A Way Boomers Can Have It All

As baby boomers age, they should increasingly seek safety and income in their investment strategies.

At least, they should if they want to avoid disappointing Wall Street, which is largely convinced that boomers will do the conservative thing and begin tilting their portfolios toward capital preservation and away from capital appreciation.

This suggests that bonds and other income-generating securities will be in much greater demand over the next few decades by the 79 million boomers, the first of whom are turning 60 this year.

The deal last week between brokerage Merrill Lynch & Co. and bond investment giant BlackRock Inc. was in part a bet on a rising appetite for bonds among individual investors. Merrill is taking a 49.8% stake in the firm and in so doing is opening a new sales frontier for BlackRock: the brokerage’s millions of retail customers.

But if it’s conventional bonds that Wall Street wants to sell the boomers, there are practical reasons that the pitch may have trouble impressing its intended audience.

One is that the interest rates paid on longer-term bonds still are near generational lows -- in the low single digits for U.S. Treasury securities. This makes them unappealing on their face to plenty of investors relative to taking a chance in the stock market or just keeping money in federally insured bank accounts.

A bigger issue may be that many people simply don’t understand bonds or bond mutual funds. That a bond fund’s share price can fall (in other words, you can lose principal value) if market interest rates rise isn’t an easy concept to grasp. Besides, if you’re supposed to be protecting your principal, who needs any risk of loss?

There is, however, one type of bond investment that seems to offer a happy middle ground:. so-called stable value funds, which provide the income return of bond funds with a guarantee (albeit, not a government guarantee) against principal loss.

Stable value funds are available only through 401(k) retirement-savings and company profit-sharing plans. More than half of such plans offer them, industry surveys show.

And where they’re offered, they’re a hit. The accounts held 16.9% of the average 401(k) participant’s plan assets in 2004, according to an annual survey by consulting firm Hewitt Associates.

Just two investment options held more money: sponsoring companies’ own stock, at 26.5% of average assets, and U.S. blue-chip shares, at 19.2%, Hewitt’s data show.

Bond mutual funds were far down the list, at just 4.1% of average assets; money market funds held even less, at 2.6%.

Stable value funds have been around for more than a decade. Their first incarnation was as “guaranteed investment contracts,” which were insurance company agreements to pay a set interest rate. Now, they more resemble diversified bond funds.

Their asset growth has accelerated in recent years as more retirement-plan investors have turned to them. The accounts held $419 billion at the end of 2004, up from $262 billion in 2001, according to the Stable Value Investment Assn. in Washington, D.C.

The concept of stable value sounds like the proverbial free lunch -- an attractive return with no risk. What makes it possible is that risk-swapping among major financial institutions has become such a big business in its own right.

Here’s how the accounts work, in a nutshell: A fund management company takes investors’ money and assembles a portfolio of bonds and other fixed-income investments, much like a conventional mutual fund. But unlike in a conventional fund, the risk of principal loss from changes in the bonds’ market value is eliminated through insurance agreements with other financial institutions, such as banks.

Those agreements “slough off the risk” of principal loss onto an institution that’s willing to take it for a fee, says Kelli Hueler, head of Minneapolis-based Hueler Cos., which tracks stable value accounts.

Even with that insurance cost, the accounts have lower management fees than bond funds because they don’t incur marketing or related expenses, Hueler said. That means investors keep more of the yield the accounts generate.

The average return on an index of stable value funds tracked by Hueler was 4.43% in 2005, and over the last three years the yield averaged 4.48%.

By contrast, the average conventional mutual fund that owns intermediate-term investment grade bonds (securities maturing in three to six years or so, similar to those in many stable value funds) had a total return averaging 3.6% a year over the last three years, according to Morningstar Inc. Total return counts interest income plus or minus principal change.

And even though yields on money market funds have risen sharply over the last 18 months as the Federal Reserve raised short-term interest rates, money funds still trail stable value returns. The current average annualized money market fund yield is 3.89%, as tracked by IMoneyNet Inc.

So for many 401(k) plan investors whose income-generating choices are a bond fund, a money market fund and a stable value account, it’s easy to see why the stable value account would be a no-brainer.

You might earn a higher total return on a bond mutual fund over time if market interest rates fall, which would boost the value of older fixed-rate bonds. But if market rates rise, your principal would almost certainly erode in a bond fund.

That just doesn’t sit well with many investors who are turning to income-producing accounts to preserve their nest egg, said David Wray, head of the Chicago-based Profit Sharing/401(k) Council of America.

When investors first take a look at conventional bond funds, “they’re thinking about secure principal,” Wray says. “And when they find out it isn’t secure, they choose other investments.”

Some analysts, however, say investors may have an exaggerated view of the potential for significant principal loss in bond funds. A stock fund could lose half its value in a matter of months. That doesn’t happen to with bond funds that own high-quality government or corporate issues.

“The average well-run bond fund doesn’t suffer that much volatility relative to what people imagine,” says Eric Jacobson, a fixed-income analyst at Morningstar in Chicago.

What’s more, with a bond fund you can see what you’re investing in because that is fully disclosed in fund documents.

Stable value accounts don’t face the same disclosure requirements, Jacobson notes. “They’re so opaque” compared with conventional bond funds, he says.

That means the investor, in effect, is being asked to say, “I trust you” to the stable value manager, Jacobson adds.

Historically, the vast majority of stable value accounts have lived up to their promises. But it isn’t clear how the principal guarantee might fare in the long run, particularly if more money is exiting than entering the accounts as boomers draw down their savings over time.

The industry suffered a rare black eye in the fall, when one $200-million fund filed for bankruptcy court protection.

Nell Hennessy, chief executive of Fiduciary Counselors Inc., which was appointed to oversee the Trust Advisors Stable Value Plus Fund after its bankruptcy, said she didn’t consider the fund typical of the stable value industry. “They invested in things stable value funds don’t usually invest in,” she said. It isn’t clear what level of losses investors in the fund ultimately may suffer, Hennessy added.

For Wall Street, the rising challenge posed by the popularity of stable value funds is that they are spoiling millions of investors. People are getting used to the idea of earning a bond-like return without the risk that normally entails.

Indeed, it’s an unpleasant surprise for 401(k) investors who have used stable value accounts to find that, when it’s time to retire and pull their money from the 401(k) plan, there is no similar stable value fund available outside of their plan.

An attempt by the mutual fund industry to create stable value accounts for non-retirement money was aborted less than two years ago because of fears that the accounting would run into trouble with the Securities and Exchange Commission. (The SEC has no jurisdiction over 401(k) plan assets.)

Baby boomers often are accused of wanting it all. With stable value accounts, they’re getting it: decent interest income and safety of principal. That will make life tougher for brokerages and mutual funds trying to sell the boomers on conventional bonds and bond funds.

How to create more income-oriented products that fill that stable-value niche “is the long-term issue the industry has to grapple with,” says Ben Phillips, head of strategic research at Putnam Lovell NBF Securities, a New York-based firm that specializes in the financial services business.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, visit: www.latimes.com/petruno.

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401(k) choices

Here is a breakdown of 401(k) plan investment holdings in 2004, based on a survey of 1.8 million investors.

*--* Average asset Investment allocation Company stock 26.5% U.S. blue chip stocks 19.2 Stable value 16.9 Balanced (stock/bond mix) 8.5 Life-stage funds 8.0 U.S. small stocks 5.9 Foreign stocks 4.4 Bonds 4.1 U.S. mid-size stocks 3.0 Money market 2.6 Other 0.9

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Survey results were equally weighted, so that investors with larger balances didn’t skew the results.

Source: Hewitt Associates