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July 2014 Employer Update Stable Value Q & A

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July 2014 Employer Update Stable Value Q & A . Page 1 of 6 July 2014 . Stable Value Q & A Andrea Bongiovanni, CFS, CIMA . Stable value funds are a staple in defined contribution plans, with $701.3B invested across 189,000 plans, which account for approximately 14% of total defined contribution assets1. 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 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? A stable value fund is an investment vehicle for defined contribution plans, whose primary objective UPDATE 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 Employer underlying investments. This rate of return is backed by the full financial strength and credit www.usiadvisorsinc.com 1Stable Value Investment Association: http://stablevalue.org USI Advisors, Inc. 95 Glastonbury Boulevard . Suite 102 . Glastonbury, CT 06033 . 860.633.5283 . www.usiadvisorsinc.com Employer UPDATE. 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 components2. 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 absorbers3” 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. 2Landmark Strategies: http://www.lmstrategies.com/types~2.html 3JPMorgan Retirement Plan Services: https://www.retireonline.com/rpsparticipant/education_center/The_Way_Forward/Frequently_asked_questions_about_stable_value_funds.jsp USI Advisors, Inc. 95 Glastonbury Boulevard . Suite 102 . Glastonbury, CT 06033 . 860.633.5283 . www.usiadvisorsinc.com Employer UPDATE. 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.
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