Feb 17, 2017
Stable value strategies are investment options that primarily seek to preserve capital and whose return is based on a pre-determined crediting rate. They are available for inclusion in ERISA-qualified, participant-directed retirement plans. Over half of defined contribution plans offer stable value options (1) and more than $750 billion is currently invested in the category (2). Defined contribution plans have aggregate assets of about $6.7 trillion3, so it is not uncommon for plans that offer stable value to have 10% or more of plan assets invested in the stable value option.The category brings with it a number of idiosyncratic considerations, which are driven by the same properties that allow participants to trade at book value under normal circumstances. In light of the importance of the capital preservation option within a plan, as well as the category’s complexity, we often receive questions about stable value from new and veteran investment committee members alike. We have developed this primer to expand the dialogue and provide new investment committee members with a strong foundation from which to select and monitor stable value strategies. The primer begins with how stable value funds work, including the vehicles available, the types of book value contracts they contain, and how crediting rates are calculated; and closes with operational considerations that are specific to the category.
How Stable Value Funds Work
Stable value strategies come in four main vehicles:
- Collective investment trusts (CITs) are offered by trustee banks and managed by an asset management firm. They are pooled funds and often hold book value contracts of multiple types from multiple contract providers.
- Insurance separate accounts are offered by life insurance companies and are secured by a fixed-income portfolio as well as the credit of the insurer. Assets are often pooled across plans.
- Group annuity contracts are customizable agreements between the plan and an insurance carrier. They may be supported by an insurance separate account or a general account guarantee. Assets are often pooled across plans.
- Single-plan separate accounts are negotiated and maintained by a plan sponsor’s investment committee, often with the advice of an asset management firm.They require considerable oversight and are usually considered only by large plans, such as those with at least $100 million in stable value assets, due to the monitoring responsibility as well as the need for sufficient assets to diversify among book value contracts.
Book Value Contracts
Book value contracts are instruments that are valued at cost plus accrued interest, net of cash flows.Stable value strategies exhibit low volatility due to this accounting treatment of their underlying holdings.CITs and single-plan separate accounts include at least one of three types of book value contracts: traditional guaranteed investment contracts (GICs), insurance separate account contracts and synthetic contracts.They also include a cash allocation outside the book value contracts for liquidity (4).
Guaranteed Investment Contracts
GICs are obligations purchased from insurance companies or banks that pay a predetermined rate of interest until they mature. GICs are supported by the general account assets of the insurer like an insurance policy. Since the interest rate is predetermined, the performance of the specific assets that the insurer holds in its general account is not a factor in the GIC purchaser’s return.In the event that the GIC issuer becomes insolvent, the recovery on the GIC is likely to be similar to the recovery on the insurer’s obligations to other policyholders. The interest rate on a GIC is determined by the issuer in consideration of what it expects to earn on the general account, less an allowance for the issuer’s expected profit. The difference between what is in fact earned on the general account and the GIC’s interest rate will be a profit or loss to the issuer. Since this difference is not known in advance, GIC expenses are often reported as though they are zero (5).
Insurance Company Separate Accounts
Insurance separate accounts are owned by a life insurance company and distinct from its general account. The separate accounts in which stable value strategies participate contain fixed-income securities that are overseen by an asset management firm, which may be affiliated with the insurance company.The market prices of U.S. fixed-income securities are affected by multiple risk factors, most notably interest rate and credit risk. This will cause the fair value of the separate account’s assets (the “market value”) to differ from the contract’s book value, which is the price at which the fund (or plan participants, in the case of a standalone separate account strategy offered by an insurance company) may contribute and withdraw assets from the contract.The separate account offers additional protection relative to GICs because the assets in the separate account may not be used to satisfy the issuing insurance company’s general obligations (6). Accordingly, the fund (or plan) is exposed to the possible insolvency of the issuer only to the extent to which the separate account’s market value is less than the contract’s book value. Insurance company separate accounts include asset management costs as well as the cost of the book value guarantee.
Synthetic contracts include two pieces: a fixed-income portfolio that the fund (or plan) owns, and a book value contract from an insurance company or bank. The contract allows the fund to transact with the portfolio at book value. As with separate account investments, market conditions will cause the value of the portfolio to change over time, leading to a difference between the portfolio’s market value and the contract’s book value. When redemptions that are covered by the contract are made from the portfolio, securities are sold and the book value is gradually reduced. If a large portion of the assets in the account are withdrawn when the fund’s market value is less than its book value, the portfolio may be depleted. Provided that the redemptions were allowed under the contract, the wrap contract issuer would be responsible for funding redemptions that exceeded the value of the assets in the account. The cost of a synthetic wrap contract includes the management of the asset portfolio, plus the book value contract itself. If the manager of a pooled fund or single-plan separate account hires a different asset management firm to manage the portfolio, there may also be a subadvisory or acquired fund fee.
Performance and Crediting Rates
Participants transact with stable value funds at book value, which increases at the net crediting rate. A fund’s net crediting rate is the underlying yield of its fixed-income portfolio, minus expenses, plus an adjustment for the amortization of its book value toward the market value of the underlying securities.
At the inception of a stable value strategy, the market value of its holdings and the book value are equal. From that point, the two will diverge for any strategy that includes separate account or synthetic wrap contracts as the book value changes at the net crediting rate and the market value changes with the performance of the fixed- income portfolio. The amortization component causes the crediting rate to be higher when the market value is greater than the book value and to be lower when the market value is less than the book value. This causes the ratio of the fund’s market value to its book value (M/B ratio) to approach 100% over time, unless there are outside influences such as cash flows or changes in the market value of the underlying fixed- income
securities.The gain or loss represented by the fund’s M/B ratio is normally amortized over the fund’s duration. For example, if a fund had a 102.5% M/B ratio, or its securities were worth 102.5% of the book value at which participants transact, it would receive a crediting rate that was 1.0% higher if its duration were also 2.5 years, all else held equal. This is the 2.5% gain reflected in the M/B ratio divided by the 2.5 year duration. A M/B ratio of less than 100% would dampen the fund’s performance. It is important to note that a low M/B ratio is not by itself an indicator of weak fund performance. When interest rates rise, we would expect M/B ratios to decline across stable value strategies. The way that amortization is performed suggests that, absent a persistent move in interest rates in one direction, M/B ratios should be above 100% half of the time and below 100% the other half of the time. Since contributions to and withdrawals from the fund are generally made at book value, net cash contributions to a fund will move the M/B ratio toward 100% and net cash outflows from a fund will cause the fund’s M/B ratio to diverge further from 100%. At the time of this writing, most CIT funds’ M/B ratios are greater than 100% because interest rates had generally declined in recent years. Funds that had received substantial cash inflows had lower M/B ratios because these inflows were contributed at book value and diluted the ratio(7).
Stable value funds’ expense ratios include management, operating, book value contract (wrap), and subadvisory expenses, plus payments to third parties such as recordkeepers to offset the cost of plan administration. Management fees are paid to the asset management firm and operating costs include items such as auditing fees. These tend to be stable over time. Wrap and subadvisory expenses were not reported in stable value expense ratios until new amendments to ERISA took effect in 20128. Wrap and subadvisory expenses change periodically as new investment contracts are added or allocations among them change. Some CIT managers update their wrap and subadvisory costs quarterly. Others do so less frequently, such as after the fund’s annual audit. A few do not include wrap and subadvisory fees in their expense ratios at all. We report expense ratios inclusive of these costs in keeping with the broader consensus. Distribution, client service, or plan administration expenses are usually adjustable by accessing different share classes of a given strategy. These expenses represent compensation to a third party and should be separately considered for competitiveness, based on the services that the plan receives from that party and the fairness of how the cost is allocated among options available in the plan.
Comparing Gross and Net Crediting Rates
As mentioned above, a strategy’s expense ratio may include payments to third parties that are not directly associated with the cost of offering it. For this reason, evaluating the fund’s management, wrap and subadvisory costs independent of administrative offsets, and then considering the administrative offsets in the context of the total plan, is more helpful. Accordingly, looking at the fund’s gross crediting rate relative to those of its peers can give a more targeted perspective on its relative performance, independent of the decision of how to pay administrative costs.A fund’s gross crediting rate is the yield of its underlying investments, minus its wrap and subadvisory costs, plus the M/B amortization adjustment described earlier. The net crediting rate is calculated by deducting the fund’s management fee, operating costs and administrative offsets from the gross crediting rate. Note that two types of expenses—wrap and subadvisory costs—are deducted before the gross crediting rate is reported. This convention for calculating the gross crediting rate was in place before the adjustments to expense ratio calculations were made in 2012. Its consequence is that the difference between the gross and net crediting rates is not equal to the expense ratio, since deducting the expense ratio would double-count wrap and subadvisory costs already included in the gross crediting rate.
Monitoring Risk and Return
Book value accounting causes a fund’s observed volatility to be unreflective of its risk. In lieu of volatility, we recommend a holistic review of the fund’s underlying holdings. We consider diversification among wrap providers, their quality, and the type of contracts they provide, as well as the quality of the underlying bond portfolio and M/B ratio in relation to recent changes in interest rates. We also consider a fund’s prospective crediting rate and the level and direction of its cash flows. Non-performance related considerations, such as stability of management, adherence to its investment process, and expenses in relation to other available options, are not affected by the lack of observed volatility.
Stable value strategies are more difficult for plan sponsors and recordkeepers to offer than mutual funds. This is because wrap contracts include guarantees that could be exploited by short-term trading if left unchecked. For that reason, it is necessary to balance the need for flexibility to replace strategies with the need for protection against market timing. Protections come in the forms of put periods, possible market value adjustments for employer-directed events, and competing option provisions.
Replacing Stable Value Funds and “Put Periods”
The ability to withdraw from a stable value strategy at book value is much like a put option. Wrap costs are a persistent drag on the portfolio, similar to option premiums, while the ability to withdraw from the fund at the book value represents the right to sell at a certain exercise price, even if the market value of the portfolio has declined. Contract providers, who have sold the put option, seek to limit the losses that could be caused by a group of plan sponsors exercising the option at the same time. Since the assets referenced in a contract are typically sold before the contract provider is required to contribute capital, the potential loss to a contract provider is the amount by which the contract’s book value exceeds its market value. The amortization of the book value toward the market value described earlier gradually diminishes this difference over time, absent defaults or cash outflows. The issue for the contract provider then, is the extent to which investors in the fund might redeem their interests before the market value has time to reach the book value when the M/B ratio is less than 100%. Participants are less likely than plan sponsors to act in a concerted fashion, due to the large number of individual participants making independent decisions about whether to withdraw from a fund. They are afforded daily liquidity at book value. However, plan redemptions involve larger portions of a fund’s assets and redemptions made at the plan sponsor’s direction are often restricted. The maximum period a plan sponsor may be required to wait in order to liquidate the plan’s investment is called the put period. This is most often 12 months for CITs. Single-plan separate wrap contracts may have longer put periods, such as one equal to the duration of the portfolio. Group annuity contracts and insurance company separate accounts offer a broader range of termination timelines, which are sometimes contingent on the M/B ratio or prevailing interest rates at the time of termination. Without liquidity restrictions, plan sponsors could exit the strategy when the M/B ratio is less than 100%, receiving book value and leaving a loss in the strategy to be spread across a smaller pool of remaining investors. This would increase the risk to the fund’s wrap providers and reduce future returns for remaining investors. Consequently, the put period serves as an element of protection for long-term investors, but it comes at the cost of reducing the plan sponsor’s ability to replace the strategy. In stable value CITs, the fund’s trustee may choose not to subject plans to the full put period. This decision is based on the trustee’s assessment of what is best for the fund. At the time of this writing, M/B ratios in most CITs are above 100%. Since withdrawals leave a gain to be spread among remaining investors, benefiting those that remain, some CITs are processing terminations without requiring plan sponsors to wait for the put period. Other CITs continue to enforce their put periods.
As discussed above, stable value contracts are less risky for contract providers when redemptions occur randomly than when large redemptions are made at the same time. In the case of large, coordinated transfers, additional protection is added through the put period. However, to protect against sudden large withdrawals, there are certain circumstances where participant withdrawals may be made at the lower of the book and market values. This may occur when the participant withdraws from the fund due to an action by the plan sponsor, such as divestment of a division where the participant had worked or bankruptcy by the plan sponsor. If the plan sponsor advises participants to divest from the fund, their transfers would also be considered employer-directed. Small transfers arising from employer-directed events may sometimes be made at book value, up to a limit set by the fund’s “corridor provision,” if one is in place. This type of transfer tends to be less problematic with pooled vehicles because each plan comprises only a portion of the total fund.
In a re-enrollment, the plan sponsor reallocates existing plan participants’ balances into other options in the plan, such as the qualified default investment alternative. This can result in withdrawals from the stable value option. Some strategies treat re-enrollments as employer-directed events and require that notice be given and the put period elapsed before they are implemented. Others consider re-enrollments to be participant-directed transfers if participants are given the opportunity to choose not to participate in the re-enrollment with sufficient notice. It is important to understand how the specific stable value option offered by a plan treats related transfers when planning re-enrollments.
Competing Options and the “Equity Wash”
While put periods and re-enrollment considerations address employer-directed transfers, participants also have the opportunity to transfer out of a stable value option after interest rates have risen, leaving mark-to- market losses in the fund for other investors. To protect against arbitrage between stable value strategies and other options in the plan, stable value options commonly have competing option provisions. The definition of a competing option is specific to the stable value strategy, but most often includes money market funds and short-term bond funds with less than three years of duration. Self-directed brokerage accounts are frequently considered competing because of money market and short-term bond options that are commonly available within them. Depending on the strategy, funds that invest primarily in U.S. Treasury Inflation-Protected Securities may also be considered competing. When another fund in the plan’s menu is considered competing, the stable value fund requires the plan’s recordkeeper to prevent transfers directly from the stable value option to the competing option. Proceeds from redemptions from the stable value option must generally be held in an option that is not considered competing, such as an equity fund, for a period that is most often 90 days. This delay can prevent participants from investing in options containing what may then be higher-yielding securities as quickly as they otherwise would have been able. The requirement to transfer into a non-competing option is also called an “equity wash.” Some stable value strategies may not be offered alongside certain vehicles, such as money market funds or self-directed brokerage accounts, even if an equity wash procedure is in place at the recordkeeper. We hope this has served as a helpful introduction to the stable value category. We are glad to serve as a resource for plan sponsors with questions about these and other aspects of both stable value strategies and retirement plan design. Please let us know how we can be of assistance as your investment committee considers the options that best align with your participants’ needs.
Ben Baldridge, CFA, CAIA, Senior Investment Research Analyst, Newport Group
1 Callan Associates. 2016. The Callan DC Index. [ONLINE] Available at https://www.callan.com/tools/dcindex/prevalence/. [Accessed 15 June 2016].
2 Stable Value Investment Association. 2016. Stable Value at a Glance. [ONLINE] Available at http://stablevalue.org/knowledge/stable-value-at-a-glance/. [Accessed 15 June 2016].
3 Investment Company Institute. 2016. Release: Quarterly Retirement Market Data, Fourth Quarter 2015. [ONLINE] Available at: https://www.ici.org/research/stats/retirement/ret_15_q4. [Accessed 15 June 2016].
4 Caswell, John R. and Karl Tourville, 1998. The Handbook of Stable Value Investments. 1st ed. New Hope, PA: Frank J.
5 Stable Value Investment Association. 2015. Stable Value Guaranteed Insurance Accounts: Frequently Asked Questions. [ONLINE] Available at: http://stablevalue.org/media/misc/Guaranteed-Insurance-Account-FAQ.pdf. [Accessed 15
6 Prudential Financial, Inc. 2013. Seeking Better Retirement Outcomes with Insurance Company Separate Accounts. [ONLINE] Available at:http://research.prudential.com/documents/rp/Insurance_Company_Separate_Accounts.pdf. [Accessed 15
7 Newport Group analysis of our internally maintained stable value peer group. Funds included in the peer group are those that are structured as CITs, use multiple wrap providers and are either held by one of our clients or we expect to be available for potential investment by our clients. As of 31 March 2016, the peer group included 18 pooled funds with total assets of $135 billion.
8 Pensions & Investments. 2013. Regulatory update: A look at fee disclosure and wrap definition. [ONLINE] Available at: http://supplement.pionline.com/stable-value/regulatory-update.php. [Accessed 15 June 2016].
FOR INFORMATIONAL PURPOSES ONLY.
Securities and investment advisory services offered through Newport Group Securities, Inc. (“NGS”) Member, FINRA (finra.org). NGS is located at 300 International Parkway, Suite 270 Heathrow, Florida 32746. Phone: 407–333–2905. NGS and Newport Group, Inc. are affiliated entities. Any information presented in connection with this communication is general in nature and is not intended to provide personal investment advice. Before investing, please talk with your investment consultant and obtain a fund prospectus. The prospectus contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.This information does not take into account the specific investment objectives, financial situation, and particular needs of any investor. Investors should understand that statements regarding future prospects may not be realized. Past performance does not indicate future results. All investments are subject to risks, which may result in the loss of principal. This information is provided solely for educational purposes only and is based on information available at the time of publication. It does not consider subsequent developments that have taken place after publication. Any discussions concerning investments should not be considered a solicitation or recommendation by NGS. Any information presented about tax considerations affecting your financial transactions or arrangements is not intended as tax advice and cannot be relied upon for the purpose of avoiding any tax penalties. NGS, Newport Group, its affiliates, its registered representatives, and investment advisory representatives do not provide tax, accounting or legal advice. An investment in a stable value fund is neither insured nor guaranteed by the U.S. government. There is no assurance that the fund will be able to maintain a stable net asset value and it is possible to lose money by investing in the fund. Stable Value Funds are not made directly available to the general public. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund. Investments in bond funds are subject to interest rate, credit, and inflation risk.
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FOR INFORMATIONAL PURPOSES ONLY.