manager that has a liquidity facility in place. So, really, it comes down to what exactly the plan sponsor is looking for. If they’re looking for only total return and they’re not as concerned about potential volatility, well, there’s obviously a segment of funds that will be best for that. If they’re looking for something that’s hybrid and, in our opinion, slightly more conservative — that focuses on liquidity, but should be able to capture some of the changes in interest rates more quickly — then there will be funds that are better structured to handle that type of environment. Those are the main categories that I think an advisor or plan sponsor should at least have answered when they go looking for options between the two.
Rick: Certain protections are built into stable value funds. Puts and market value adjustments [MVAs] are a couple that come into that conversation. Maybe give a quick definition of each and why they’re in place, because I think some people sort of get put off, no pun intended, by that concept. At the end of the day, if understood, it makes a lot of sense.
Steve: Yes, it does make sense. I would argue that the put (specifically on CIT-based products) is actually something that plan sponsors should welcome, as it protects them as much as it appears to restrict them if they’re looking to terminate. A put provision, which is exclusive to the CIT products, is required by the wrap issuers. Basically, what it allows a manager to do is to delay a plan-level termination at book value from a fund for up to 12 months, generally, but, in a few cases, up to 24 months. This delay lessens the chance of any single — or several — large, plan-driven cash flow events that occur around a similar date having effect on the future return of the remaining plans and participants who are remaining in the fund.
Just to go back to puts for a second, one thing plan sponsors should do is ask how a manager usually uses the put. There are some managers out there who will simply put every plan that’s terminating, because it’s easier to do that as a blanket policy. They’ll do it regardless of the size, the timing, or the potential economic impact, positive or negative. Others will be more strategic about it, only using a put when it makes sense for all parties involved, with particular concern about the effect on the fund structure and any changes to future return implications after the withdrawal is completed.
You also mentioned MVAs. This is something mostly contained in non-CIT products and, specifically, the general account insurance product space. A lot of those products will have what I would consider overly punitive termination options in their contracts in terms of the length of time to get your money out whole or the chance that the Plan will have to pay a market value adjustment to get out sooner. When you’re evaluating these products as a plan sponsor or advisor, it’s something you’ll need to be very aware of before entering into one of these deals. A lot of times, what you’ll see is very attractive rates upfront, but then they’ll be very difficult to get out of without an MVA on the back end.
Rick: All right. I can’t let you get out of here without some commentary or prediction, whatever you’re comfortable with, on where we are today. The hot topic obviously is, are we in a recession or are we not in a recession? And is the Fed going to continue to raise rates? If so, by how much? What happens with inflation? All of these things are water cooler talk or questions on the minds of employers in terms of their own businesses or the impact on their retirement plans. I gave you a lot there. Pick and choose what to take on.
Steve: Given that there is still a tremendous amount of uncertainty, it makes it difficult to provide any clear directional comments. We have to remember that we are in uncharted territory on a lot of fronts: coming out of two years of a pandemic, fiscal stimulus larger than any in history, and a labor market that for some reason has been very resilient to date. That all being said, we don’t see any near-term change in Fed policy for the balance of 2022 or until they see significant progress on the inflation front. For stable value funds, what I would say is that crediting rates will most likely move higher over time on a lagged basis, as managers invest more of their legacy underlying portfolios in what today is the new rate regime. However, we caution that results will most likely vary from manager to manager based on cash flow. That’s a big part of stable value returns. But results will also vary based on fund structure and, certainly, the investment guideline flexibility managers are able to utilize to try to obtain the most value for their participants. It’s an environment that we’re paying very close attention to.
We also would expect that market-to-book ratios will probably continue to stay below 100 for the balance of this year and into 2023. So far, that has not been a big concern overall from the issuer perspective, but it’s definitely something to keep an eye on to see whether they start to be less comfortable with what we have seen so far in the marketplace.
Rick: I appreciate everything you shared today. Thanks.
Listen to the full conversation here.
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About Steve Horner of Putnam Investments.
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