Investment Consultant
Bridgebay Financial, Inc.
Stable-value funds have played an integral role in
employer retirement plans and have evolved, growing in complexity and
structure. Despite issuer downgrades and constraints on wrap capacity, demand
for stable-value funds continues to be strong as participants seek safety from
the volatility of equity markets. This article examines the unique
characteristics of stable-value funds and identifies the benefits and potential
downsides of this in-vestment strategy.
Until the financial crisis, stable-value funds were
considered a conservative investment option, being a hybrid asset class that
produced bond-like returns while seeking to maintain a stable principal value.
The advent of the financial crisis exposed several structural weaknesses and
caused numerous detrimental plan events that negatively impacted these funds.
Today, stable-value fund providers face countless
challenges including limited wrap capacity, restrictive investment guidelines,
higher wrap fees and exceptionally low yields.
Background
Prior to the financial crisis, banks and insurance
companies considered wrap insurance contracts to be a highly desirable source
of revenue. Competition for this coveted market rapidly grew, resulting in
increasingly thin wrap fees or insurance premiums as wrap providers took on
increased risks by insuring a broader range of riskier asset classes without
differentiating for potential risk/returns. The plan sponsor benefited from the
low fees and excellent yields with perceived principal protection.
During the financial crisis, the prices of the
underlying assets dropped dramatically (yields on bonds rose sharply) causing
market-to-book ratios for many stable-value portfolios to plunge below 100%.
Contractually, wrap providers insure the difference between the market and book
value of a plan and have to step in to provide capital when the market value is
significantly below book value.
What is a Stable-Value Fund?
Today’s stable-value fund is typically a
high-quality, diversified portfolio of fixed income in-vestments that includes
U.S. Treasury and Agency securities, corporate bonds, asset-backed and
mortgage-backed securities held in commingled bond trusts or mutual funds.
Another variation of the stable-value fund is the
synthetic GIC (guaranteed investment contract) which consists of a fixed-income
portfolio and a wrap contract issued by a bank or insurance company that
guarantees the principal.
Stable-value funds generally are available as
separately managed accounts or commingled funds.
Separately managed accounts are comprised solely of
the assets of a specific DC plan managed to their unique investment guidelines.
No other plan assets are in the account. Commingled funds, similar to mutual
funds, combine the assets of multiple unrelated DC plans in one fund. There are
restrictions that apply to the fund's liquidity provision called the
"equity wash rule" or competing fund rule that forbids any redemption
out of the stable-value fund into a "competing" fund such as a money
market fund or a short-duration bond fund (typically less than 3.5 year duration).
Long duration bond funds and equity funds are considered noncompeting funds and
money must stay at least 90 days.
Book Value Accounting
Stable-value funds seek to maintain a $1 per unit
price. Interest is credited to the account. These funds use book-value
accounting to smooth out any difference in market values and provide a stable
net asset value (NAV).
A successful stable-value fund relies on having
well-capitalized and financially sound wrap providers, close tracking of the
market-to-book value ratio and reasonable cash flows to insure liquidity and
participant withdrawals without principal loss.
Participant directed withdrawals from the
stable-value fund are made at book-value rather than market value. This works
well for the fund when the market values are higher than the book values but is
problematic when market values fall below book values. When the market-to-book
value ratio drops below 100%, the wrap provider insurance may be triggered to
pay out the participant at book value or principal.
During the turbulent financial crisis, the market
value of the underlying securities in many stable-value funds fell below the
book value triggering the guarantees.
Wrap Provider Exposure
Stable-value funds have unique structural risks
that differ from fixed income bond funds. The fund's reliance and exposure to
wrap providers can be quantified as the difference between book value and
market value of the underlying investments. As the market-to-book value ratio
falls below 100% the risk to the wrap provider grows because the provider is
required to make up the difference in order to provide liquidity.
Employer-Initiated Event Risk
Event risk arises when the market value is below
the book value and a plan level or employer-initiated event other than a
termination occurs. During the crisis, layoffs, mergers, divestitures, plan
changes and bankruptcies triggered "plan events". Many contracts
enable wrap providers to pay participants less than the book value (principal)
at redemption when employer-initiated events occur.
This plan level event risk was significant in
separately managed stable-value funds that were dedicated to a single plan.
Commingled stable-value funds that pool the investments of multiple, unrelated
plans fared better.
Stable-value funds have been widely used yet not
fully understood as to how various events are treated by book value guarantee
providers (wrap providers). Even some of the retirement plan consultants
advising DC plans on the fund selections were not well versed on the wrap
provider covenants until the plan was notified of a potential violation.
Employer-initiated events can lead to payments to
participants at market value, which during recent times of stress, have been
below book value.
Fortunately, plan sponsors are now generally more
discerning of the creditworthiness and financial strength of the wrap provider
while historically, fees had been the most significant criteria for selection.
Insurance Costs Rising
table-value portfolios have been traditionally
insured by insurance companies. As a result of poor fixed income performance
and pricing, heightened market volatility, and increased capital requirements,
many wrap providers have raised fees, tightened portfolio requirements or
exited the market altogether.
New wrap capacity entering the market consists of
insurance companies that are charging 2-3 times the fees previously charged.
Wrap insurers are also requiring that their asset management services be used
as part of the stable-value program in order to gain access to wrap capacity.
Many wrap providers have exited the market because
the margins are too thin or they lack sufficient capital or resources to
maintain this exposure. Issuer downgrades, constraints on wrap capacity, and
low fees are limiting the availability of stable-value funds.
Regulatory Impact
New regulations present new and ongoing challenges
to the stable-value market. The financial crisis triggered bank regulatory
reforms with the introduction of Basel III and Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank) in July, 2010.
These regulations have prompted bank wrap providers
to re-evaluate the market and reduce their wrap insurance exposure. As some
banks have exited the wrap business, a number of insurers have re-entered the
market.
Declining yields exacerbated by higher expenses and
wrap fees make these complex and less transparent investments less desirable in
the current market environment.
Conclusion
Plan sponsors that have a stable-value fund option
in their DC plan should understand the structure of this investment option, new
developments in the wrap issuer market and the risks associated with this
perceived "safe" option. A review of the stable-value documentation
should focus on under-standing what events may trigger a violation of the wrap
agreements, causing a potential market value adjustment (loss). Any clauses
that could impair the coverage provided by wrap providers should be understood.
Enhanced, timely re-porting and transparency to the underlying investments for
quarterly reviews should be available to the plan sponsor to ensure consistent
due diligence.
Plan sponsors should re-evaluate the stable-value
option within the plan's current fund line-up to determine if it still meets
the needs of the plan's participants. A short bond fund that provides current
income, minimal principal volatility and the flexibility to transfer money may
offer a less complex and more transparent investment alternative for a plan
sponsor to monitor.
