Tight Liquidity Can Create Volaitility

All is good in the financial markets, right?   The stock market continues to climb; and, Frank Norris in the New York Times suggests that the thrid year of a presidential term is a good one for the stock market. On top of that, no doubt, Wall Street and Corporate America will be thrilled that a compromise appears to have been worked out on the Bush Tax cuts.  And yet, I have a quesy feeling that a perfect storm is brewing with respect to stable value funds.

You may ask, what would a recovering stock market have to do with stable value funds? Experience shows that the two move hand in hand with one another —- except, in opposite directions. This phenomena is attributable one-part to investor phsychology and two-parts to the arcane mechanics of stable value programs.

Coming out of the financial crisis of ’08-’09, many plan participants sought safety in stable value programs.  First, the programs were typically marketed as safe (and possibly even as risk free); and second, with money market rates excessively low, stable value programs offered a slightly higher return.

Bingo — higher returns, lower risks and huge waves of money shift into stable value funds.

While yields remain at historically low levels, the robust returns generated by equity funds will likely attract attention from plan participants.  So far, plan participants have been reluctant to embrace the equity markets, but at some point, and we don’t know when, the equilibrium will tip and vast amounts of retirement assets will likely flow back into equity funds.  Plan fiduciaries must anticipate that a significant portion of these assets will come from withdrawals from stable value programs.

Prudence requires that plan sponsors plan for this contingency. If plan participants “head for the exit all at the same time” to cash out of stable value programs, plan fiduciaries will have to sell assets into a falling market.  We’ve seen this movie before.

Plan fiduciaries must instruct investment managers of stable value products to evaluate and monitor their liquidity needs.  Liquidity guidelines must be re-assessed for the market conditions.

Similarly, plan fiduciairies must also review the demographics of their participant base.  Understanding previous flows in and out of various investment options, can also provide important data for assessing liquidity needs.

Of course, rising equity equities markets are generally a good thing (assuming it is not a bubble brewing).  However, there can be unintended consequences.  The stable value world is a small niche within the global capital markets.   However, it is a niche with $700 billion of retirement assets.  It is also a niche in which many investors have been promised “safe” “stable” returns.  These promises can set the stage for a calamity.

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