Employer U PDATE Stable Value Q & A August 2014 189,000 plans, which account for approximately 14% of total defined contribution assets 1. to view stable value investments as beneficial to a DC plan s line-up and hopes to shed some light on this topic by addressing some of the most frequently asked questions we receive from the plan sponsors that we work with. 1. What is stable value? Page 1 of 6 Stable value funds are a staple in defined contribution plans, with $701.3B invested across Andrea Bongiovanni, CFS, CIMA These unique investments offer several attractive benefits including principal preservation and benefit-responsive participant liquidity, but have been yielding lower and lower over the past several years, prompting many questions for plan sponsors. USI Advisors continues A stable value fund is an investment vehicle for defined contribution plans, whose primary objective is capital preservation, liquidity, and a return higher than that of a money market over longer periods of time. There are several structures that a stable value can be offered in, including commingled accounts, separate accounts, and Guaranteed Interest Contracts (GICs). The unique feature of stable value funds is that they all use investment contracts, which can be issued by a variety of financial institutions, and are used to allow the fund to carry assets at book value (Invested principal and accrued interest) and smooth return volatility. Compared to other investments offered in 401(k) plans, stable value funds are generally considered the most conservative option, next to cash. 2. How does a stable value fund work? There are two available structures for stable value funds: a separately managed account and a commingled, or pooled, fund. The separately managed stable value account is managed specifically for a single client s defined contribution plan. The commingled fund pools together the assets of many 401(k) plans. The benefits of a commingled stable value fund include economies of scale as well as diversification. In either type of structure, stable value funds are all comprised of a portfolio of fixed income securities as well as investment contracts that are used to smooth return volatility and allow the investment to be benefit responsive. Where stable value funds differ is how this contractual protection is executed and delivered. Three types of stable value funds are described below. Guaranteed Interest Contract (GIC): A GIC is an investment offered by insurance companies that will deliver a stated and guaranteed rate of return, regardless of the performance of the underlying investments. This rate of return is backed by the full financial strength and credit www.usiadvisorsinc.com 1 Stable Value Investment Association: http://stablevalue.org
Page 2 of 6 of the insurance company, and is generally guaranteed for a month to six months. The assets invested are owned by the insurance company, and held in its general account. While there is diversity in the fixed income securities that comprise the portfolio, the key risk with GIC s is that only one insurance company is guaranteeing the assets. Separate Account Contract: A separate account contract is an investment offered by insurance companies that will deliver either a stated rate of return over a set period of time regardless of the underlying asset performance, or a rate of return based on the underlying assets. This rate of return is backed by the full financial strength and credit of this insurance company, and is generally guaranteed for a time period of one to six months. The assets invested are owned by the insurance company, and are held in a separate account, specifically for the benefit of the contract holder. Like GIC s, while there is diversity in the fixed income securities that comprise the portfolio, the risk with separate account contracts is that only one insurance company is guaranteeing the assets. Synthetic GIC: A synthetic GIC is an investment offered by an insurance or investment company that contains contracts (wraps) from bank or insurance companies that insulate the performance of the securities from interest rate volatility. The owners of these assets are the defined contribution plan and its participants. Where synthetic GIC s differ the most from traditional GIC s is that the synthetic GIC has unbundled the investment and insurance components 2. While synthetic GIC s offer diversity both in the underlying holdings as well as the institutions providing protection of the principal, these wrap providers charge a fee for their services, which lower the returns for investors. 3. What is a wrap? A wrap, also called wrap contract or investment contract, is a contract issued by a bank or insurance company. These contracts are constructed to work like shock absorbers 3 in that they help smooth returns. This smoothing occurs even when markets are volatile, including when interest rates jump or fall quickly. This is done by the insurance company or bank s wrap providing the difference between their wrapped portion s market value and book value (defined in question #4), which spreads out investment gains and losses over time. 4. What is the difference between Book Value and Market Value? What is a Market-to-Book ratio? The book value of a stable value investment is the total participant balances in the fund, which is the sum of the net contributions and the accrued interest. The market value of a stable value investment is the current value of the underlying securities on the open market. The market value and book value of a stable value investment can be different at any given time, as the market value of a stable value fund will change daily with market and interest rate fluctuations. At the same time the book value of the stable value fund is fairly stable, as interest is accrued generally monthly and participant contributions are usually added to the fund bi-weekly. The relationship between these two values, the market value and the book value, is simply called the market-to-book value ratio. This ratio can be a telling barometer of a stable value fund s health, but is not the end all, be all indicator. Other factors of a stable value fund need to be reviewed as well, such as credit quality, duration, and diversification. When a fund s market-to-book ratio is low, this generally means that the fund s investors are more reliant on the financial strength of the providers of the wrap contracts. In periods of rising rates or spreads widening, the market-to-book ratios have historically dipped below 100%, but then subsequently moved back towards parity as crediting rates were adjusted to amortize the losses. It is important to note that during these time periods, pooled stable value funds were still able to provide participants with book value liquidity, capital preservation, and attractive credited interest, with relatively low volatility of returns. 2 Landmark Strategies: http://www.lmstrategies.com/types~2.html 3 JPMorgan Retirement Plan Services: https://www.retireonline.com/rpsparticipant/education_center/the_way_forward/frequently_asked_questions_about_stable_value_funds.jsp
Page 3 of 6 5. Are more or fewer insurance companies wrapping stable value investments? What should we be concerned about regarding these insurance companies? During the 2008 financial crisis, many institutions were asked to keep more capital reserves than previously required due to deteriorating balance sheets. This caused several wrap issuers to exit the business, they were not being compensated enough to carry this risk. When wrap issuers began to exit the business, many stable value managers followed suit, as they were unable to secure the wrap capacity they needed. Since that time, however, the risks of wrapping stable value have been examined. Wrap prices have been increased to be more in line with the risk that wrap issuers are taking on, which has led to an influx of providers coming back into the wrap business. While an increase in wrap fees seems like a negative, it can actually be considered a positive, as it has drawn more wrap providers into the business, extending wrap capacity for stable value managers, helping to ensure the book-value redemption guarantee for current and future stable value investors. 6. What is a put, and how does it work? A put is a termination provision set in most stable value accounts at the plan sponsor level, used with the intention of protecting the remaining investors in the stable value fund, as well as the wrap provider. While participants may make distributions at any time at book value for most stable value accounts, it is common that a plan sponsor is required to give notice when terminating or liquidating a stable value option from their plan. In the past, in order to receive book value, a plan sponsor would need to give 12 months notice, which would mean their investment has a 12 month put. Over the past couple of years, some stable value providers have upped their puts to 18 or 24 months. Question #10 goes into more depth regarding this, but cash flows from investors have an impact on the crediting rate or return of stable value funds. Stable value providers try to minimize this impact by managing their cash flows using puts. For a provider given 12 months notice, or whose 12 month put has been activated, participants will still be granted the return on the fund that they have earned, and will still let participants contribute and withdraw at book value. The provider may pay out all the funds to the plan sponsors before the put period is over as well, but not after. Puts are for withdrawals at book value, but plan sponsors may generally discontinue a stable value fund at market value at any time. As discussed in Question #4, the relationship between the market value and the book value is called the market-to-book value ratio. If this ratio is less than 100%, then a Market Value Adjustment (MVA) could be implemented. This means that the plan sponsor could receive less than book value at withdrawal, they would receive market value, and in some cases vice versa. 7. What is the difference between a stable value fund and a money market? Are there times when it makes sense to be in a money market instead of stable value? A stable value is a conservative product by construction, but has an objective of outpacing money markets over longer periods of time with lower volatility. It will invest in a variety of fixed income investments, from short to intermediate term, government, mortgage-backed, and corporate bonds. This diversity is what gives stable value funds a return edge over money market funds. As with everything, however, greater return potential generally equates to greater risk potential. This is where the wraps (as defined earlier) come into play. These wraps provide the stability and smoothness of returns for the stable value fund and manage the additional risk.
Page 4 of 6 As demonstrated by the chart below, stable value funds have provided smoother returns over time relative to both money markets and high quality intermediate-term bond funds. In times of rising interest rates, money markets returns will spike to that of stable value returns or higher, but over long periods of time, stable value products have produced a steadier, higher return. 8. If rates go up, how will that affect my stable value fund? As we all know, we are likely coming to the end of a 30 year bond market, with interest rates steadily declining over time. We will most likely see rates rise in the future, whether that is in the near or intermediate-term. Bond prices and interest rates have an inverse relationship, which means that in the rising interest rate environment we anticipate in the future, bond prices of the underlying securities for stable value funds will take a hit. The benefit of stable value funds in this scenario is that the assets are smoothed by the insurance contracts in place, which give book value liquidity and low volatility in returns to participants. Galliard, a large stable value manager, released a study in early 2013 that analyzed the hypothetical performance of a stable value fund using a couple of different interest rate scenarios. In the first scenario, the environment was a steady, extended climb in rates, where investors in mutual funds holding shortand intermediate-term bonds would see their balances decline over three years, but holders of money market funds and stable value funds saw their balances grow, with the stable value fund holders balances growing larger than money market balances. Another scenario was a large, sudden spike in rates. Both short- and intermediate-term bond funds took a large hit to their value immediately, gaining it back in about two years time. Those in money market funds and stable value funds never saw their account balances go down, with stable value funds doing slightly better than money market funds again 4. A negative environment for stable value, relative to money markets, would be for the federal funds rate to be increased to a level greater than a stable value fund s crediting rate. Generally the Federal Reserve shifts this rate in 25 basis point increments, so with the fed funds rate near zero, it would take a considerable number of rate hikes to bring this rate higher 4 A 401(k) Defense Against Rising Rates, Dorianne Perrucci, WSJ: http://online.wsj.com/news/articles/sb10001424127887323393304578358651907757698
Page 5 of 6 than stable value crediting rates. Short-term rates are generally controlled by this fed funds rate, which directly impact money market yields. Therefore, it would take a considerable number of rate hikes to bring money market yields higher than stable value crediting rates. 9. Why has my stable value return been so low? There are a few factors at play regarding the recent decline in returns for stable value funds. Historically low interest rate environment: As stable value funds are open to defined contribution plans, they experience periodic contributions from investors, generally biweekly. These contributions need to be invested, and are done so at current interest rates. In the historically low interest rate environment we have experienced over the last several years, this new money invested at new low rates has watered down some returns for the fund s investors. This effect is somewhat exacerbated in an open stable value fund. An open stable value fund is one that will take new plans as investors, which can mean large transfers of assets as a plan sponsor sells its investment and maps those assets into the new stable value fund. This potentially large new addition needs to be invested in the current rates as well. Increased wrap provider fees: During the financial crisis in 2008, stable value funds came under pressure as their market values dipped lower, some lower than 90% of book value. As a result of this, wrap providers, like many in the financial industry, began to take a closer look at their business and potential risks, and underwent changes. One of these changes was to increase wrap fees. In 2007, wraps were as low as 6 basis points, and are now in the 20 basis point range, which can have a moderate impact on returns. Because some wrap providers had reduced their stable value business or exited the business altogether, it allowed for those remaining to increase their wrap fees. It does seem like wrap fees have hit a peak and have begun to stabilize, as more wrap providers have entered the business again, which should help to lower future costs. Increased restrictions from wrap providers: Another way that wrap providers have tried to insulate themselves from future potential losses has been to add or increase their restrictions on the securities they are wrapping. Some examples of these include restrictions regarding duration, credit, and type of security. These have typically amounted to less risky portfolios with slightly lower return potential. As with most factors at play in the market, these are all cyclical, meaning that as rates rise, stable value funds will have the opportunity to invest new assets into higher yielding securities, and wrap providers will most likely become more lax and lower their fees as time goes on. 10. Can I lose money in a stable value fund? What are a stable value fund s risks? Yes. A stable value fund is managed conservatively and seeks to preserve principal while providing a credited rate of interest, but (while unlikely) can lose money. Like any other investment, there are risks with stable value funds. These risks include: Interest rate risk: There are two issues to consider with interest rate risk. The first is that interest rate changes can affect the market value of the fund if these changes cause the underlying securities to lose value. This could cause the market value to be lower than the book value. Another issue to consider is that when interest rates rise or fall quickly, a stable value fund s return will be affected more slowly than that of a money market fund. This is a positive in a declining interest rate environment, as we have observed as of late. In a rapidly rising rate environment, however, a stable value fund will take a longer time to adjust its rates, than would a money market. It is important to note, however, that over time stable value funds have outpaced money market funds.
Page 6 of 6 Investment contract risk: This is the risk that the stable value is exposed to regarding the wrap contract issuers. These contracts are designed to allow for participant driven transactions to be conducted at book value. A contract could lose its book value withdrawal features if the following occurred: an issuer defaults on its obligation, an event of default occurs that renders the contact invalid, the contract will lapse before a replacement wrap can be found with favorable terms, employer-initiated events. Investor cash flows: As described in the answer to question #8, cash inflows can have an impact on a stable value fund s return. In addition to this, cash flows out of the fund, like withdrawals or terminations, have an affect on the fund, potentially causing gains or losses for the underlying portfolio that will now be spread among the remaining investors in the smaller asset base. 11. Who is keeping an eye on these products? How are they regulated? Stable value funds are not registered products, meaning that they are not required to file either a registration statement or prospectus with the Securities and Exchange Commission (SEC). This also means that their performance is not made public; there is no ticker symbol, you cannot look online or in a newspaper for performance. That being said, stable value funds are subject to several layers of governmental oversight, including the Department of Labor and the Federal Reserve. They must also comply with accounting regulations as defined by either the Financial Accounting Standards Board (FASB) or the Governmental Accounting Standards Board (GASB). As discussed above, stable value funds are unique investments that account for a good portion of Defined Contribution assets. Over time, they have historically generated returns higher that of money market funds, though this is not their sole positive attribute. Their principal preservation guarantees and steady returns are attractive to conservative investors in retirement plans, generally those at or near retirement. These are particularly important in relation to the demographic shifts that are occurring with in the United States, namely the 76 million Baby Boomers, born between 1946 and 1964, who are close to, or beginning retirement. As such, more and more plan participants are looking for conservative investment options with return potential. USI Advisors hopes to have provided a comprehensive yet comprehendible overview of Stable Value. As always, if you have any questions, please feel free to contact your USI representative. Investment Advice provided by USI Advisors, Inc. 860.633.5283 Under certain arrangements, securities offered through USI Securities, Inc. Member FINRA / SIPC 860.652.3239 95 Glastonbury Blvd, Glastonbury, CT 06033 Employer UPDATE is a publication circulated by USI Consulting Group and is designed to highlight various retirement and employee benefit matters of general interest to our readers. It is not intended to interpret laws, regulations or to address specific client situations. The information contained herein is meant for general educational purposes only. 2014.031