During periods of market turbulence and low interest rates, many investors struggle to find investment alternatives that aren't getting hammered. But those saving for retirement may be pleasantly surprised to discover a unique breed of mutual fund known as stable value funds. These funds are somewhat similar to money market accounts, except that they post much higher yields with relatively little risk. We'll explore stable value funds and their advantages and disadvantages, as well as for whom these funds are appropriate.

What Is a Stable Value Fund?
As their name implies, stable value funds are a type of cash fund that resembles money market funds by offering protection of principal while paying stable rates of interest. Like their money market cousins, these funds maintain a constant share price of $1. However, stable value funds have typically paid twice the interest rate of money market funds. Even intermediate term bond funds tend to yield less with considerably more volatility.

Stable value funds used to invest almost exclusively in Guaranteed Investment Contracts (GICs), which are agreements between insurance carriers and 401(k) plan providers that promise a certain rate of return. However, a number of insurance carriers that invested heavily in junk bonds in the '80s suffered heavy losses and defaulted on some of their agreements. Retirement plan participants of other providers, such as Lehman Brothers, which declared bankruptcy, discovered that their GICs became invalid in the event of corporate insolvency. Therefore GICs fell largely out of favor as funding vehicles for stable value funds.

These funds now invest primarily in government and corporate bonds with short- to medium-term maturities, ranging from approximately two to four years. Stable value funds are therefore able to pay higher interest than money market funds, which usually invest in instruments with maturities of 90 days or less. Of course, this means that the holdings within stable value funds are also more susceptible to changes in interest rates than money market holdings. This risk is mitigated by the purchase of insurance guarantees by the fund that offset any loss of principal, which are available from around a dozen different banks and insurance carriers. Most stable value funds will purchase these contracts from three to five carriers to reduce their default risk. Usually these carriers will agree to cover any contracts defaulted upon in the event that one of the carriers becomes insolvent. There has also been a recent shift towards more conservative portfolio offerings as a result of the market meltdown in 2008. (For more, see The Money Market: A Look Back.)

Pros and Cons
As mentioned previously, stable value funds pay an interest rate that is a few percentage points above money market funds. They also do so with substantially less volatility than bond funds. However, these funds also charge annual fees that cover the cost of the insurance wrappers, which can be as high as 1% per year in some cases. Furthermore, most stable value funds prevent investors from moving their money directly into a similar investment, such as a money market or bond fund. Participants must instead move their funds into another vehicle such as a stock or sector fund for 90 days before they can reallocate them to a cash alternative.

Perhaps the biggest limitation of stable value funds is their limited availability: They are generally only available to 401(k) plan participants of employers who offer these funds within their plans.

Another key point to remember is that these funds are stable in nature, but not guaranteed. Although the chances of losing money in one of the funds is relatively slim, they should not be categorized with CDs, fixed annuities or other instruments that come with an absolute guarantee of principal. (To learn more, see our Traditional IRA Tutorial.)

Who Should Invest in a Stable Value Fund?
Stable value funds are excellent instruments for conservative investors and those with relatively short time horizons, such as workers nearing retirement. These funds will provide superior income with minimal risk and can serve to stabilize the rest of the investor's portfolio to some extent. However, they should not be viewed as long-term growth vehicles, and they will not provide the same level of return as stock funds over time. Most advisers recommend allocating no more than 15-20% of one's assets into these funds. (For more tips, read Asset Allocation Strategies.)

Stable value funds serve as a happy medium between low-yielding cash and money market funds and bond funds, with their higher risk and volatility. These funds provide higher rates of interest with little or no fluctuation in price. However, this stability comes at a price in the form of annual fees, and transfers into other cash instruments can only be made under certain conditions. To learn more about stable value funds, visit www.morningstar.com or consult your financial adviser. (For more, see our Investopedia Special Feature: Individual Retirement Accounts.)

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Mutual Funds & ETFs

    The Democratization of the Hedge Fund Industry

    The coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
  3. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  4. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  5. Retirement

    How a 401(k) Works After Retirement

    Find out how your 401(k) works after you retire, including when you are required to begin taking distributions and the tax impact of your withdrawals.
  6. Stock Analysis

    Why did Wal-Mart's Stock Take a Fall in 2015?

    Wal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
  7. Investing News

    Should You Invest in Disney Stock Before Star Wars?

    The force is strong with Disney stock, as it continues to make gains going into the launch of EP7. But is this pricey stock a good buy at these levels?
  8. Investing Basics

    Do You Need More Than One Financial Advisor?

    Using more than one financial advisor for money management has its pros and cons.
  9. Mutual Funds & ETFs

    Top Schwab Funds for Retirement

    These Schwab funds are strategically designed and have performed well on a historical basis, meaning they're solid options for retirement.
  10. Investing News

    Silicon Valley Startups Fly into Space

    Space enthusiasts are in for an exciting time as Silicon Valley startups take on the lucrative but expensive final frontier.
  1. Can a 401(k) be taken in bankruptcy?

    The two most common types of bankruptcy available to consumers are Chapter 7 and Chapter 13. Whether you file a Chapter 7 ... Read Full Answer >>
  2. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
  3. Who can make catch-up contributions?

    Most common retirement plans such as 401(k) and 403(b) plans, as well as individual retirement accounts (IRAs) allow you ... Read Full Answer >>
  4. Can you have both a 401(k) and an IRA?

    Investors can have both a 401(k) and an individual retirement account (IRA) at the same time, and it is quite common to have ... Read Full Answer >>
  5. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>
  6. Are 401(k) rollovers taxable?

    401(k) rollovers are generally not taxable as long as the money goes into another qualifying plan, an individual retirement ... Read Full Answer >>

You May Also Like

Trading Center