JAMES MCKAY, CFA, PORTFOLIO MANAGER, STABLE VALUE MANAGEMENT, AMERIPRISE TRUST COMPANY ALICE M. FLYNN, DIRECTOR, FIXED INCOME PRODUCT MANAGER, COLUMBIA THREADNEEDLE INVESTMENTS Highlights Stable value investments generally protect investors from price volatility, provide daily liquidity and allow participant transactions at book value. Stable value investments have historically earned attractive returns with less interest rate volatility than other fixed income investments. Stable value funds can be managed to benefit from a rising interest rate environment. THE ADVANTAGE OF STABLE VALUE Interest rate expectations On December 16, 2015, the Federal Reserve raised the fed funds target rate by 25 basis points to a range of 25 to 50 basis points. Although the fed funds rate had been near zero for seven straight years, the Fed s move signaled what is widely expected to be further gradual rate increases. While the effect of the U.K. s decision to leave the European Union has yet to be fully realized, the resulting uncertainty would argue in favor of pushing out the prospect of rate hikes. However, with short-term interest rates hovering near historic lows, it still appears that rates have nowhere to go but up. With that expectation, let us focus on stable value investments and why plan sponsors and individual investors should give them careful consideration. At their core, stable value investments invest in fixed-income securities, which are subject to price declines when interest rates rise. We expect plan sponsors, consultants and plan participants to be concerned with the potential impact of rate increases on their fixed-income investments. However, stable value investors should take comfort in the fact that their stable value investments can mitigate the impact of rising rates. They do this by the use of investment contracts, which help to preserve principal and stabilize returns despite declines in market value of the underlying bond portfolios. By including stable value as a low-risk alternative, plan sponsors can help meet the requirements of ERISA to offer a broad range of investment options for their plan participants. Investing in stable value products Stable value products are available only in tax-qualified retirement savings and tuition assistance plans, such as 401(k), 457, 403(b), and 529 plans. They cannot be sold as mutual funds or through IRAs. The size of the plan s stable value assets generally dictates how many and which types of stable value options plan sponsors will have access to. Stable value products use several different forms of investment contracts issued by banks, insurance companies and financial institutions. Plan sponsors can invest in a stable value separate account or a 3(c)11 collective trust fund, both of which may have multiple investment contracts in place. Qualified plans may choose to invest in a collective trust fund if they want to pool their assets with other plans investments and/or do not meet the asset size required for a separate account. Alternatively, they can purchase guaranteed investment contracts (GICs) directly from an insurance company. Analysis of these contracts varies depending on whether the investment is made directly by a plan sponsor with an insurance company or by a stable value manager for a separate account or collective trust fund in which the plan invests. In the next section, we look at the various types of stable value investment contracts and the characteristics of each.
Exhibit 1: Stable value contracts and characteristics Contract type Who owns the assets? company Who manages the assets? company Exposure to issuer? Duration and credit quality Unwind parameters? Rate responsiveness? No, only at maturity when assets reinvested traditional GIC with maturity date 100% exposure Unknown Typically penalty is assessed if redemptions are allowed prior to maturity date traditional GIC without maturity date separate account contracts company company 100% exposure Unknown. A high yield implies long duration and/or lower credit quality. Varies typically 5-year annual book value payments or market value payout Amortize for book value = market value over duration Long duration implies less rate responsiveness separate account company or subadviser it appoints Stable value manager or third party sub-adviser If market value < book value Short to intermediate duration, high quality Short to intermediate duration, high quality Actively managed to help rate responsiveness Book value investment (wrap) contract Plan and Trust If market value < book value Amortize for book value = market value over duration Actively managed to help rate responsiveness Source: Ameriprise Trust, Columbia Threadneedle Investments Guaranteed investment contracts GICs were the original type of investment contract used when stable value products were first introduced in 1973. Plan sponsors can purchase GICs directly from an insurance company. GICs are backed by life insurance company general account assets. In return for the plan participant s deposit in their general account, the GIC issuer commits to providing book value benefit payments, even if the market value of the fixed-income investments in their general account has gone down. (Book value is a participant s deposits plus accrued interest.) GICs can be offered with or without a maturity date and may offer a fixed rate or floating rate. There is typically little transparency as to how deposits in GICs are invested. Though the investment contracts may offer an enticing yield, should there be a problem with the financial status of the insurance company offering the GIC, plan participants will have to get in line with the company s other policyholders to try to get their retirement savings back. In other words, GICs are 100% exposed to the credit risk of the life insurance company. GICs also tend to be less rate-responsive when interest rates are changing. So while the guaranteed interest rate may be appealing at the time of the initial investment, the rate (either fixed or floating) is governed by the terms of the contract and may not track future market rates. This feature is one of the key reasons other stable value products were developed: to provide more rate-responsive stable value options. 1 Federal Register vol. 75, No. 202, Wednesday, October 20, 2010. Department of Labor Employee Benefits Security Administration, 29 CFR Part 2550 Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans. Lastly, according to the Department of Labor (DOL) fee disclosure rules, fixed return investments, such as GICs, are not required to disclose the spread earned on the insurer s general account over the guarantee interest rate paid to the plan. That means there may be difficulty in determining some of the costs of the investment. 1 Book value investment contracts Book value investment contracts, also referred to as wrap contracts, were developed during the 1990s in response to plan participants desire for a stable value product that separated the investment of the assets from the contract issuer. This allowed the development of a rate-responsive stable value product that didn t lock plan participants into a guaranteed rate when interest rates were rising, while still protecting them from the risk of the market value falling below their book value investment. Separate accounts and collective trust funds may invest in book value wrap contracts to allow payment of certain participant withdrawals at book value regardless of the market value of the underlying bond portfolios. However, they may also invest in GICs and life insurance separate accounts. Book value investment contracts allow the separate account or collective trust fund s trustee to hold the fixed-income assets that back the contract and the plan to maintain ownership of participants assets. The book value contract may be able to be transferred to another stable value provider, according to the terms governing the investment contract. The plan retains all the income earned by the
underlying bond portfolios, which is passed onto the plan participants through the yield, sometimes referred to as the crediting rate, which is net of the book value wrap fees and other fees associated with the account. In essence, book value investment contracts allow plan participants to withdraw their investment in the fund at book value which is the amount they ve deposited plus all accrued interest to date even if the market value of the fixed-income investments backing the investment contract has gone down in value. More simply, the investment contracts ensure that the yield earned by plan participants will never go below zero (thus providing principal protection, subject to the issuer s ability to meet its obligations under the contract). This feature is referred to as book value benefit responsiveness. FASB AAG INV-01 and SOP 94-4-1 accounting rules allow stable value funds to accrue interest on the bonds and pass it through to the investors, but they do not have to mark the bonds to market. It is these accounting rules based on the book value contracts commitment to pay book value benefit payments that help provide the principal stability that investors are looking for as they earn returns from the bond funds irrespective of their market value. Book value investment contracts are the most commonly used contracts by stable value collective trust funds and separately managed accounts. The yield earned on book value investments is determined by the crediting rate, which is recalculated on a regular basis, typically quarterly. The crediting rate formula starts with the yield on the underlying bond portfolios, factoring in the market value to book value ratio and the duration of the fund, and then subtracting the wrap contract fees. (Duration is a measure of a bond s price sensitivity with regard to changes in interest rates.) Although stable value funds hold fixedincome investments whose prices fluctuate with interest rates, the use of book value investment contracts allows gains and losses in the underlying bond portfolios to be amortized over the duration of the fund by adjusting the crediting rate earned by plan participants. Therefore, the stable value investor earns a more consistent return and does not experience any direct price volatility. Sample crediting rate formula = ((1+ Bond Yield) * (MV/ BV)^(1/Duration) 1) Wrap Fee When the market value is greater than book value, the crediting rate increases above what the bonds are yielding, and when the market value is less than book value, the crediting rate decreases below what the bonds are yielding. However, unless the contract issuer defaults, plan participants will never experience a negative return as a result of participant-initiated activity. Stable value yields follow market interest rates, but with much less volatility and a delay in moving up and down as they continually move toward market rates. By investing in a stable value fund, investors can experience returns commensurate with the underlying bond portfolios (e.g., short to intermediate term bonds), but with return volatility that has historically been similar to, or even less than that of, a money market fund. Conservative investors and those investors nearing or in retirement should find this feature very attractive. Unlike the original guaranteed interest rate products that once dominated the industry, stable value funds and separately managed accounts that use book value wrap contracts were specifically designed to offer more competitive yields and returns during a rising rate environment. Exhibit 2: Investment contracts provide consistent, positive monthly returns with low volatility 4.0 3.0 2.0 1.0 0.0-1.0-2.0-3.0 12/88 12/89 12/90 12/91 12/92 12/93 12/94 12/95 12/96 12/97 12/98 12/99 12/00 12/01 12/02 12/03 12/04 12/05 12/06 12/07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 12/15 Total return (%) Barclays Intermediate Govt/Credit Bond Index Sources: Barclays Live, evestment Alliance, Lipper ev Alliance Stable Value (BV) Fixed Income Average Lipper Money Market Fund Average
separate accounts separate account contracts have characteristics of both GICs and book value investment contracts. The plan participants deposits are held by the life insurance company, but in a separate account not subject to the liabilities of the insurance company s general account. There may be greater transparency regarding the management of the assets backing the deposits and the crediting rate reset formula. The contract provides book value payments to participants in the same manner as book value investment contracts. As previously mentioned, stable value collective trust funds and separately managed accounts may also invest in GICs and/or book value investment contracts. Stable value managers may choose to diversify the portfolio by contract issuer as well as by investing in several investment contracts and a combination of different contract types. The tradeoffs that enable the benefits The significant benefits of investment contracts make stable value funds desirable capital preservation options within qualified employee benefit plans. However, the use of investment contracts adds a layer of expenses to a portfolio, which reduces returns. Additionally, the insurance companies and banks issuing these contracts place certain restrictions on plan participants and plan sponsors in return for the commitment that enables plan participants to transact at book value. If the plan sponsor offers a competing fund, defined by the contract issuers as a second capital preservation option with similar short duration bond features (for example, a fixed-income fund with a duration three years or less, or a money market fund), plan participants requesting to transfer assets from the stable value fund into a competing fund would first need to complete a 90-day equity wash. This means transferring the assets to a non-competing fund for 90 days before being allowed to complete the transfer to the competing fund. This requirement is intended to prevent plan participants invested in collective trust funds and separate accounts from market timing to arbitrage between capital preservation options. Investment contracts do not cover book value withdrawals due to employer-driven events. Such events include closing or sale of divisions, early retirement programs and employer communications that are intended to influence participants to withdraw assets from the fund. These events may result in withdrawals not being covered by contract issuers at book value, in which case the contract terms govern. The restrictions on employer-directed redemptions vary depending on the structure of the investment option. Stable value collective funds: Employer-directed redemptions may be subject to a delay in payment of up to 12 or 24 months, depending on the fund. This includes requests by the plan sponsor to redeem all or a portion of the plan s interests in the fund. Separately managed stable value funds: Employer-driven events may be addressed in one of three ways: If a division of a company is sold or spun-off and a new plan will cover the employees, the investment contracts may be cloned, or divided pro rata, with a new identical contract being issued to the new plan to cover those employees. If there is no new plan covering the affected employees, the investment contract may provide an employer corridor, which will allow book value benefit payments for employer-driven events up to a given percentage of fund assets, such as 10% or 15%. Benefit payments in excess of that amount would be paid at market value rather than book value. If the investment contracts will not make book value benefit payments, then the stable value fund would need to maintain liquidity sufficient to cover the benefit payments of those employees affected by the employer event. The liquidity position will make payments at book value without needing to access the contracts and receive a market value payment. Breaking down the stable value universe Stable value funds invest in the same pools of bonds as bond funds, so higher yields and total returns available in some products may be the result of longer duration, lower credit quality and higher risk investments. Fixed-rate insurance products can be exempt from ERISA if they offer a guarantee of a reasonable rate of return on those funds and a mechanism to convert the funds into guaranteed benefits at rates set by the contract. GICs and life insurance separate accounts are not required to disclose how their general account assets are invested, providing greater flexibility and a broader investable universe but little transparency to investors. Insurance regulations allow insurance companies to invest general account assets in a manner that is
generally not allowed by more conservative book value wrap contract issuers that seek to avoid high yield bonds and generally require fund effective durations to be maintained at less than four years. Exhibit 3: The major categories of stable value products Stable Value Assets Under Management ($777 billion total) 53.6% $416.9 billion 27.6% $214.7 billion 18.7% $145.4 billion Individually managed Pooled funds GICs and separate accounts Source: Stable Value Investment Association (SVIA) Stable Value Quarterly Survey for 4Q 2015 The Life Insurance GICs and separate accounts category makes up more than half of the stable value universe, and therefore their characteristics tend to skew the category averages. Conservatively managed stable value collective trust funds make up less than 20% of the stable value universe. Exhibit 4 shows the relationship that duration and credit quality have on the crediting rate/yield that each type of investment can offer. GICs and insurance company separate account contracts sold directly to plan sponsors tend to have higher durations and invest in lower quality bonds, which is why they are typically able to offer higher crediting rates/yields to investors. While stable value funds tend to use book value investment contracts most frequently, they may allocate a percentage of the fund to GICs and/or insurance separate accounts to add diversification and yield, or to access additional stable value contract capacity if needed. Stable value funds that invest in book value investment contracts have the ability to communicate clear information regarding the management of the assets backing the contracts, including both investment strategies and characteristics, as well as the risks taken to earn the fixed income returns. GICs provide less information regarding the management of the assets backing the contracts or the risks taken to earn the returns. In general, stable value funds that invest mainly in book value investment contracts allow fiduciaries to get a much better understanding of how the portfolios are managed, and the risks they may wish to accept to earn those returns. 2 Exhibit 4: Stable value characteristics by type Stable Value Investment Association 4th quarter survey Duration and Credit Quality 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 AAA 3.0 2.5 2.0 1.5 1.0 0.5 0.0 BB+ 0.0 Individually Managed Pooled Funds Life Insurance GICs and Sep Accounts Stable Value Average *Credit Quality Scale: 10 = AAA; 9 = AA+; 8 = AA; 7 = AA-; 6 = A+; 5 = A; 4 = A-; 3 = BBB+; 2 = BBB; 1 = BBB-; 0 = BB+ Duration (Years) Average credit quality* Average crediting rate Source: Stable Value Investment Association (SVIA) Stable Value Quarterly Survey for 4Q 2015 The SVIA Stable Value Quarterly Characteristics Survey crediting rate is the weighted-average contract yields as of the report date, gross of stable value management and distribution fees and net of contract (including wrap) fees. Correlation of stable value investments Regardless of which type or combination of types of stable value contracts is used by a stable value investment option, stable value products typically offer low or negative correlation to the plan s equity and fixed-income offerings. This makes stable value a good diversifier in a participant s overall asset allocation. Book value returns are subject to less volatility than other asset classes, making them a good defined contribution investment option for plan sponsors to offer plan participants. Crediting Rate (%) 2 Federal Register vol. 75, No. 202, Wednesday, October 20, 2010. Department of Labor Employee Benefits Security Administration, 29 CFR Part 2550 Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans.
Exhibit 5: Stable value provides low or negative correlation to stocks and bonds 3-year rolling correlation of stable value to stocks and bonds 1.0 0.8 0.6 0.4 0.2 0.0-0.2-0.4-0.6 12/05 06/06 12/06 Equity market corrections: Feb/Mar 2009 Jun 2010 Aug 2011 Sep 2015 06/07 12/07 06/08 12/08 06/09 12/09 06/10 12/10 06/11 12/11 06/12 12/12 06/13 12/13 06/14 12/14 06/15 12/15 03/16 Source: Morningstar Direct, as of 03/31/16 Morningstar U.S. SA Stable Value S&P 500 TR USD Barclays U.S. Agg Bond TR USD Easing the impact of rising rates What actions can stable value managers take to mitigate the negative impact of rising rates on the fixed-income investments in their fund, while at the same time position their funds to be rate responsive? Stable value funds can be managed to benefit from a rising rate environment. This process can include active management of the bond portfolios backing the investment contracts to mitigate the negative impact of rising interest rates and strategically structuring the bond portfolios to maximize the yield potential, combined with using different types of investment contracts which may also help increase yield. These actions may include: Shortened duration The stable value manager may shorten duration, or decrease interest rate risk, to help preserve the market value of the bonds as interest rates rise. For example, if a bond has a duration of 4 years, its market value will decrease approximately 4% for each 1% increase in market interest rates. However, a bond with a duration of 2 years will see its market value decrease only about 2% for the same 1% increase in market rates. A shorter duration will therefore help preserve the principal value of the current bond holdings. A shorter duration bond portfolio will also result in securities maturing at par more quickly than a longer duration bond portfolio. In a rising rate environment, the maturity proceeds may be reinvested into new bonds that capture the higher market interest rates. The manager may also make strategic investments in short-term investments that mature quickly and can be reinvested to capture higher market rates at maturity. Portfolio structure It is important to understand that each sector of the bond market will react differently than U.S. Treasuries when rates rise, so being well diversified between allowable sectors may help to mitigate the negative impact of rising rates. We believe sector rotation and being selective about which securities are owned in the portfolio tends to add the most value to yield and total return. Credit risk can be reduced by limiting overall corporate exposure, as well as by diversifying among industries and individual companies. It is possible to get attractive yields without dipping down into noninvestment grade bonds. Structured assets such as agency mortgage-backed securities can also provide additional diversification and attractive yields if permitted under the investment guidelines. Within sectors such as mortgages, 15-year mortgages and structured mortgages currently have shorter duration than 30-year mortgages and will not extend duration as much as 30-year mortgages during a rising rate environment. Managers can also add a duration and/or quality barbell to the portfolio using higher coupon, lower quality (A- and BBBrated) and longer duration securities at the upper end and short-term debt and floating rate notes on the short end.
Barbell structure Being selective about duration and yield curve positioning of the underlying bond portfolios can help to manage the overall interest rate risk of a stable value investment option. We believe the composition of a stable value fund or account s duration (placement along the maturity spectrum) is just as important as the duration itself. Rising interest rates may affect different parts of the yield curve in different ways. For instance, if short-term rates are rising, the 2-year and 3-year part of the yield curve may experience large interest rate increases, while the 5-year part of the curve may experience less increase. Depending on the market environment, a bond portfolio that invests fewer assets in the 2- and 3-year part of the yield curve and more assets in a combination of very short or floating rate securities along with securities in the 5-year part of the curve may outperform a portfolio with investments evenly allocated along the yield curve. Judgment must be made on the level and the slope of the yield curve to determine if a barbell structure may help bond portfolio performance during a period of rising interest rates. Investment-grade floating rate instruments If permitted by the investment guidelines, an investment in investment-grade floating rate bonds provides the opportunity to increase coupon rates as market rates increase while adding very little duration risk to the stable value fund or account. In addition, the floating coupon helps the principal value of the floating rate bond remain near par value, rather than decreasing as a fixed rate bond would as market rates rise. Although floating rate instruments will decrease in yield if rates fall, principal preservation and increased coupon rates will help the bond portfolio to perform well in a rising interest rate environment. Short-term investments Stable value funds may make strategic investments in shortterm investments that help to preserve principal and manage liquidity during the rising rate period, and then allow quick reinvestment into higher market rates at maturity. Investment contracts Each book value contract uses a crediting rate formula that resets periodically and reflects (1) interest earned on the underlying bonds and (2) an adjustment for changes in the market value of the bond portfolio, usually amortized over the duration of the portfolio. Since the market value of bonds is inversely related to interest rate changes, the market value adjustment to the crediting rate will be positive in falling interest rate environments and negative in rising rate environments. When interest rates are rising and the market value of the bonds is falling, the yield increase and the market value adjustment tend to offset each other. However, because the market value adjustment is amortized over the duration, its effect is diluted and the increasing bond portfolio yield helps the crediting rate to increase, but not as fast as market rates. The net effect is a gradual adjustment of the stable value fund yield toward current market rates. When Interest rates Interest rates Traditional GICs Market value of existing bonds (decrease amortized over duration) Market value of existing bonds (increase amortized over duration) Yields on new bonds Yields on new bonds Crediting rate gradually Crediting rate gradually GIC issuers provide a fixed rate of return in exchange for keeping a deposit for a fixed period of time. These contracts help protect principal by providing for the return of the assets at maturity and also stabilize income over the contract period because the rate of return does not change if market interest rates change. Although this fixed rate can be beneficial when market rates fall, it can be a disadvantage in a rising rate environment. However, there is no principal loss in a rising rate environment and at maturity, the contract proceeds may be reinvested at current market rates. Floating rate GICs Certain life insurance companies offer floating rate GICs. These contracts operate like the traditional GICs described above, but the coupon resets monthly or quarterly based on current market rates. Therefore, floating rate GICs offer the potential for higher returns in a rising rate environment, offset by the risk that market rates may fall and the coupon rate will decrease accordingly.
Uncertainty about timing of higher short-term rates Many experts feel that the Federal Reserve will continue to raise interest rates this year. However, it is uncertain when or how quickly short-term interest rates may rise. The Fed has emphasized that it will judge economic strength based on a range of future economic factors, including employment statistics and inflation expectations. The cumulative opportunity cost of investing in shorter duration options will grow the longer the investor waits for short-term rates to rise. Rather than trying to time the market and jump into short-term investments at the perfect time, investors should consider a stable value allocation as part of their long-term strategy for investing for retirement. Regardless of an investor s investment time horizon or the type of stable value product selected, a stable value investment may help to reduce overall portfolio volatility and preserve principal. To find out more, call 877.894.3592 or visit columbiathreadneedle.com/us Not for public distribution. This material has not been filed with FINRA and may not be reproduced, shown or quoted to, or used with members of the general public, including plan participants. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. 2016 Morningstar, Inc. All rights reserved. The Morningstar information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. The Barclays Intermediate Government/Corporate Bond Index tracks all investment grade corporate and U.S. Government issues over $200 million with remaining maturities of between one and ten years. The Standard & Poor s (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks. The Barclays U.S. Aggregate Bond Index is a market-value-weighted index that tracks the daily price, coupon, pay-downs and total return performance of fixed-rate, publicly-placed, dollardenominated, and non-convertible investment-grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity. It is not possible to invest directly in an index. There are risks associated with a stable value investment, including credit risk, interest rate risk, counterparty risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Diversification does not assure a profit or protect against loss. Investment contracts are subject to counterparty risk, other risks and increase fees associated with an investment in a stable value fund. Contracts may restrict liquidity under certain circumstances, such as requiring an equity wash before transfers to competing funds. In addition, investment contracts usually do not cover redemptions due to plan-sponsor actions, such as layoffs or a change in plan investment options. Ameriprise Trust Company is a Minnesota state chartered trust company. Columbia Management Investment Advisers, LLC ( CMIA ) is an investment adviser registered with the U.S. Securities & Exchange Commission that provides subadvisory services for certain Ameriprise Trust Company products. Securities products are distributed by Columbia Management Investment Distributors, Inc., member FINRA. These companies are part of Ameriprise Financial, Inc. Columbia Threadneedle Investments in the global brand name of the Columbia and Threadneedle group of companies. 2016 Columbia Management Investment Advisers, LLC. All rights reserved. CT-TL/112705 A (07/16) 274P/1473343