DC Design

Designing Balanced DC Menus: Considering Capital Preservation Strategies​​

Low-risk bond strategies offer DC plans an alternative to money market funds.​

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 c​apital 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.​

The Author

Stacy Schaus

Head of Defined Contribution Practice

Ying Gao

Disclosures

Past performance is not a guarantee or a reliable indicator of future results.All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Money Market funds are not insured or guaranteed by FDIC or any other government agency and although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund. Stable value wrap contracts are subject to credit and management risk. Like other actively managed investments, stable value investments are subject to investment management risk. PIMCO does not guarantee the investment performance of the separate account and the separate account may not achieve its stated objectives. Returns on stable value investments can also vary from benchmark indices because gains and losses are amortized over time and due to other portfolio-specific factors, such as the amount and timing of cash flows to the investment and interest rates when those cash flows occur. There can be no assurance that the investment will be able to maintain a stable value or that the investor will receive the same return as may be realized by directly investing in the underlying assets. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market.

Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

The Lipper Money Market Fund Index is comprised of funds that invest in high-quality financial instruments rated in the top two grades with dollar-weighted average maturities of less than 90 days. Lipper Fund indices are calculated using a weighted aggregative composite index formula that equal-weights the constituent funds and reinvests capital gains distributions and income dividends. The Hueler Analytics Stable Value Index is an equal-weighted total return index averaging all participating funds in the Hueler Universe. It represents about 75% of the stable value pooled funds available to the marketplace. This index is a 23-year historical return series and is produced on a monthly basis. The Barclays Intermediate Aggregate Bond Index is an unmanaged index representing domestic taxable investment grade bonds with an average maturity and duration in the intermediate range, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. This index represents a sector of the Barclays Aggregate Bond Index. The BofA Merrill Lynch US 3-Month Treasury Bill Index is comprised of a single issue purchased at the beginning of the month and held for a full month. At the end of the month that issue is sold and rolled into a newly selected issue. The issue selected at each month-end rebalancing is the outstanding Treasury Bill that matures closest to, but not beyond, three months from the rebalancing date. To qualify for selection, an issue must have settled on or before the month-end rebalancing date. While the index will often hold the Treasury Bill issued at the most recent 3-month auction, it is also possible for a seasoned 6-month Bill to be selected. The Barclays 1-3 Year U.S. Government/Credit Bond Index is an unmanaged, market-weighted index generally representative of intermediate and long-term government and investment grade corporate debt securities having maturities of greater than 1 year but less than 3 years. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.​