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Stable Value and GICs Q&A
a chapter for the Pension Investment Handbook
IV. Deposit and Withdrawal Features of Stable Value Contracts
Q19 What is a benefit-responsive contract? Return to topA benefit-responsive investment contract is one 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 Q36).
By issuing a benefit-responsive contract, the issuer is exposing itself to anti-selection risk, since participants are most likely to want to withdraw or transfer funds when market interest rates are higher than the crediting rate on the contract. The issuer underwrites the risks posed by each plan individually and assigns a risk charge based on the estimated potential for anti-selection (see Q15). Most GIC and synthetic wrap issuers will not underwrite a plan allowing direct transfers to a competing fund (see Q21)
Q20 What are the withdrawal protocols for stable value contracts? Return to top
Each plan maintains rules that determine 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 or "last-in-first-out";.
In a LIFO contract, all benefits are taken from the most recently issued contract, usually the one with the open deposit window (see Q:22), 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 risk to the issuer of market value losses on participant withdrawals is reduced by the contribution flow 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 pays withdrawals 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 Q5), helping to keep the fund’s crediting rate 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 a STIF fund (see Q5), which the plan agrees to maintain at some specified proportion of stable value assets, say within 5-10 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. Since the STIF must be replenished before new GICs or synthetics can be purchased, the fund is also assuming more interest rate risk than if the investment contracts had paid 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. Pro-rata by participant or class year. In this type of stable value fund, participants own specific shares of each contract in the fund based upon the amount of his or her contribution to that contract relative to the total deposit amount. Withdrawals are made from each contract in direct proportion to each participant’s ownership share. Anti-selection risk 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, the dwindling number of providers who will underwrite the risk, and the complexity of administration.
Q21 What is a competing fund? Return to top
A competing fund is an investment option within a defined contribution plan that poses anti-selection risk on participant investment transfers to stable value contract issuers, such as a money market fund. A stable value fund’s credited rate lags market rates whenever there is a significant movement up or down in interest rates because its investments are medium-term. Money market rates, however, follow market interest rate changes closely. If a money market fund is present along with a stable value fund in the plan, there is incentive for plan participants to switch their funds to the money market option 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 investment 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.
Q22 What are the various types of deposit features for stable value contracts? Return to top
GICs and other stable value investments are issued to salary-reduction plans, and new contributions are generally deducted directly from participants’ pay. To handle this ongoing stream of contributions as well as reinvestment of funds from maturities on existing stable value investments, there are several different types of deposit features available on investment contracts:
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. There is a significant amount of risk to the issuer on this type of contract, since participants are likely to deposit more funds than originally anticipated if market rates fall and the contract rate is attractively high and less than expected if rates rise. Most traditional GIC issuers offer window contracts, but they are rarely offered for synthetic and separate account alternatives.
3. Net dollar window contracts: investment contracts in which the issuer agrees 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 against another contract. This type of contract provides a stable crediting rate to the fund for the window period but reduces the contribution risk to the issuer. The fund assumes the interest rate risk on any contribution shortfall or excess. Typically only traditional GICs offer net dollar window features.
Q23 Why do investment contracts require timely payment of contributions and impose a penalty when this does not occur? Return to top
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 is done 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.
