The stock market's slide has exposed a glaring shortcoming in some 401(k) retirement plans.
Though employers have increased the average number of investment options in these company-sponsored plans from five to eight over the last four years, what they added were mostly stock funds.
By contrast, bond funds--a natural alternative when investors are seeking a relatively safer, income-paying asset--have gotten short shrift. In fact, many 401(k) plans still offer employees only a single bond fund option, said John Doyle, vice president at mutual fund firm T. Rowe Price Associates.
And even in plans that offer a choice of bond funds, "the average plan participant is still confused about how bond funds work--what makes them go up and down in value," said Shellie Unger, a principal at Vanguard Group's institutional investor unit.
The result: Scared 401(k) investors who pulled money out of stocks as the market sell-off intensified in the last two weeks redirected much of that money not into bonds but into so-called stable-value funds or old-fashioned guaranteed investment contracts--without necessarily knowing what these investments are and how they affect a portfolio.
A guaranteed investment contract, or GIC, is something like a certificate of deposit, but with significant differences. The company that writes the contract, generally an insurance company or a bank, promises the investor a certain interest rate over the life of the contract, which varies.
But don't let the term "guaranteed" fool you. Unlike with a bank CD, the principal invested isn't federally guaranteed. It is backed only by the insurance company or bank that issued it.
A stable-value fund typically invests in individual GICs. A growing number of stable-value funds, sometimes called "synthetics," also invest a significant portion of their funds in bonds. These investments are then "wrapped" in a contract by a bank or insurer that promises investors their principal won't decline in value.
According to Hewitt Associates, an employee-benefits consulting firm in Lincolnshire, Ill., 83% of the money that was yanked out of 401(k) stock funds last Monday--when the Dow Jones industrial average tumbled nearly 513 points--was put into GICs or stable-value funds.
By comparison, 11% went into bond funds and only 4% into money market funds.
Stable-Value Not for All
This past week, Cigna Retirement & Investment Services, the nation's third-largest 401(k) plan administrator, reported that 96% of its plan participants who fled stock funds put their money into stable-value investments.
That doesn't surprise Carol Glickman, an associate with Mercer Investment Consulting, a subsidiary of the consulting firm William M. Mercer in Los Angeles.
"Stable-value is always billed as the safest fund in a plan. So that's where those who are scared of losing any money are going to put it," Glickman said.
But even if it's the automatic choice, a stable-value fund or individual GIC may not be the right choice for investors seeking shelter from the stock market's swings.
First, a bond fund may be more appropriate--even though it carries the risk of principal loss--depending on an investor's goals and risk tolerance, experts say.
"To say that stable-value funds can replace bonds entirely is implying something that history shows is untrue," said Greg Schultz, a principal at Asset Allocation Advisers of Walnut Creek. "Short-term funds are not going to return as much as long-term funds over sustained periods of time."
Second, although a stable-value fund or GIC may be safe, it may not get you where you need to be financially in the long run.
Investors "don't realize the risk of putting all their money there is they won't have any money for retirement," Glickman said.
As with money market funds, stable-value investments are designed to preserve capital. They typically offer higher yields than a basic money-market fund, but over the long-term they provide less capital growth than stocks--and also than many bond funds.
Over the last 10 years, the average stock fund has delivered a total return of 13.2% a year, and the average taxable bond fund has returned 8.5% a year, according to fund tracker Morningstar Inc.
By contrast, the average return on the Hueler Stable Value investment index, which tracks about 30 of the largest stable-value funds, has been 7.25% a year in that period. Trailing that return is the 5.4% earned by money market funds.
With the exception of investors who need to tap all of their 401(k) money in less than five years, financial planners say most investors--even those close to retirement--should keep a significant sum in stocks, and avoid the temptation to invest too heavily in stable-value funds.
Why? Even the typical 65-year-old can expect to live at least 20 years after retirement. Odds are that, as in the past, stocks will provide far better growth over 20 years than what you'll earn in lower-risk stable-value funds.
That's news to many 401(k) investors. According to a recent survey of 1,000 working Americans by the consulting firm Towers Perrin, 17% said they did not know whether stocks or "guaranteed" investments produced higher returns over the long term.
And of those who claimed to know, half thought guaranteed investments earned greater or similar returns as stocks--which certainly hasn't been true long-term.
For the same reason, 401(k) investors--especially younger ones with a longer time horizon--who have a choice of good bond funds may want to consider those before jumping into a stable-value fund or GIC, financial planners say.
If your plan doesn't offer a choice of bond funds, you could choose a "balanced" fund, which invests in a mix of stocks and bonds (often 60/40). That at least gives you some bond exposure.
Although it's true that stable-value returns are far less volatile than bond funds and even money market funds, stable-value investments aren't without risk.
For example, GIC principal values aren't subject to fluctuations in market interest rates, but the contracts are subject to the so-called credit risk of the issuing company.
In 1991, 401(k) investors were among the big losers when two large GIC issuers, Executive Life and Mutual Benefit Life, collapsed.
Admittedly, the risks are very low: According to the Stable Value Investment Assn. in Washington, D.C., the historical rate of default for GIC issuers is a fraction of 1%.
Even so, Scott Lummer, chief investment officer for the 401(k) Forum, an investment advisory service for plan participants, recommends that employees who choose GICs make sure they're investing in ones issued by companies with credit ratings of AA or better. (If the rating isn't printed in the brochures provided by your benefits department, ask your plan administrator for the information.)
Because stable-value funds invest in individual GICs, employees interested in these funds should ask about the credit quality of the companies issuing the GICs.
More important, employees should ask about the credit quality of the company that provides the "wrap," the contract around the fund that promises investors their money back in full.
Also, because a so-called synthetic stable-value fund will also invest in bonds, it wouldn't hurt to know the "'duration" of the bonds the fund owns, Lummer said.
Duration, similar to average maturity (the time till a bond matures), is a statistic that indicates how sensitive a bond's principal value is to market interest-rate fluctuations.
Bond investors must worry about market rate movements because a fixed-rate bond's price moves in the opposite direction of market rates. When rates rise, the price of older bonds that carry lower yields falls. When rates fall, older bonds rise in value because their yields are better than those on new bonds.
The lower a bond fund's duration, the less volatile its principal value will be as rates move.
The worst-case scenario for a synthetic stable-value fund, Lummer said, would be if interest rates spike up and the insurer, like Executive Life, goes under.
Although he says such a scenario is extremely unlikely, Lummer nonetheless recommends avoiding stable-value funds that invest too heavily in bonds with durations of three years or more.
Wayne Gates, general director in charge of guaranteed and stable-value products for John Hancock Financial Services, said the typical stable-value fund has an average duration of 2 to 2.5 years.
Because stable-value investments can offer 1 to 3 percentage points more yield than money market funds while being less volatile than bond funds, Gates says they may indeed be appropriate for risk-averse 401(k) investors.
Even so, investors who want to make a bet that market interest rates will decline over the next year or so face a trade-off: A GIC or stable-value fund offers a way to lock in an interest rate, but you might not get the principal appreciation that a bond fund would offer if market rates slide.
Watch for Restrictions
And here's one final caveat: Putting money into a GIC or a stable-value fund might not be as simple as parking it in a money market fund. Once invested in a GIC, there may be some restrictions on shifting that money.
For instance, let's say your 401(k) plan offers a choice of stock, bond, stable-value and money market funds. And assume you decide to shift some money out of stocks into a stable-value fund until the market calms down.
If for some reason you become concerned about your stable-value investment, some plans won't let you shift out of the GIC directly into a money market fund. You may have to shift that money back into a stock fund for two to three months before you can go into the money market fund. This is referred to as an "equity wash."
Plans do this because money market funds--and in some cases bond funds--are considered competing products for the GIC.
That's why financial planners suggest checking what restrictions, if any, there are in your company's plan before rushing into a GIC or stable-value fund.
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A Snapshot of Markets
Dow average, Friday close: 7,640.25
Dow's decline from '98 peak: --18.2%
Avg. U.S. bear market loss (since 1946): --29.4%
Avg. U.S. stock mutual fund, year-to-date loss: --8.0%
Avg. U.S. stock mutual fund, decline since July 16: 20.3%
Avg. intl. stock mutual fund, year-to-date gain: +0.8%
Avg. intl. stock mutual fund, decline since July 16: --17.1%
Price-to-earnings ratio, Standard & Poor's 500 index* : 21.5
Current yield, 10-year U.S. Treasury note: 5.01%
Current yield, avg. money market fund: 5.03%
Avg. yield, 1-year bank CDs: 4.93%
Current yield, U.S. corporate junk bonds** : 10.01%
* Based on 12-month operating earnings, through June 30
**Based on Merrill Lynch index
Mutual fund data as of Thursday's market close.
Sources: Lipper Analytical Services; RateGram; Times research
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Two-thirds of tax-deferred 401(k) retirement plans offer stable-value investment options to their participants, but bond-fund options are more limited. The following is a ranking of fund categories available through 401(k) plans in 1997, according to a survey of 451 major plans by Hewitt Associates.
Stable value: 66%
Large-cap stock: 61%
Stock index: 59
Company stock: 52%
Money market: 51%
Foreign stock: 47%
Small-cap stock: 41%
Longer-term bonds: 38%
Short-term bonds: 21%
Emerging markets: 11%