LANDMARK STRATEGIES PO Box 804              Whately, MA 01093  413-665-4638

Stable Value and GICs

by Judy Markland
President, Landmark Strategies


a chapter in the
Pension Investment Handbook
by Aspen Publishers
updated 2002

Contents 

Introduction:  The Origins of Stable Value

The Basics of Stable Value

Q1	What is a stable value fund?
Q2	Why are stable value funds such popular investments for defined contribution participants but not for institutional investors?
Q3	What types of people should invest in a stable value fund?
Q4	How does the performance of stable value funds compare with that of other conservative options for defined contribution investors?
Q5	How is a stable value fund invested?

Types of Investment Contracts

Q6	What is a GIC?
Q7	What is a synthetic GIC?
Q8	How does a synthetic wrap work?
Q9	What types of risk protection do synthetic GICs offer?
Q10	Who are the largest providers of synthetic GIC wraps?
Q11	What are the advantages of synthetic GICs compared with those of traditional GICs?
Q12	What is a universal wrap?
Q13	What is a separate account GIC?
Q14	What is a bank investment contract?
Q15	What is a muni-GIC?

Stable Value from the Issuer's Perspective

Q16	What risks do stable value contracts pose for the issuer?
Q17	How do stable value issuers protect themselves against stable value risks?
Q18	How are stable value contracts priced?
Q19	What is underwriting for a stable value contract?

Deposit and Withdrawal Features of Stable Value Contracts

Q20	What is a benefit-responsive contract?
Q21	What are the withdrawal protocols for stable value contracts?
Q22	What is a competing fund?
Q23	What are the various types of deposit features for stable value contracts?
Q24	Why do investment contracts require timely payment of contributions and impose a penalty when timely payment does not occur?

Investment Characteristics of Stable Value Contracts

Q25	What are the investment risks in a stable value asset?
Q26	What are the withdrawal protocols for stable value contracts?

Considerations in Purchasing a Stable Value Contract and Managing a Stable Value Portfolio

Q27	How is a stable value investment purchased?
Q28	How does the investor evaluate credit risk on stable value assets?
Q29	What are the primary firms providing financial ratings on insurance companies and banks?
Q30	Why does the investor care about credit risk if GICs and other stable value investment contracts are guaranteed?
Q31	What happens if a stable value asset defaults?
Q32	What protection is available in the case of downgrade or default on investment contracts?
Q33	What are the investor’s concerns about assuming interest rate risk in stable value funds?
Q34	What termination provisions apply to stable value contracts?
Q35	What considerations are important in purchasing a synthetic wrap contract?
Q36	What are a plan’s investment management options for a stable value portfolio?
Q37	What are the pension accounting rules for stable value investments?
Q38	Are stable value contracts derivatives under FASB Statement 133?
Q39	Do stable value funds qualify under ERISA Section 404(c)?
Q40	Are stable value contracts registered?

 

Introduction: The Origins of Stable Value

             Stable value funds are one of the most popular investment options in defined contribution plans and the most popular conservative or fixed income option.  This popularity stems from the fact that they offer participants the principal stability of a money market fund with average returns comparable to those of an intermediate-term bond fund.  The market value risk on participant transactions (the risk of any gains or losses on assets sold to pay benefits to participants at book value) is borne by a high-quality financial institution which issues the investment contracts that fund the option.  This principal stability makes the asset class and excellent diversifier of investment risk as well as a good investment option for funds which may be needed in the relatively near term.  The recent turbulence in investment markets demonstrates the importance of these characteristics.

             The stable value asset class is unique in being found almost exclusively in 401(k) and other defined contribution plans.  It evolved from GICs and other group annuity contracts sold originally to defined benefit plans.  Pension accounting rules gave these contracts book value treatment, which made it possible to extend principal protection to participants.  Issuers are uniquely able to underwrite this benefit in defined contribution plans because of the arbitrage constraints which can be imposed by plan rules [See Qs 19, 22] and deterrent effect of losing company matches and tax benefits from switching out of the plan.

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The Basics of Stable Value

Q1 What is a stable value fund?

        Stable value funds are options offered by 401(k) and other defined contribution plans, typically as the most conservative investment option.  These funds are invested in GICs and other medium-term fixed-income investment contracts which offer participants the ability to withdraw or transfer their funds subject to plan rules without any market value risk (risk of principal loss as interest rates rise) or other penalty for premature withdrawal.  The issuer of the investment contracts, a high quality investment institution, provides this book value liquidity on participant transactions and also guarantees principal plus accumulated interest and an interest rate for a specified period of time.
            In the past the stable value option was usually called the GIC or guaranteed option.  However, since the advent of many new types of investment contracts for these funds, fund names such as stable value, fixed income, or interest income are more frequent. 
            Historically, stable value has been the most popular conservative defined contribution investment option.  A 2001 Hewitt Associates survey  reported that 69 percent of defined contribution plans offered a stable value option. 
        As of year-end 2001, allocations to stable value funds were 29 percent of plan assets in those plans where it was offered, according to a survey by the Stable Value Investment Association .

Q2 Why are stable value funds popular with defined contribution participants but not institutional investors?

            No other medium-term investment offers liquidity without any market value risk or interest rate penalty, and this favorable risk/return tradeoff is only available to defined contribution plan participants, which explains why their relative popularity is limited to this investment group.   Stable value investment contracts do not provide principal  safety to the pension plan contractholder.  Investment contracts in defined benefit plans must generally be reported at market value (see Q 37), and plan-initiated withdrawals from the contracts are honored either at market value or at the lesser of book or market (see Q 34).   In fact, because stable value contracts are non-assignable private placement investments which cannot be readily traded or marketed by the contractholder, they have less liquidity than corporate bonds of similar yield and credit rating.  This gives them a slightly worse defined benefit risk/return profile than other fixed income investments, accounting for their low concentration in defined benefit plans (see Figure 1).

figure 1

Q3 What types of people should invest in a stable value fund?

            The stable value option is attractive to two types of defined contribution participants:  those seeking principal safety and those seeking to diversify their investments.  Many of the largest plan balances are owned by retirees or those nearing retirement who may need the security of knowing that their assets are protected from market value risk.  Many younger participants lack savings outside the plan and need assets with principal safety to cover contingencies.  Others may intend to use their balances in the near term to invest in a home or education, alternative ways to invest in their retirement security.  Stable value funds offer this principal safety in combination with a good rate of return.
            In addition, the principal stability offered participants by stable value funds provides better diversification with equities than other conservative investment options typical in defined contribution plans.   This means that overall portfolio risk to the investor can be reduced by investing in a combination of stable value and equities.  (see Q4).

Q4 How does the performance of stable value funds compare with that of other conservative options for defined contribution investors?

    Stable value funds tend to have average returns comparable to those available on medium-term bond funds, but with much less volatility in annual earnings.  Because the option is invested in medium-term assets (see Q 5), the returns are higher on average than those available on a money market fund.  This is illustrated in Figure 2, which  shows that over the period 1983-2000, the stable value portfolio had returns well in excess of the 6-month certificate of deposit and far less volatile returns than the intermediate government bond index, which experienced a loss in one year during this period.   

            The five-year GIC Index compiled by Deutsche Asset Management consists of a portfolio that invests monthly in a stable value instrument with a maturity of 5 years and is held to maturity, so that the effective duration of the portfolio is about 2.5 years.  The average return for this index over the last ten years was 7.02 percent, compared to 6.77 percent for the Lehman Intermediate Government Index and only 5.00 percent for the money market proxy.
            The low volatility in stable value returns increases the diversification benefits it offers with other typical investment options for defined contribution plans, especially common stocks.  One measure of good diversification between asset classes is a low correlation of returns, showing that the performance cycles of the assets differ.  Table 1 shows that stable value returns have a much lower correlation with stock market movements than bonds.
            This low correlation means that stable value investors may have a higher concentration of equities at the same level of downside risk  than if they invested in a market value bond fund.  In fact, a 401(k) investor with a 10-year time horizon could shift from a portfolio with 40 percent invested in a medium-term bond fund and 60 percent in common stocks to one with only 30 percent stable value and 70 percent in stocks with a 95 percent certainty that annual losses would not be increased. Not surprisingly, expected returns are higher on the stable value/equity portfolio as well, 14.4% per year compared to 14.37% on the stock/bond mix.¹

                        Table 1

Correlation of Returns with the S&P 500 correlation coefficients; annual returns 1987-2001
Ryan Cash	.24
Intermediate bond funda	.36
5-year maturity Stable Value Fundb	-.04
a Lehman Intermediate Government /Credot  Bond Index;    bDeutsche Asset Management GIC Index

 The low correlation with stocks also means that stable value investments are better choices for balanced and life cycle funds than are bond funds, since they offer greater diversification at similar return levels.  

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¹“Stable Value Basics”, Stable Value Investment Association web site, http://www.stablevalue.org/public/SlideShow/Slide6.htm

Q5 How is a stable value fund invested?

            Stable value funds invest in high-quality, fixed income investment contracts such as GICs (see Q 6) and synthetic GICs (see Q 7), generally with a credit quality of A or better (see Qs  28 and  29).   Most funds purchase investment contracts with durations of three to five years and maintain their overall stable value portfolios at a duration of 2-3 years.  This produces yields substantially above those available on money market funds in most interest rate environments, while keeping the portfolio responsive to market interest rates. 
            A well-structured portfolio produces ample cash flow each year to both fund benefits and permit reinvestment at the interest rates then prevailing.  This is typically accomplished with a laddered maturity structure, a series of growing scheduled contract maturities that extends over several years so that the maturity in each period is expected to remain roughly the same proportion of the portfolio.
            Many stable value funds also have a cash or short-term investment fund (STIF) component.  Maintained at a fixed percentage of the fund - usually between 5 and 15 percent, depending upon the volatility of the plan’s cash flows - the STIF provides a buffer for the investment contracts paying participant withdrawals and reduces risk charges on stable value contracts; however, because the STIF assets have very short-term maturities, they typically yield substantially less than the investment contracts.
            Weighing the relative cost of withdrawal risk charges or maintaining the STIF is a key stable value fund management decision.  STIF buffers first became popular in an environment of relatively flat yield curves; in a steep yield curve environment, there may be little or no incremental yield benefit.   The STIF must be large enough to cover the sizable variability in any single plan’s investment transfers and benefits over time.  However, since GIC and synthetic wrap issuers are able diversify much of this plan-specific cash flow volatility across a large number of plans, their risk charges only cover the more systematic or interest-rate induced risks (see Qs 16 and  20).

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Types of Investment Contracts

Q 6  What is a GIC?

            A GIC is a a group annuity contract issued by a life insurance company to a tax-qualified pension plan as an investment.  The acronym refers variously to guaranteed interest contracts, guaranteed investment contracts, and guaranteed insurance contracts.   A GIC is a private-placement investment, with specific terms and contractual provisions negotiated at the time of purchase.  GICs come in many varieties, but all provide for a guarantee of principal and accumulated interest and most offer a guaranteed interest rate for some period of time.   In addition, all GICs offer the pension plan the right to purchase annuities for plan participants.  Interest rates on GICs are quoted at an annual rate, as though interest payments occur once a year, rather than on a semi-annual coupon basis as is typical for bonds.
            The most typical GIC is a zero-coupon instrument which offers a guaranteed or predetermined rate of interest applied to all funds under the contract.  The accumulated value is paid at maturity.  In this traditional contract, the issuer assumes all of the credit and interest rate risks on the assets used to back the annuity contract and the market value risk on any participant withdrawals.  Although GICs originated as a defined benefit plan investment, most today are issued to defined contribution plans, where they offer plan participants the ability to withdraw their funds (subject to plan rules) for benefits or transfers to other plan options at book value.  The life company issuer underwrites the market value risk on this popular withdrawal feature (see Q 16).
            GICs are relatively illiquid at the contractholder or plan level, which has limited their popularity in defined benefit plans;  however, in periods of very high interest rates such as those experienced in the early 1980s, GICs’ zero-coupon feature and excellent call protection are popular with defined benefit investors, who value the ability to lock in both the high coupon and reinvestment yields.

 Q 7  What is a synthetic GIC?

            A synthetic GIC is an investment for tax-qualified, defined contribution pension plans consisting of two parts:  an asset owned directly by the plan trust and a wrap contract providing book value protection for participant withdrawals prior to maturity.  An alternative to a traditional GIC in a stable value fund, a synthetic GIC unbundles the GIC’s investment and insurance components.  A plan that invests in a traditional GIC owns a group annuity contract, and the insurance company owns and retains custody of the assets backing the contract.  Under the terms of a synthetic GIC, the plan has custody of the asset and negotiates separately for the wrap contract providing the book value insurance protection.  The synthetic instrument is diagrammed in Figure  3.

     figure 3

            Almost any type of fixed income asset or group of assets may be used as the synthetic asset:  a single bond or other security; a share in a mutual fund or other commingled investment option; or a portfolio established specifically for the synthetic.  The accompanying wrap contracts are issued by high-credit quality banks and life insurance companies, institutions with the capital base to support the wrap risk (see Q 16). The contracts come in many different legal forms: group annuity contracts (issued only by insurance companies), interest rate swap agreements , asset purchase agreements, investment management agreements, and others.
            Synthetic GICs were first introduced in the late 1980s by banks and investment managers anxious to capture a share of the rapidly growing stable value market.  By replicating the traditional GIC’s book value payment feature for participants, synthetic GICs were granted similar book value accounting treatment by many accounting firms.  Synthetic GICs provided the investor with a means of diversifying away from the single-industry concentration posed by GICs.   The need to diversify became a driving force in the stable value market after the financial difficulties of Executive Life and Mutual Benefit in 1991 and 1992, respectively.  Synthetic GICs now make up slightly more than 50 percent of all stable value portfolios. 

	Investment Mix of Stable Value Portfolios
	(12/31/2000)
		Cash	5.0%
		Traditional GICs1	40.4%
		Synthetic GICs	50.9%
		Separate Account GICs	3.4%
	1 includes life company full service general account contracts Source:  Stable Value Investment Association

            Under the terms of a typical synthetic GIC, the plan trustee has one contract with the asset manager and another with the wrap provider.  At the time of purchase, all parties agree to specific investment policy guidelines (such as the duration of the assets and their credit quality), and the wrap agreement stipulates that book value benefits will only be paid as long as these guidelines are followed. Typically the wrap provider and the asset manager are independent firms, but under some circumstances they may represent a single company or corporate affiliates.           

Q 8  How does a synthetic wrap work?

            The synthetic wrap contract maintains a book value asset or fund balance for the underlying asset and credits interest on that book balance.  Any market value gains or losses are amortized over a multiyear period, usually either the time to maturity or the duration of the asset(s) being wrapped, and the crediting rate (the dollar-weighted average of the yields on the book values of the stable value fund assets)  is adjusted by this amortized gain or loss.  This amortization process maintains the yield and principal stability that plan participants desire.  Yields are credited at an annual effective rate.
            The wrap provider agrees to maintain principal and accumulated interest on the synthetic asset at book value and guarantees the crediting rate for the period until the next rate reset.  The crediting rate may never be negative, because this would violate the guarantee of principal.  Wraps are typically fully participating for credit and call experience on the underlying asset(s) and may also participate in gains and losses on assets sold to fund participant withdrawals or transfers (see Q 21).   

Q 9  What types of risk protection do synthetic GICs offer?

            As with traditional GICs, the degree of risk protection available in synthetics covers a wide range, from full guarantee of principal and interest to maturity to a guarantee of principal with full participation in the experience on the underlying assets and plan cash flows and an interest rate guaranteed only until the next rate reset.  However, most synthetic GICs outstanding are participating products where the stable value fund is assuming all credit and interest rate risk on the underlying assets, with market value gains and losses reflected on an amortized basis in the credited rate as long as the credited rate does not drop below zero.

 Q 10  Who are the largest providers of synthetic GIC wraps?

            The market requirements for a successful synthetic wrap issuer are similar to those for a traditional GIC issuer:  excellent financial quality (typically an AA rating or better); risk capital or another mechanism to absorb the risk of market value fluctuations on benefits maintained at book; and the financial expertise to immunize or protect the firm from the market value risks guaranteed in the contract (see Q 16).  It is not surprising therefore that large, high quality domestic and foreign banks and life insurance companies are the predominant wrap issuers.

 Q 11  What are the advantages of synthetic GICs compared with those of traditional GICs?

            Synthetic GICs offer the investor more flexibility and the potential for lower wrap and asset management fees, especially if a single buy-and-hold asset or an index fund is wrapped.  Many investors like the ability to select the asset manager and the wrap provider separately, so that they can replace the asset manager if performance is unsatisfactory and leave the wrap in place.  The fact that the trust has direct ownership of the wrapped asset is also appealing, because that reduces the risk of regulatory hassles and valuation difficulties should the wrap issuer have financial difficulties.
            Traditional GICs, on the other hand, are generally simpler to negotiate and purchase and typically offer more forms of risk protection than most synthetic GICs.  The  traditional GIC requires only a single contract with the insurance company, rather than separate contracts with the custodian, wrap provider and the asset manager as in most synthetic GICs.  Traditional GICs typically offer protection against all credit, call or extension, and interest rate reinvestment risks on the underlying assets plus protection against contribution and withdrawal risk.  Most synthetic GICs are structured so that the fund participates in many, if not all, of these risks. Traditional GICs are also more readily available in smaller sizes (i.e., deposits of $2 million or less) than synthetic GICs.

Q 12  What is a universal wrap?

            Some stable value managers have created a universal wrap structure for a segment of their stable value fund.  This segment is designed to be the last to be tapped for any withdrawal payments from the fund (see Q 21) and usually consists of actively-managed fixed income portfolios which are wrapped with a single wrap contract entered into on a pari passu or equal risk-sharing basis by three or more wrap providers.   The presence of a single wrap contract simplifies administration for the fund manager.  However, the difficulty of getting the wrap issuers to agree on similar contract wording and risk assessment has somewhat limited the use of this structure.

 Q 13  What is a separate account GIC?

            A separate account GIC is a guaranteed group annuity contract issued by a life insurance company that is backed by an actively-managed portfolio invested in a separate account, a fund owned by the life company but invested outside the insurance company’s general investment account.  The contract guarantees are additionally supported by the surplus and assets of the general account.  The separate account may be one created specifically for the investor or a commingled account in which the investor purchases a share.
            Guaranteed separate account products are sold to both defined contribution and defined benefit plans and may be issued as either book or market value products for the plan.  The term “separate account GIC”, however, typically describes a book value product sold to stable value funds that provides a guarantee of principal and accumulated interest and benefit-responsiveness, maintaining participant withdrawals at book value (see Q  20).
            The separate account GIC investor receives title to the annuity contract, not direct title to the assets in the separate account. To provide stable value investors a degree of diversification from their insurance company credit concentration, most separate account GICs are contractually “walled off” or insulated from general account liabilities in the case of any financial impairment of the insurer.  The degree of legal protection for this insulation varies from state to state.  Many states have enacted laws stipulating separate account insulation where the contract so specifies;  in many other states the insurance department has issued letters ensuring the protection of insulated separate account assets.  The states where major separate account GIC issuers are domiciled generally have either statutes or opinion letters granting insulation status, but this is something that the investor should check prior to purchase.
            Most separate account GICs are participating products, in which the crediting rate (see Q  8) is adjusted to reflect market value gains and losses on the assets in the separate account and on participant withdrawals.  The adjustment is made on an amortized basis, usually over the period to maturity or over the duration of the portfolio where the contract has no stated maturity.  This amortization process keeps the credited rate relatively stable.  To maintain the guarantee of principal, the crediting rate may not be negative. Yields are credited on an annual effective rate basis.
            Some describe separate account GICs as “asset-backed” contracts rather than “insurer-backed” like traditional GICs, since stable value funds are expected ultimately to assume all the credit and interest experience on the assets in the portfolio.

 Q 14  What is a bank investment contract?

            A bank investment contract (BIC) is a GIC-like investment contract purchased by a defined contribution plan from a commercial bank.    Technically a BIC is a bank deposit agreement, and it is therefore classified on the bank’s balance sheet as a deposit.    Like a traditional GIC, a BIC provides an issuer guarantee of principal and accumulated interest and typically offers a guaranteed rate of interest over the life of the contract.  BICs issued to stable value funds are benefit-responsive contracts that maintain participant transfers made subject to plan rules at book value (see Q 20).  Because BICs are bank deposits, they typically have priority over other types of bank liabilities in the case of insolvency. 
            BICs were extremely popular in stable value funds in the late 1980s because Federal Deposit Insurance Corporation (FDIC) rules permitted each participant’s implicit share of the contract to be insured up to $100,000.  Thus, under the rules,  a $5 million BIC might receive full FDIC insurance.  This provision was amended as a part of FDIC reform measures, however, and bank deposits which permit withdrawals without any interest rate or market value penalty prior to maturity no longer receive FDIC insurance when issued to most types of defined contribution plans, nor do the banks pay FDIC premiums on those deposits. 
            Currently most banks who provide investments for the stable value market issue wraps for synthetic instruments rather than issuing BICs. 

 Q 15  What is a muni-GIC?

            A muni-GIC is a investment agreement sold by an insurance company to a municipality which provides for a guaranteed rate of interest over the life of the contract.  Unlike traditional GICs, the muni-GIC is not an annuity contract.
            These investment agreements are often used by municipalities to collateralize borrowings by relying on the good credit of the insurance company issuer.  They also may be utilized to increase the yield on funds being held awaiting completion of construction projects.  In the first instance, the issuer is providing a form of credit enhancement.  In the second, it is providing a longer-term investment with a higher yield than the municipality could obtain through other short to medium-term investment channels.

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Stable Value Contracts from the Issuer’s Perspective

Q 16   What risks do stable value contracts pose for the issuer?

            A GIC or synthetic wrap issuer assumes risk whenever it makes a guarantee of interest or principal on an investment contract.  These risks fall into two categories:  asset risk and liability risk.
            There are three primary forms of asset risk, as follows:

1.  Default risk.  The risk that the assets that are backing the contract will default on interest or principal payments.
2. Call or extension risk.  The risk that an asset’s principal will be paid more quickly than expected when market rates fall or more slowly than expected when rates rise, so that the income generated by the asset and its market value are inadequate to support the guarantee.
3.  Reinvestment risk.  The risk that income on the assets backing the contract will be invested at a rate lower than the rate guaranteed by the contract.

There are two basic forms of liability risk as follows:

1.      Contribution risk.  The risk that the amount of deposits at the guaranteed rate of interest during the window period of a contract will differ from expectations.  Changes in deposit activity may be induced by large movements in interest rates.  If market interest rates rise, the guaranteed rate will seem less attractive to participants, who may reduce their contributions, forcing the issuer to sell fixed-income assets at a loss.  If market rates drop substantially, contributions may rise, forcing the issuer to buy additional, lower-rate assets to back the contract.

2.      Withdrawal risk.  The risk that participant withdrawals from the contract will exceed expectations when interest rates rise above the rate guaranteed on the contract, forcing the issuer to sell assets at a loss.

 Q 17  How do stable value issuers protect themselves against stable value risks?

            Insurance companies and banks participating in the stable value market use a combination of risk underwriting and sophisticated asset/liability matching techniques to protect themselves from losses on the risks assumed.  When a contract is issued, a risk charge is assessed based on the underwriter’s estimate of the likely contribution and withdrawal rates.  The issuing company determines the likely pattern of inflows and outflows on the contract and estimates its effective duration Assets are acquired to match the duration and/or expected cash flows of  the contracts.  Issuers have elaborate computer systems to monitor and project the duration, convexity, and cash flows of their asset and liability portfolios.  Most do the process on a stochastic basis that varies the cash flows under different interest rate scenarios.  Generally issuers don’t match a single contract with a single asset but work with a portfolio of assets that is internally dedicated to their stable value contracts.  The portfolio approach provides diversification and better flexibility to handle liquidity needs.  However, the issuer’s full asset and capital base are available to support its guarantees.

            The right to withdraw from the contract at book is an option issued by the financial institution providing benefit-responsiveness to the participant.  Estimating the exercise efficiency of this option - the likelihood of withdrawal at various levels of interest rates - is a highly subjective exercise.  Most issuers use a combination of option techniques and probabilistic scenario testing.  The underwriting process is also designed to limit this risk by screening out plans containing excessive arbitrage risks, such as those that allow unrestricted investment transfers to a competing fund (see Q 22).  Good contract design is also important in reducing risk.

            Rating agencies and others evaluating the risk of stable value issuers routinely analyze the risks assumed in the contracts and the matching techniques used to protect against those risks as a part of the rating agencies’ credit review process (see Q 29).

 Q 18 How are stable value contracts priced?

            Stable value contracts include both asset fees for asset management and custody and wrap fees for administrative expense, risk charges, and profit to support the capital to support the risk.  In a traditional GIC, the investor is quoted a guaranteed rate that is net of all the insurance company’s expense, risk and profit charges.  In a synthetic structure, the investor negotiates fees with both the asset manager and the wrap provider which are then deducted from the earnings on the synthetic portfolio.  Wrap fees usually range from 6 to 25 basis points depending on the size of the deal and the risks covered;  standard fixed income asset management fees apply.

            Traditional GIC issuers generally price their products based on the yield available for investments of the appropriate duration for the contract being quoted.  Deductions are made for the estimated credit and call risk in the asset, and the yield is then converted to the annual effective basis credited in stable value contracts.   Investment and administrative expenses are deducted as well as a plan-specific risk charge for the liability risks assumed.  The life company also deducts a profit charge for a return on capital, a charge that increases with the amount of risks assumed.  Total GIC risk charges and fees are generally in the 55 to 90 basis point range depending on the size of the contract, the risks assumed and the types of assets utilized by the issuer.

            The plan can choose whether to self-insure against risks in its stable value assets and liabilities by buying participating contracts or whether to purchase insurance for those risks by having the issuer assume them.   The issuer can diversify many of its risks, thus reducing the charge below the effective cost to the plan.  By self-insuring, however, the plan avoids paying for the issuer’s capital costs and profit taxes.

 Q 19  What is underwriting for a stable value contract?

            Stable value issuers evaluate the interest rate risks posed by each plan that requests a contract bid.   This evaluation process is called underwriting the contract or bid.  The firms analyze the bid specifications provided by the prospective purchaser (see Q 22) to determine how likely participants are to change their deposit and withdrawal patterns in response to interest rate changes by looking at the financial sophistication of the participants, the other investment options in the plan, past investment behavior, the plan’s allowed transfer frequency, the composition of the stable value fund, etc.  Underwriters are concerned about the presence of any competing funds (see Q 20) and large participant investments in company stock because changes in the price of the stock can mean large inflows or outflows for the stable value fund.  Another key factor is the proportion of assets belonging to retirees or terminated vested employees, because these can be rolled over into IRAs or removed from the plan without a severe tax penalty.  The underwriter assigns a risk charge based on each plan’s circumstances and the length of the requested contract term, and this charge is deducted from the credited rate.
            On a synthetic GIC, the underwriting process also includes evaluating the market value risk posed to the wrap provider by the assets being wrapped.  Important considerations include the duration of the asset, its credit, liquidity, and the amount of call and extension risk. The diversification of a portfolio being wrapped is also important.  The synthetic GIC underwriting process also includes an in-depth analysis of the investment manager’s ability to manage appropriately the assets backing the stable value fund.

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Deposit and Withdrawal Features of Stable Value Contracts    

Q 20  What is a benefit-responsive contract?

            A benefit-responsive investment contract is a contract issued to a defined contribution plan that provides book value protection for all participant-initiated transfers and withdrawals made subject to plan rules.  The GIC or wrap issuer agrees to maintain all such payments at book or contract value and underwrites the market value risk on these payments.  Benefit payments are typically allowed for reasons such as termination of service, death and financial hardship, and investment transfers may be made to other investment options within the plan.  Each contract in a stable value fund must be benefit responsive in order to be eligible for book value accounting treatment (see Q 37).
            By issuing a benefit-responsive contract, the issuer is exposing itself to anti-selection risk, since participants are most likely to withdraw or transfer funds when market interest rates are higher than the crediting rate (see Q 8) on the contract.  The issuer underwrites the risks posed by each plan individually and assigns a risk charge for each based on its estimated potential for anti-selection (see Q 16).  Most GIC and synthetic wrap issuers will not underwrite a plan allowing direct transfers to a competing fund (see Q 22)

Q 21  What are the withdrawal protocols for stable value contracts?

            Each plan maintains rules for determining the proportion of each period’s withdrawals to be paid by each contract within the fund.  The GIC or synthetic wrap issuer underwrites the risk based on that withdrawal protocol, which cannot be changed without the issuer’s advance consent.

1. LIFO (“last-in-first-out”).   Under a LIFO contract, all benefits are taken from the most recently issued contract, usually the one with the open deposit window (see Q 23), until that contract is exhausted, then the next most recent, etc.  The net amount to be deposited to this type of contract is highly uncertain, but the issuer’s risk of market value losses on participant withdrawals is reduced by the contribution inflow and by the fact that most outflows on LIFO contracts occur relatively close to the time of issuance.
2. Pro-rata .  A pro-rata contract makes withdrawal payments in direct proportion to its size relative to all the investment contracts in the stable value fund.  This type of contract is generally considered to be the most equitable for participants because each contract is tapped for withdrawal payments regardless of its age and interest rate.  All new contributions are available to be invested in new investment contracts rather than used to pay withdrawals or replenish a STIF buffer (see Q 5), this has the effect of helping to keep the fund’s crediting rate (see Q  8) in line with market rates.
3.  Pro-rata after net cash flow A fund with this type of withdrawal protocol first pays withdrawals from new contributions and the proceeds of any maturing contracts.  When these flows have been exhausted for the period, each contract is tapped for withdrawals on a pro-rata basis.
4.  Pro-rata with a cash buffer     Under this type of withdrawal protocol, withdrawals are first paid from fund  contributions  and then from a STIF fund (see Q 5), which the plan agrees to maintain at some specified proportion of stable value assets, (e.g.,  within 3-10 percent of the fund.  When the STIF is exhausted, withdrawals are paid on a pro-rata basis from each contract.  Whenever the buffer fund falls below its pre-determined range, any net new cash flow must be used to restore the STIF before it can be invested in investment contracts, which generally have higher yields.  The presence of the STIF lowers withdrawal risk charges, but the fund sacrifices some income from the short-term assets in the STIF.  Because the STIF must be replenished before new GICs or synthetics can be purchased, the fund is assumes more interest rate risk than if it had used investment contracts to pay the withdrawals.
5.  LIFO with a cash buffer   Similar to pro-rata after the STIF, but once the STIF fund is exhausted the withdrawals are paid on a LIFO basis.
6.  Tiered withdrawal structure.   Some stable value funds are now utilizing a structure in which the fund has a tiered or layered withdrawal hierarchy.  Payments out of the stable value fund are first made from incoming cash flow and then from the STIF.  The second tier for payments is a cluster of fully guaranteed GICs or synthetic GICs with relatively short durations.  The top layer, with the least likelihood of being tapped for payments, typically consists of actively- managed synthetic GICs.  The top layer may be wrapped with a universal wrap contract (see Q12) .
7.  Pro-rata by participant or class year   In this type of stable value fund, a participant owns specific shares of each contract in the fund based upon the amount of his or her contribution to that contract in proportion to the total deposit amount.  Withdrawals are made from each contract in direct proportion to each participant’s ownership share.  Anti-selection risk of this protocol is very high because if interest rates rise, participants can withdraw funds from older, low-yielding contracts while making deposits to the new contract at higher rates.  This type of fund is becoming very rare because of the high risk charges and the complexity of administration, although some single-life company funds (see Q 36) continue to utilize it.

Q 22  What is a competing fund?

            A competing fund is another investment option in addition to a stable value fund within  a defined contribution plan that offers relative principal stability, such as a money market fund.  This type of option presents an anti-selection opportunity for plan participants.  A stable value fund’s credited rate (see Q 8) lags market rates whenever interest rates move up or down significantly because its investments are medium-term.  In contrast, money market and short-term bond fund yields follow market interest rate changes closely.  Participants would likely transfer their funds out of the stable value option into these alternative options in periods of steeply rising interest rates, forcing  the GIC or synthetic wrap issuer to bear a market value loss on assets sold to fund the transfer.  
            Most investment contract issuers consider any investment option with little or no market value risk to be a competing fund. This includes money market funds, short- to medium-term bond funds, and asset allocation or balanced funds whose investment policy guidelines permit them to become predominantly short fixed-income vehicles.  Very few GIC or wrap issuers will underwrite a plan that provides for direct transfers to a competing fund.  Most require an equity wash - an intermediate investment in an equity fund or other fund with significant market risk for a period of at least three months - before the funds can be transferred to the competing fund.  

Q 23  What are the various types of deposit features for stable value contracts?

            GICs and other stable value investments are issued to salary-reduction plans, and new contributions are generally deducted directly from participants’ pay.  Investment contracts offer several different types of deposit features to manage this contribution stream of participant funds as well as the reinvestment of principal payments from existing stable value investments:

1.  Bullet contracts .  An investment contract in which the deposit is made in a single lump sum amount.
2.  Window contracts.  An investment contract in which the issuer agrees to pay a guaranteed rate of interest to maturity of the contract on all deposits to be received from the plan for a pre-determined period of time, known as the “window” period. This feature is especially important for startup situations and plans where contributions are large relative to the existing assets in the stable value fund, since the pre-determined rate of interest allows the plan sponsor to communicate the future rate of interest to be credited on the stable value fund.  Historically, 12-month windows were the most typical.  With today’s more mature plans, windows as short as one to three months are not unusual.  The issuer  bears a significant amount of risk on this type of contract because participants are likely to deposit more funds than originally anticipated if market rates fall and the contract rate is attractively high and less if rates rise.  Most traditional GIC issuers offer window contracts, but they are rarely made available for synthetic and separate account alternatives.
3.  Net dollar window contracts.   Investment contracts in which the issuer agrees to credit a specified rate to maturity on a pre-determined volume of deposits to be received over a specified period of time.  Any shortfall is paid to the issuer from the subsequent period’s net cash flow;  any excess is repaid to the fund or applied to another contract.  This type of contract provides a stable crediting rate (see Q  8) to the fund for the window period but reduces the issuer’s contribution risk.  The fund assumes the interest rate risk on any contribution shortfall or excess.  Typically only traditional GICs offer net dollar window features.

Q 24  Why do investment contracts require timely payment of contributions and impose a penalty when timely payment does not occur?

            When a GIC provides a guaranteed interest rate on future contributions, the issuer must protect itself against any declines in interest rates that might occur before the contribution deposit is received.   This protection is achieved either through the use of options and futures to hedge the risk or by committing to investments to back the contract at the time the guarantee is made.  If, however, interest rates rise rather than fall and the plan sponsor opts to divert future contributions to a new GIC issued by another company at the higher prevailing rates, the original issuer would be forced to unwind the hedge or sell the assets purchased in anticipation of receiving the deposits at a loss.

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Investment Characteristics of Stable Value Contracts

Q 25  What are the investment risks in a stable value asset?

            The risks of any investment contract vary depending upon the extent of the guarantee provided by the GIC issuer or the synthetic wrap provider. Typically, traditional GICs offer the investor full protection against all the risks in the assets backing the contract:  credit, call or extension, and income reinvestment.  Most traditional GICs also offer protection against any gains or losses on either contribution or withdrawal activity.  The investor is depending on the creditworthiness of the issuer to deliver this protection.
            On the other hand, although most synthetic and separate account GICs provide a guarantee of principal and accumulated interest, the  stable value fund participates in both gains or losses due to asset experience through amortized adjustments to the crediting rate.  Thus, the fund is directly assuming default, call or extension, and reinvestment risk on the portfolio being wrapped.  Any experience on plan withdrawals or new contributions is generally also passed through to the fund on a synthetic or separate account contract.  Because the return depends upon the performance of the underlying assets the future performance of the asset manager is also a risk.   If there is no maturity on the product, the purchaser also incurs a risk of needing to terminate when market values are depressed.  Table 3 below outlines the basic risks in stable value assets and the risk-bearer in the most typical contracts.

 Table 3                Assumption of Risks on Traditional and Alternative GICs

	Risk bearer on a typical
	GIC/BIC	Synthetic/ SA GIC
Issuer/wrap credit	Participants	Participants
Asset credit	Issuer	Participants
Reinvestment	Issuer	Participants
Call/extension	Issuer	Participants
Withdrawal	Issuer	Participants
Contribution	Issuer	Participants
Maturity	Issuer	Manager
Manager	Issuer	Participants

Whenever the stable value fund self-insures or assumes an investment risk itself, it should be compensated by a somewhat higher expected return on the investment contract purchased.

Q 26  What are the investment characteristics of GICs and other stable value investment contracts?

            Stable value investment contracts may be negotiated with a wide variety of investment and interest-crediting features.  The standard traditional GIC or BIC is a zero-coupon investment that earns an annual effective rate paid at maturity, usually three to five years.  The issuer assumes all the investment risk on the underlying assets and the extent of contribution and withdrawal risk stipulated in the negotiated contract (see Q 16).  A wide variety of interest-rate crediting options are available. 

1.  Participating or experience-rated contract. Under this type of contract, the crediting rate (see Q  8)  is reset periodically, usually quarterly or annually, to reflect experience on the contract. In order for the contract to receive book value accounting treatment, the GIC or wrap issuer must guarantee that the crediting rate will not become negative. Contracts may participate only in the asset experience or in both the asset experience and plan cash flow or liability risks.  Where there is full risk participation, the stable value fund self-insures risks.
2.  Floating-rate contract. This type of contract provides a credited rate that floats with a pre-determined market rate, usually one with a relatively short duration (see Q5).   This type of contract is very attractive to help keep the stable value fund’s crediting rate in line with market rates.  Many plans use floating rate contracts to provide liquidity for their stable value fund.  Most floating-rate contracts do not have a set maturity date but provide that the contract may be terminated at book value with thirty to ninety days’ notice.
3.  Evergreen or constant duration contract.  An evergreen contract has no pre-determined maturity, but the asset portfolio is managed to a targeted duration.  Evergreen contracts are usually actively-managed synthetic (see Q 7) and separate account GICs (see Q 13) in which the fund is investing in a specific fixed income investment portfolio, either commingled or established specifically for the fund.  Most evergreen contracts are participate fully in both asset and liability risks.  The investor should choose an investment style designed to keep the crediting rate stable and avoid excessively long durations if there is substantial potential for participant withdrawals because losses on those withdrawals will be passed on to remaining participants through lower crediting rates. 
            Evergreen contracts can be terminated at market value and most can be terminated at book value following a multi-year notice period.  During this period the portfolio is reinvested in shorter - and typically lower-yielding - assets that mature near the agreed upon date.  In a period of rising interest rates, it will be difficult if not impossible to terminate this type of contract quickly without suffering some market value losses.
            Evergreen contracts typically quote an initially higher rate than those contracts of similar duration with a stated maturity  because the ongoing asset management allows the portfolio manager to reinvest in instruments close to the original duration, rather than reinvesting in shorter instruments as the contract ages.  The difference in yields is analogous to that between yield to maturity and the spot rate on an investment.  It will be largest when the yield curve is steep and may disappear altogether when the curve is flat.  This differential is compensation for the termination risk on the contract.
4.  Alpha GIC.   An alpha GIC is a  synthetic or separate account GIC coupled with an interest rate swap.  The underlying asset portfolio is typically a fixed income fund managed with a target of exceeding a specified index or benchmark.  In addition to the asset management and wrap agreements, the plan sponsor enters into an interest rate swap in which the stable value fund pays a yield equivalent to the benchmark;  in return, the fund receives a fixed rate for a specified period. If the asset manager performs as expected, the fund receives the fixed rate plus the manager’s “alpha” on the portfolio.
            These arrangements offer investors the positive return benefits of active management with less rate volatility than in many synthetic and separate account products.  There is also a fixed maturity inherent in the swap agreement.  Alphas GICs quote the highest expected return when the swap yield curve moves favorably relative to corporate curve.  One drawback is that interest rate swaps have low liquidity and may be difficult to sell if the plan needed the funds.  Also, those swaps incorporating the most typical fixed income benchmarks tend to be expensive and thinly traded.  This product is much discussed, but its complexity, potential liquidity problems and high fee structure have limited the volume issued to date. 

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Considerations in Purchasing a Stable Value Contract and Managing a Stable Value Portfolio

 Q 27  How is a stable value investment purchased?

            All stable value assets are private placement investments whose terms are negotiated at the time of purchase.  Most typically the investor seeks bids from a number of potential issuers.  Several weeks prior to the expected purchase date, the plan or its agent sends bid specifications (‘bid specs’) to a number of providers to determine their interest in bidding upon the amount to be invested.  The bid specs indicate the dollar amount expected to be invested, the type(s) of contracts for which the investor would like to receive bids (window, bullet, etc.), and the desired maturity and payout provisions (one payment, installments over time, etc.)  They also provide the issuer the basic data necessary to evaluate the risks of issuing a contract to that plan (See Qs 17 and 19) such as the duration and yield of the stable value fund, the size of any STIF fund within the fund, existing contract maturity schedules, the stable value withdrawal protocol (See Q 21),  the types and dollar amounts of other investment options in the plan, frequency of allowed participant transfers, etc.
            The issuer reviews the bid  specs and determines whether or not it will bid on the deposit.  For a traditional GIC, the bid is based on the current yield for investments of an appropriate duration to back the contract less deductions for asset risk charges (call and default), any liability or plan cash flow risk charges, expenses, and a return on the capital necessary to support the issuer’s guarantees.  For a synthetic or separate account GIC, the bid is based upon the current earning rate of the underlying asset(s), with deductions for investment management fees and wrap fees (risk charges, expenses, and profit).  A synthetic contract may also have custody fees (see Q 18).
            At the specified time and date, the investor receives the bids that have been solicited and evaluates the yields quoted relative to the risks entailed in each type of contract.  Typically, the higher the credit quality and the more risks assumed by the GIC or wrap issuer, the lower the rate bid.  However, because this is a private transaction, occasionally there are market imperfections that produce special value opportunities for the investor.  

Q 28  How does the investor evaluate credit risk on stable value assets?

            The first step in credit evaluation is to understand which risks are assumed by the GIC issuer or wrap provider and which are being passed through to the fund (see Q 25).  Where an investment contract participates in the credit risk on the underlying assets, it is important to determine the credit guidelines and diversification policies for the underlying assets.  Where the issuer or wrap provider assumes all the asset risks, only the issuer’s credit need be evaluated.
            Credit ratings from major rating agencies such as Moody’s, Standard & Poor’s, and Duff & Phelps are an excellent guide to the credit standing of investment contract issuers and any bond or mortgage investments that might be utilized in the portfolio.  The table below lists various types of ratings that are most applicable.  Where both asset and wrap risks must be evaluated, the listing in the bold type shows which is generally of the greater importance in determining the results to the stable value investor.  

Table 4         Appropriate Rating Categories for Various Stable Value Asset Types

	Relevant rating
Investment contract type	Wrap	Asset
GIC	Claims paying	n/a
BIC	Deposit	n/a
Separate Account GIC	Claims paying	Debt
Synthetic      Annuity      Other	Claims paying Debt	Debt Debt

Note:  Where both asset and wrap risks must be evaluated, bold type is used to indicate the rating of greater importance to the stable value investor.  

            Insurance contracts and bank deposits each have a higher standing in the event of insolvency than the debt issued by their respective institutions.  In recognition of this, the rating agencies have created special rating categories to evaluate the credit risks on the institutions’ financial liabilities.  Insurance liabilities are rated using claims paying ratings and bank deposits have their own rating categories, which may be slightly higher than the debt rating of the same firm.  Any debt issue or other type of contract liability issued by the institution is evaluated using the standard debt rating.  As the rating declines, the credit risk increases and the investor should receive incremental return for the additional risk.
            Financial measures also used to assess the quality of a GIC or wrap issuer include capital (or surplus) to asset ratios, asset quality and diversification, proportion of problem loans, profitability, and the degree of business diversification.  More subjective factors are management capabilities, asset/liability management skills, the proportion of participating versus guaranteed liabilities, and experience with stable value risks.  An issuer should be able to explain how its stable value risks are being managed and controlled.
            Because stable value funds are generally the most conservative fund option in the defined contribution plan, plan sponsors tend to keep the credit quality of the portfolio high.  A common investment policy requirement is that the average credit quality of the portfolio be Aa or better, with no single asset having a credit rating lower than A.  Many stable value portfolios also have formal credit diversification policies limiting the percentage of the portfolio that may be invested with a single credit and industry.

Q 29  What are the primary firms providing financial ratings on insurance companies and banks?

            The debt of insurance companies and banks is rated similarly to that of other debt issuers by the major rating agencies.  Duff & Phelps, Moody’s and Standard & Poor’s all issue claims paying ratings for insurance companies with ratings categories similar to those for corporate debt  In addition, A.M. Best & Company rates insurance company claims paying abilities on a scale ranging from A⁺⁺ to F, with the categories A⁺⁺ to B⁺ comprising secure or investment grade firms.  Although more insurance companies are covered in Best’s rating universe, Best’s ratings are not frequently used by GIC and synthetic customers, perhaps because they fail to distinguish clearly among the upper tiers of insurers.  Companies such as Townsend and Schupp and Conning and Company offer commercial services that provide information on the relative financial strengths of life insurance companies.

Q 30   Why does the investor care about credit risk if GICs and other stable value investment contracts are guaranteed?

            The guarantee in a GIC or other stable value contract is the promise of the financial institution that issues the contract; it is only as strong as the ability of the issuer to support it.  In the case of a default by an issuer, the contract would not be guaranteed. Therefore, plan sponsors should evaluate the likelihood of default.  In addition, the range of guarantees available in stable value contracts varies widely (see Q 26).  When credit risk on the assets backing the contract is not fully guaranteed, the stable value fund will participate in any changes in those assets’ credit experience on an amortized basis, except that principal and accumulated interest can never be eroded.  

Q 31  What happens if a stable value asset defaults?

            In addition to any losses incurred by the fund, stable value defaults pose operational problems because the contract may cease paying benefits.  In addition, determining the amount of the appropriate credit write-down is difficult.  The latter problem is especially acute for GICs, since general account insurance company rehabilitation and workout proceedings are conducted under the supervision of the state insurance department and are lengthy.   Where the defaulted asset represents a small enough component of the fund, it may be sufficient to hold it as a non-performing asset.   It is also generally possible to obtain a synthetic wrap for a problem contract that will maintain the value of the contract at book and amortize any principal losses into changes in the rate credited on the wrap over time.  Historically, defaults have not resulted in any losses of original principal.  

Q 32  What protection is available in the case of downgrade or default on investment contracts?

            Generally there is no automatic credit backstop other than the financial soundness of the issuer.  Some BICs issued to Section 457 plans may be eligible for FDIC insurance.  Eligibility for state guaranty fund coverage for GICs and other insurance company investment contracts varies from state to state.  In most states GICs are considered to be unallocated insurance contracts with either no coverage or coverage up to $5 million per issuer. 
            Plans may purchase credit insurance on investment contracts from financial guaranty insurance companies and may also arrange benefit-responsive wraps on investment contracts from synthetic wrap providers or GIC issuers.  This type of private credit insurance can usually be arranged for defaulted as well as performing contracts, although the expense rises significantly as the credit standing of the investment contract issuer declines.

Q 33  What are the investor’s concerns about assuming interest rate risk in stable value funds?

             Plan participants are most distressed about the performance of a stable value fund if its credited rate lags substantially behind market rates in a steeply rising interest rate environment.  To address this concern, it is important that stable value investors limit the fund’s exposure to potential market value losses from participant withdrawals and underperforming assets when rates rise because both types of losses will further depress the interest crediting rate .
            The problem of lagging crediting rates is exacerbated by  the fund’s participation in assets which can extend their maturity when rates rise, such as collateralized mortgage obligations.   In this situation, the investor owns a lower-yielding asset for longer than had been anticipated, reducing the fund’s ability to reinvest at the new, higher yields.  A similar problem can occur if the wrap contract is written to pass on any market value gains or losses on participant withdrawals.  Sophisticated participants may recognize the arbitrage potential offered by their book value withdrawal rights in the rising rate environment and withdraw from the fund.  The losses from those withdrawals are amortized over time, depressing the crediting rate for the less sophisticated investors remaining in the fund and potentially stimulating even more withdrawals.
            Interest rate risk is not as easily diversified as credit risk.   In evaluating whether the fund should assume the risk or pay for wrap protection, it is helpful to have the asset manager simulate the asset or portfolio experience in a steep and prolonged interest rate run-up and to include the effects of severe adverse cash flow experience within the stable value fund.  Many funds establish policy limits on the proportion of the stable value portfolio that should participate in the risks.   

Q 34  What termination provisions apply to stable value contracts?

            Stable value investments offer participants full liquidity at book value prior to the contract’s maturity, but this right is not extended to the contractholder.  Surrender or early termination provisions vary by the type of contract.  Traditional GICs generally pay the lesser of book value or a formula-determined market value in response to any non-employee-initiated request for funds prior to maturity.  Many contracts also will pay the contractholder at book value in a series of installment payments spread out over a period of years to avoid any negative market value adjustment to participants’ balances.  Participating, separate account and synthetic GICs generally pay market value at the time of premature surrender or the effective equivalent of market value in a series of book value payments.
            The  traditional GIC ’penalty’ of surrender payments at the lesser of book or market value is designed to keep the contract in effect until maturity.  Many GICs are backed by relatively illiquid investments such as private placements and commercial mortgages, which offer attractive yields but cannot always be quickly sold without some sacrifice in value.   In addition, managing the asset and liability risks assumed under the traditional GIC contract requires the extensive matching of assets and liabilities, a process that is expensive to recreate for unexpected transactions.  Synthetic and separate account GICs, however, are generally backed by actively managed, publicly-traded securities that are easily bought and sold.  Unless interest rate swaps or some other derivative structure is involved, their portfolios generally have a very high degree of liquidity.
           Traditional GIC contracts generally specify a methodology for determining the amount to be paid to the contractholder if the contract is terminated before maturity.  Such surrender formulas vary greatly from issuer to issuer.  Some firms retain the contractual right to change the formula during the life of the contract.  Evaluating the formula and the likelihood of its being used are important parts of the stable value purchase decision.

 Q 35  What considerations are important in purchasing a synthetic wrap contract?

            When selecting a wrap provider, it is important to choose not only a high-quality financial institution, but a firm that can demonstrate that it understands the benefit withdrawal risks on the contract and that it has protected itself against these risks  (see Qs 16 and 17).  The wrap contract should clearly delineate the situations under which book value payments will be made.  The wrap provider should also be able to demonstrate a real commitment to the marketplace, so that the plan sponsor can be sure that the contract will be well supported until maturity.
            Most wrap contracts stipulate that book value benefit payments will only be made as long as the stipulated investment guidelines (duration, asset quality, sector concentration, etc.) are honored.  Many also include provisions protecting the wrap provider against extreme underperformance by the investment manager.  Typically, such provisions require that the portfolio be liquidated and the assets invested in Treasury bonds when the market value drops to a certain percentage below book value.  The investor and the asset manager must both be comfortable with these restrictions, and the plan sponsor should understand whose responsibility it is to monitor compliance with the investment guidelines.
            The investor should also consider whether the synthetic GIC package raises any potential for prohibited transactions or provider self-dealing under the Employee Retirement Income Security Act of 1974 (ERISA).  Traditional GICs, bank deposits, and commingled separate accounts have class exemptions from many activities that might be construed as prohibited transactions.  Where the wrap provider and the asset manager are affiliated, there is greater likelihood of ERISA complications.  Some experts advise that a qualified professional asset manager (QPAM) choose the wrap provider to mitigate potential ERISA liabilities.  

Q 36  What are a plan’s investment management options for a stable value portfolio?

            As is true of most assets, stable value investors have the choice of managing assets themselves, with or without the help of advisors; hiring an investment manager to manage a separate portfolio for them, or investing in a ready-made portfolio.

1.   In-house management.  Many defined contribution plans, especially the largest, choose to manage the stable value option internally.  The benefit manager, treasurer or chief financial officer is responsible for selecting and negotiating the investment contracts and for all ongoing aspects of fund management.  The plan may purchase advisory help for contract or credit evaluation.  Fund management expenses are typically borne by the plan sponsor in this situation.
2.   Stable value consultants. Many employee benefit and stable value management firms offer plan sponsors consulting advice on the investment contract purchase decision and fund structure.  The consultant typically provides credit evaluation services, issues the bid specifications, receives contract bids, advises on the selection of a bid, and negotiates investment contracts.  The advisor is paid on a per transaction basis and the expense is usually borne by the plan sponsor.
3.   Stable value managers.  There are firms that specialize in the management of stable value assets, just as there are firms that manage stocks and bonds.  These firms have discretionary investment management responsibility for all aspects of the management of a plan’s stable value fund.  They offer individual fund management based on investment policy guidelines developed by the plan sponsor. The use of managers has increased in recent years due to the growing complexity of the marketplace and a desire to reduce the plan’s fiduciary responsibility (see chapter 18) for asset choice, especially in the wake of GIC issuer defaults.  Corporate cost-cutting and downsizing measures have also played a role in the growing popularity of managers.  Managers’ fees are generally deducted from the credited rate on the fund, which effectively shifts the fund management cost to the participants.  The size of the fee varies inversely with the volume of assets under management and is privately negotiated with the manager.
4.  GIC/stable value pooled funds.    Plans may invest some or all of their stable value fund in commingled pools of stable value assets that function much like mutual funds. These are generally managed by banks and mutual fund companies that offer bundled, full service 401(k) options.   Most are unit value bank collective investment funds, although a few are mutual fund pools.  Most pools are operated on an open-end basis and offer all investors the same portfolio yield.  Fees generally range from 50 to 100 basis points and are deducted from the yield credited on the portfolio.
            Pooled funds are especially attractive to small plans, since they offer investment diversification among a number of providers and sophisticated fund management.  Furthermore, a yield advantage arises in pooling deposits and purchasing larger investment contracts.  
            One disadvantage of participating in a pooled fund is the risk that transactions by other investors in the pool may adversely impact the plan’s crediting rate.  The portfolio rate will be attractive in a declining rate market, which may attract new investors whose deposits must be invested at the lower market rates, dragging down the portfolio yield for everyone.  Similarly, withdrawals at book value by either plans or their participants in a steeply rising rate environment may reduce the cash flow to be invested at the newly higher rates.   This risk can be reduced by maintaining a relatively short portfolio duration, imposing plan diversification limits, and controlling the volume of deposits from new customers, if necessary.
            Unlike most stable value investments, bank and mutual fund pools provide liquidity to contractholders at book value because of regulatory requirements. This presents an increased arbitrage risk to the stable value contract issuer.  Bank pools have up to twelve months to honor the withdrawal request which reduces the risk somewhat.   Mutual fund pools must pay more promptly and generally impose some sort of penalty or surrender charge on employer-initiated withdrawal requests to reduce arbitrage potential at the plan level. 
5.   Single life company fund options.  Many life insurance companies that provide full-service 401(k) plans to the small to mid-size plan market offer a stable value option that is invested entirely in one or a series of guaranteed annuity contracts issued by that company.  These are usually participating contracts in which the current year’s deposit receives a new money rate and all other funds earn a portfolio rate reflecting the earnings experience on the assets backing the contracts.  Some form of minimum rate guarantee may apply, in addition to the guarantee of principal and benefit responsive features. Unlike the bank pools, most credit a different interest rate to each plan that reflects only the asset and liability experience of that plan.  Fees are negotiated with the issuer and typically decline as the amount of the fund grows.
            These single provider funds compete directly with stable value pools in the small plan market.  By providing a new money rate for new deposits, the issuer can maintain a longer duration on the portfolio than is typical for a pool, providing, on average, some yield benefit.  The plan-specific crediting rate and the inability of the contractholder to withdraw funds at book reduce the likelihood that one plan’s behavior will adversely influence another’s yield. 
            The key drawback for this type fund is the lack of diversification of the issuer’s credit risk.  This is allowable under the Department of Labor’s ERISA 404(c) guidelines, because these funds are considered “look-through investments” backed by a diversified portfolio of assets.  (See Q 38)  The plan sponsor retains full fiduciary responsibility for choosing a creditworthy life insurance company to manage the fund, and it should evaluate the tradeoff of any increase in risk from a single guarantee or wrap provider versus any higher yield or lower fees available to the participant.  Because the insurer maintains records of each participant’s share of its contract, these funds may be fully eligible for guaranty fund coverage in some states.
            Historically, many single-provider funds have contained a provision limiting the percentage of a participant’s balance that could be transferred to another investment option in the plan at book value, usually a 20 percent limit on investment transfers within a 12-month period.  This type of restriction may cause problems under the AICPA’s (American Institute of Certified Professional Accountants) guidelines for book value accounting treatment (see Q 37) and should be reviewed with an accountant.

Q 37  What are the pension accounting rules for stable value investments?

            A number of agencies have oversight authority for asset reporting for documents affecting pension plans.  Table 5 lists the documents and the relevant authority for each.

 Table 5  Reporting Authorities for Stable Value Investments

Regulated entity	Reporting authority
Pension plan statements		Financial Accounting Standards Board (FASB) and  American Institute of Certified Public Accountants (AICPA
IRS Form 5500		Department of Labor (DOL)
National bank pool customer statements		Office of the Comptroller of the Currency (OCC)

             Pension plan statements. Defined benefit plans are required by FASB Statement No. 110 to report all investment contracts, whether issued by an insurance company or other financial institution, at fair value.  This includes GICs purchased by defined benefit plans.
            Defined contribution accounting of investment contracts is defined in the AICPA SOP 94-4, which establishes guidelines under which investment contracts may qualify for book or contract value accounting.   Essentially, the contract, the pool (if any), and the plan all must permit participants access without undue restriction to their funds at book value. Each investment contract is to be evaluated on its own and each must be fully benefit-responsive to be carried at book value rather than fair value. 
            The SOP clarifies some reasonable restrictions on plan and contract operation that do not jeopardize book value treatment.   Contracts providing for future adjustments to the crediting rate may be benefit responsive if negative interest rates are not allowed.  Plan provisions limiting participant fund access to certain times of the year and standard “equity wash” provisions (see Q 22) are acceptable.   Contracts in single fund plans which restrict fund access by active participants except for retirement or health and welfare benefits may receive book value treatment if reasonable access is provided for inactive participants (those who are no longer employees of the firm).   The SOP uses a likelihood or probability criterion to determine whether use of contract value is appropriate.  For instance, if the contract does not provide for book value payments under a plan termination, contract value is appropriate until a plan termination becomes likely.   Similarly, the issuer’s credit deterioration should be reflected in the reported value as soon as it appears likely to impair the issuer’s ability to support the guarantee. 
            The SOP also requires that the stable value fund disclose the average yield for the period since the last report; the current crediting rate; the market value of all contracts reported at book as determined by FASB 107; the methodology and frequency of any crediting rate resets; the presence of any crediting rate minimums; any limitations on book value guarantees such as premature surrender, plan termination, early retirement programs, plant closings, and so forth;  the amount of any credit write-down on contracts; and any differences between valuation on the From 5500 and the plan statement.
            DOL Form 5500.   The rules for filling out the 5500 stipulate that assets are to be reported at fair market value where it is available and otherwise fair value as determined by a fiduciary or trustee, assuming an orderly liquidation.  An exception exists for unallocated general account insurance contracts - a category that includes most GICs and insurance company synthetic wraps - that allows contract value reporting for both defined benefit and defined contribution plans.  Otherwise, if a fair market value is available, the current 5500 rule requires the stable value asset to be reported at market value.
            Bank stable value pool valuation ..   National bank collective investment funds are generally required to report all assets to their investors at fair value, which generally means market value.  However, the OCC has granted an exemption to defined contribution stable value pools that allows contract value reporting under the principles of the AICPA’s SOP 94-4.  Under this exemption, all investment contracts in the pool must be benefit responsive to be carried at contract value.  The exemption utilizes the SOP disclosure and valuation standards in the case of credit deterioration or other events that might affect the issuer’s ability to pay book value.  An OCC letter ruling permits defined benefit plans to invest in these stable value bank pools as well, as long as the bank examiner is in agreement that the valuation methodology employed for the defined benefit assets is satisfactory.  

Q 38  Are stable value contracts derivatives under FASB Statement 133?

            As of this writing, the provisions of Statement 133, Accounting for Derivative Instruments and Hedging Activities are not applicable to stable value contracts.  As guaranteed insurance contracts, traditional and separate account GICs are explicitly exempted from the provisions of Statement 133.  In October 2001, the FASB Derivatives Implementation Group determined in Statement 133 Implementation Issue Co. C19 that fully-benefit responsive contracts meeting the requirements of SOP94-4 (see Q 37) are not subject to Statement 133.             

Q 39  Do stable value funds qualify under ERISA Section 404(c)?

            The ERISA 404(c) regulation outlines the basic standards of prudent plan structure and operation under which a plan fiduciary can avoid liability for participant investment decisions.  Stable value funds are an excellent core option under the principles of 404(c).  Their principal safety satisfies a basic investment need for plan participants.  Furthermore, they meet the diversification requirements for core fund options: diversification within the fund, good risk/return diversification with other investment options, and the ability to be combined in a portfolio so as to reduce the overall risk for any expected level of returns (low correlations of return with other typical fund options) (see Qs  1- 3).  Most stable value funds provide the required transfer frequency.
            A stable value fund invested in a bank or insurance company contract is considered a look-through investment vehicle under 404(c) and is considered diversified if the assets backing that contract meet prudent diversification standards.
            ERISA Section 404(c) requires that information about the individual assets comprising each fund option be made available to participants.  For fixed-rate contracts in stable value funds, that information must include the name of the issuer, the term of the contract, and the rate of return on the contract.  

Q 40 Are stable value investments registered?

            Most stable value assets are private placement investments that are not registered with the Securities and Exchange Commission (SEC) because they are annuity contracts, bank deposits, or are issued in a sufficiently large size to be bought only by sophisticated investors.  Similarly, most commingled stable value pools are not registered as mutual funds.  These funds are either bank collective investment trusts, pooled insurance company separate accounts, or collective trusts managed by investment firms. Several mutual fund firms have recently introduced stable value mutual funds which are registered with the SEC.  Most of these are designed for the defined contribution marketplace, but a few are targeted to individual investors.

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