What Price a STIF?
by Judy Markland
During the1990ís, the practice of using a STIF or cash component of a stable value fund became almost universal. The STIF, along with cash flows from asset maturities and participant contributions, pays the initial volume of fund outflows, thus reducing risk of losses on withdrawals and benefit payments to the contract issuer. This has meant lower risk charges and therefore a higher interest rate on the stable value contracts. It is generally assumed that it also means a higher stable value portfolio rate. Over most of the 1990ís that was likely true for most funds, but will it also be true in the future?
Where Weíve Been
Looking back, itís easy to see why STIFs became so prevalent. In the early 1990ís, SV blended rates on SV portfolios were well above the yields available on new stable value investments, as the chart below illustrates. Using a STIF to pay benefits and transfers lengthened the life of the higher-rate contracts already in the fund. Also, as SV funds grew, the number of contracts in most funds ballooned. It became both a logistical and administrative hassle to tap so many contracts for small routine fund outflows.
In the second half of the 1990ís, the gap between portfolio and new investment yields narrowed appreciably. However, yield curves flattened at the same time, so the cost to the portfolio of investing in short-term assets was relatively small.
Many stable value issuers now require that a fund contain a STIF as a condition of underwriting the withdrawal risk. Most, if not all, issuers consider a stable value fund without a STIF or comparable reliable cash flow buffer to be high risk. Contract risk charges have often been estimated on the basis of this level of protection, and funds without a STIF may find it difficult to find a diversified portfolio of providers.
Where Weíre Going (????)
Maintaining a STIF makes sense for the SV fund only if the aggregate risk charge reductions for holding short-terms exceed the average yield sacrifice for holding the short-terms. A good case can be made that the cost of short-terms going forward can be expected to be higher than in the 1990ís, while the risk of losses on the first layer of stable value fund withdrawals has shrunk over time.
The yield curve during the last half of the 1990ís was exceptionally flat in historical terms, as can be seen in the chart below. In fact, while yield curves currently seem very steep, the steepness at the short end of yield curves now is not that far above the 22-year average. The low level of current interest rates, however, means that the current yield curve is exceptionally high on a percentage basis.
When buffers were first introduced, both DC plans and stable value cash flow risks were very different. As recently as 1993, the average stable value fund was about 70 percent of the size of all the planís equity funds combined. The phenomenal returns on stocks during the second half of the 1990ís changed that picture dramatically, however. Even after two years of negative stock returns, the average planís equity holdings as of 9/30/2001were four times the size of the average stable value fund.
Inflows to stable value funds in 1993 were large and a negative cash flow history was rare. Stable valueís large allocation percentage was a major stabilizing influence on cash flows. Had all 1993 participants opted to increase their total stock allocations by 5 percent by taking funds from the stable value option, about 7 percent of SV assets would have been withdrawn. That same decision today would move 20 percent of the assets out of the fund. SV cash flow volatility is higher simply because SV allocation percentages are lower.
This greater SV cash flow volatility doesnít necessarily mean greater risk of issuer losses. A decade ago large cash flow volatility was assumed to result primarily from interest rate arbitrage. Todayís higher level of volatility is caused primarily by stock price changes and company-specific circumstances, with rate arbitrage remaining an additional factor in extreme circumstances. Thereís little evidence that stock prices are positively correlated with rising interest rates.
Moreover, company stock price fluctuations Ė and the resulting SV cash flow volatilityĖ can be diversified by the issuer. This means that is will be cheaper for the SV issuer to underwrite the withdrawal risk than for the fund to self-insure with a STIF.
In todayís world, the first level of withdrawals in a SV fund may well have as much chance of producing gains as losses for the issuer. Itís ironic that providers have shunned this risk level in favor of the higher tiers of withdrawal risk, those that are more likely to result from rate arbitrage, thus giving up a share of the SV market to short-term instruments.
Many SV funds are increasing the durations of their stable value investments slightly to gain additional yield in this low-rate environment. Perhaps it would make as much sense to eliminate the STIF. Whatís needed is a mechanism to pay transfers and benefits without tapping multiple contracts. Surely a creative provider can solve that problem.
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