Expanding the Capital Preservation Conversation

By Brett Minnick, Vice President, and Kyli Soto, AIF®, Vice President

Any discussion of capital preservation in a defined contribution plan can cause confusion or disinterest amongst plan fiduciaries. But much like the offensive line during a game-winning drive, its importance is most apparent amidst times of turmoil. As capital preservation continues to be one of the few asset classes providing participants with a positive nominal rate of return, fixed account products and stable value funds have come to the forefront when fiduciaries speak with recordkeepers and investment managers.

Although these may fill the “cash” bucket of the defined contribution plan investment menu, they might better be viewed as cash-like. Many include unique terms and conditions that could prove challenging in the future. We’ll endeavor here to describe the different types of investment products that can be used as the capital preservation offering within a plan menu, discuss how they differ from one another, and explain the considerations that must be evaluated.

The most well-known of the three major capital preservation types is a money market fund. It is best described as a fixed income mutual fund that invests in short maturity, high credit quality securities. Money market funds are designed to hold a net asset value (NAV) of $1.00, regardless of economic circumstances. Earning a consistent yield can be challenging, as returns are strongly linked to interest rates.

Next are stable value funds, which typically hold a diversified portfolio of short- and intermediate-maturity fixed income securities. Stable value funds provide participants with a guaranteed rate of interest dependent on the underlying securities, and they have an explicit expense ratio.

Finally, fixed accounts are like stable value funds in that they have a guaranteed interest rate. However, occasionally those rates are negotiated rather than market-based and there may not be an explicit expense ratio.

When assessing your current capital preservation offering, there are three aspects that must be assessed: transparency, portability, and termination provisions.

Transparency

All money market funds are registered under the investment act of 1940 and are legally required to maintain a certain level of transparency. They are also the only capital preservation investment discussed in this piece that have a ticker symbol, thereby allowing investors to easily research them.

Stable value funds are available to retirement plan participants through collective investment trusts, and therefore do not typically have a ticker symbol. While this makes research on stable value funds’ underlying securities more challenging, it is not impossible. Statements generated by stable value providers show fixed income classes similar to what they show in their core bond holding, such as treasuries, asset-backed securities, and municipals. Stable value funds also generally have an explicitly stated expense ratio that can be used for benchmarking purposes.

Fixed accounts are available through a variety of vehicles, most notably separate accounts or commingled funds, and therefore it is difficult for participants to conduct research independent of what is provided directly to them. Fixed accounts also may incorporate asset classes not generally seen in capital preservation products, such as below-investment grade credit and even alternative investments. Finally, many fixed accounts are spread products – the amount being collected by the account provider (the spread) is the difference between what the portfolio earned and what the guaranteed crediting rate is. This can make it very challenging for a fiduciary to properly benchmark expenses, as they may change as often as quarterly.

Portability

The next consideration is portability, or the option to move these assets to another fund or provider. When we assess portability, it is more so at the plan level than at the participant level. In almost every case, participants will have immediate access to their assets invested in a money market, stable value, or fixed account fund.

As discussed earlier, money market funds are registered mutual fund under Investment Company Act of 1940. Therefore, a recordkeeper that offers an open architecture platform should allow for a variety of money market funds. Stable value funds, on the other hand, are not always available on every recordkeeping platform. Plan fiduciaries conducting a stable value search or considering a change of recordkeeping provider should confirm the availability of the desired stable value fund. General accounts, due to their proprietary nature, are almost entirely non-portable. Given that the fund typically participates in the recordkeeper’s general account, the option to move the product to another provider is only available in the rarest of circumstances. This could prove to be financially burdensome to participants should the plan make the decision to change recordkeepers.

Termination Provisions

Much like portability, termination provisions will have a much greater impact at the plan level as opposed to the participant level. At the participant level, most capital preservation products will not have termination provisions written into their contract, but they often do at the plan level.

For money market funds, should a plan decide to move to another capital preservation product, they can do so as if they were terminating any other mutual fund within their investment menu. In the event of a recordkeeper transition, a government money market fund does not have the ability to gate (or limit) withdrawals.

In stable value funds, the most common plan level termination provision is a 12-month put. Essentially, a 12-month put requires that plan sponsors provide a year’s advance notice before terminating the fund. The put is designed protect the fund’s remaining investors from a decline in the market value.

Fixed accounts can also include a 12-month put, but sometimes also include a market value adjustment (MVA). An MVA is a monetary adjustment that can be applied to the fixed account contract in the event of plan level termination. If applied, participants would only receive a portion of their balance, corresponding to the market-to-book value at the time of termination. In a rising interest rate environment like we are currently experiencing, market-to-book values can be well below 100%.

For all these reasons, it is important that retirement plan fiduciaries consider the merits of their capital preservation fund on a regular basis. As we have seen in 2022, there can be times where capital preservation funds are the only positive nominal returns seen within an investment menu. While similar in objective, money market funds, stable value funds, and fixed accounts each have unique characteristics that should be evaluated. The transparency of the product, the portability at the plan and participant level, and the termination provisions in play could leave participants at a loss should the plan change recordkeepers.