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Stable Value and GICs
a chapter for the Pension Investment Handbook
VI. Considerations in Purchasing a Stable Value Contract and Managing a Stable Value Portfolio
Q26 How is a stable value investment purchased? Return to topAll 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 specifications 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 16 and 18) 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 20), 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, with deductions for investment management fees and wrap fees (risk charges, expenses, and profit). A synthetic contract may also have custody fees (see Q17).
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 which produce special value opportunities for the investor.
Q27 How does the investor evaluate and manage credit risk on stable value assets? Return to top
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 Q24). Where an investment contract participates in the credit risk on the underlying assets, it is important to determine what the credit guidelines and diversification policies are 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
wrap
asset
Bundled Products
GIC
claims paying
- - -
BIC
deposit
- - -
SA GIC
claims paying
debt
Synthetics
with annuity wrap
claims paying
debt
with other wrap debt
debt
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.
Other measures besides ratings can be used to assess the quality of a GIC or wrap issuer. Useful financial measures include surplus to asset ratios, asset quality and diversification, proportion of problem loans, profitability, and 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 most stable value funds are the most conservative fund option in the defined contribution plan, plan sponsors generally 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 invested with a single credit and industry.
Q28 What are the primary firms providing financial ratings on insurance companies and banks? Return to top
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 their debt rating categories. 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, the firm’s ratings are not relied upon as frequently by GIC and synthetic customers, perhaps because they provide less distinction among the upper tiers of insurers. There are also companies offering commercial services that provide information on the relative financial strength of life insurance companies, such as Townsend and Schupp and Conning and Company.
Q29 Why does the investor care about credit risk if GICs and other stable value investment contracts are guaranteed? Return to top
The guarantee in a GIC or other stable value contract is the promise of the financial institution that issues the contract and is only as strong as the ability of the issuer to support it. In the case of an issuer default, 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 Q25). 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.
Q30 What happens if a stable value asset defaults? Return to top
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. If the defaulted asset is a small enough component of the fund, it may be sufficient to hold it as a non-performing asset. However, if the defaulted contract is a large part of the portfolio, many plans have opted to freeze its portion of the fund and to treat it as a separate part of the fund until the appropriate valuation can be determined. Benefit payments on this portion of the fund are also frozen.
Before 1991, many plans described their GIC funds as guaranteed options, without specifying the extent of the guarantee or the risks involved. Some plans with defaulted contracts have elected to reimburse the fund for the amount of the default, by purchasing the contract from the fund at book. The purchase is technically a prohibited transaction under ERISA, but the Department of Labor has readily granted exemptions for defaulted GICs. Most plans have now changed the name and description of the fund to clarify the source of the guarantee and the investment risks to the participants.
Today it may also be possible to purchase credit reinsurance or a benefit-responsive wrap for a defaulted contract. (see Q31). This is relatively easy for a synthetic or walled-off separate account GIC, since the value of the underlying assets can be readily determined by the wrap provider. It is more difficult to purchase wrap protection for a defaulted general account GIC until the value of the assets available to support that class of contract is determined by the rehabilitators. The price of the reinsurance or wrap will depend on the size of the gap between the book value of the contract and the market value of the assets backing it.
Q31 What protection is available in the case of downgrade or default on investment contracts? Return to top
Generally there is no automatic credit backstop other than the financial soundness of the issuer for an investment contract. 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, however, 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.
Q32 What are the investor’s concerns about assuming interest rate risk in stable value funds? Return to top
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. Because of this, it is important that stable value investors limit the fund’s exposure to losses from underperforming assets and market value losses on participant withdrawals when rates rise, since both will further depress the crediting rate.
Participation in assets which can extend their maturity when rates rise, such as collaterilized mortgage obligations or CMO’s are an excellent example. 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 risks are 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. It may be helpful to establish specific limits on the proportion of the stable value portfolio that should participate in these risks.
Q33 What are the termination provisions on stable value contracts? Return to top
Stable value investments offer participants full liquidity at book value, but this is not true at the contract holder level. Surrender or early termination provisions vary by the type of contract. Traditional GICs generally pay an employer-initiated request for funds before maturity only at the lesser of book or a formula-determined market value. Many contracts also will pay the contract holder at book in a series of installment payments spread out over a period of years to avoid any negative market value adjustment to participant balances. Participating, separate account and synthetic GICs generally pay market value at the time of premature surrender or the effective equivalent in a series of book value payments.
The lesser of book or market "penalty" in traditional GICs 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 can’t always be quickly sold without some sacrifice in value. In addition, managing the asset and liability risks assumed in the traditional GIC requires 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.
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 that it might need to be used are important parts of the stable value purchase decision.
Q34 What are the considerations in purchasing a synthetic wrap? Return to top
Because the synthetic GIC is still a relatively new instrument and many providers are new players in stable value investing and underwriting, the purchase decision should be made especially carefully. 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 15 and 16). 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 these provisions require that the portfolio be liquidated and the assets invested in treasuries 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 there are any ERISA prohibited transactions or provider self-dealing issues involved with the synthetic GIC package. (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 increased potential for ERISA complications. Some experts advise that a QPAM, qualified professional asset manager, choose the wrap provider to mitigate some of the potential ERISA liabilities.
Q35 What are a plan’s investment management options for a stable value portfolio? Return to top
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. 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 which professionally manage stable value assets for plan sponsors, just as there are stock and bond managers. These firms have discretionary investment management responsibility for all aspects of 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 mitigate the plan’s fiduciary responsibility for asset choice, especially in the wake of GIC issuer defaults. Corporate cost-cutting and down-sizing have also played a role in the growing popularity of managers. Manager fees are generally deducted from the credited rate on the fund, shifting 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 offering bundled, full service 401(k) options. Most are unit value bank collective investment funds, although there are also a few life company separate account pools. Most pools are operated on an open-end basis and offer all investors the same portfolio rate. There are also some pools which maintain closed-end cells accepting deposits for a specific period of time and crediting cell-specific rates to their investors. Fees generally range from 50 to 100 basis points and are deducted from the rate credited on the portfolio.
Pooled funds are especially attractive to small plans, since they offer credit diversification among a number of providers and sophisticated fund management. There also is a yield advantage in pooling deposits and purchasing larger investment contracts. A disadvantage is the risk that transactions by other investors in the pool may adversely impact the plan’s crediting rate. Open-end pools’ portfolio rate will appear attractive in a declining rate market, which may attract new investors with deposits to be invested at the lower market rates, dragging down the portfolio yield for everyone. Similarly, withdrawals at book 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. These risks 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, national bank pools provide liquidity to contractholders at book value. These pools will pay book value for employer-initiated withdrawals with a notice period of up to 12 months, a provision required to satisfy a Comptroller of the Currency regulation for liquidity at the contractholder level in collective trusts managed by national banks. Some GIC and synthetic wrap issuers are unwilling to underwrite a pool containing this feature on a non-participating basis, believing that it exposes their firm to a significant arbitrage risk. Others have strict underwriting criteria for assuming the risk. Pool managers, on the other hand, maintain that there is little additional risk to a GIC issuer from the book surrender provision because a well-managed pool maintains ample cash flow and short-term assets to pay such premature contract surrenders without tapping its investment contracts.
5. Single life company fund options: Many life insurance companies providing 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. There may be some form of minimum rate guarantee, 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. Providing a new money rate on new deposits allows the issuer to maintain a longer duration on the portfolio than typical for a pool, giving some yield benefit on average. 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 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 Q37) The plan sponsor retains full fiduciary responsibility for choosing a credit-worthy 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 twelve-month period. This type of restriction may cause problems under the AICPA’s guidelines for book value accounting treatment (see Q36) and should be reviewed with an accountant.
Q36 What are the pension accounting rules for stable value investments? Return to top
There are a number of authorities with 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
pension plan statements:
Financial Accounting Standards Board (FASB) and American Institute of Certified Public Accountants (AICPA)
form 5500:
Department of Labor (DOL)
national bank pools:
Office of the Comptroller of the Currency (OCC)
1. 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. 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 Q21) 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 inactives. The SOP uses a likelihood or probability criterion to determine whether 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 is known to be likely. Similarly, credit deterioration of the issuer 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 for any crediting rate resets and the presence of any crediting rate minimums, any limitations on book value guarantees such as premature surrender, plan termination, early retirement programs, plant closings, etc., the amount of any credit write-down on contracts, and any differences between valuation on the 5500 and the plan statement.
2. DOL Form 5500: The rules for filling out the 5500 stipulate that assets are to be reported at fair market value where available and otherwise fair value as determined by a fiduciary or trustee, assuming an orderly liquidation. There is an exception 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 stable value asset should be reported at market value under the current 5500 rules.
3. 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. All investment contracts in the pool must be benefit-responsive to be carried at contract value under that exemption, which also looks to the SOP for standards about disclosure and valuation in the case of credit deterioration or other events that might affect the ability to pay book value. A letter from the OCC 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.
Q37 Do stable value funds qualify under ERISA Section 404(c)? Return to top
The ERISA 404(c) regulation outlines 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 provides a basic investment need for plan participants. They satisfy 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.
Among the information required to be made available to participants under Section 404(c) is the list of assets comprising each fund option. 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.
Q38 Are stable value investments registered? Return to top
Most stable value assets are private placement investments that are not registered with the SEC because they are annuity contracts, bank deposits, or are issued in a sufficiently large size to be bought only by sophisticated investors. Similarly, commingled stable value pools are generally 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. However, there is at least one registered stable value mutual fund.
