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SVIA's National Forum Capitol Ideas: Inside the National Retirement Debate An Outlook for Stable Value

The Role of Alternative Products & Markets

The Stable Value Investment Association's National Forum on Capital Ideas: Inside the Retirement Debate opened with a symposium on October 27 on alternative products and markets. Much of the symposium's discussion focused on keeping stable value attractive to investors and growing market share.

Using Equities in Stable Value

The symposium's first debate was the role of equities in stable value. "Equities are slowly making their way into stable value portfolios," says C. Jason Psome, a Principal at Bankers Trust.

Robert W. Whiteford, a Vice President in Bank of America's Financial Engineering and Risk Management Group, supported adding equities to a stable value portfolio. "If you are looking at it for the long haul having a mix of equities and fixed income, I think that would be a good thing" Whiteford declares. He is also weighing adding commodities in a stable value portfolio.

"Well of course it can be dangerous, just as actively managed fixed income funds can be dangerous if they aren't properly managed. It is also another way to diversify your investment options and reduce the volatility of the funds managed," explains Whiteford.

While the products are exciting, a conservative industry may frown on using these new asset classes. Education efforts have trained participants to expect fixed income products and GICs to be the dominant, if not exclusively the assets that comprise a stable value portfolio. Including new, and riskier, assets requires new educational efforts.

"This is one component of stable value which is, unfortunately, not necessarily scientifically related," Psome emphasizes. "How the stable value option is communicated to participants will determine what you put in because it is also a public relations issue."

However, the industry may not yet be quite ready to add equity assets to stable value portfolios. Based on a poll of symposium participants, almost all of the 125 participants supported traditional asset classes in stable value, bonds and GICs. Only three participants supported including equities in a stable value portfolio. No one at the symposium supported adding commodities or managed futures in a stable value portfolio.

"We, historically, have really not even taken the idea of introducing equities into stable value portfolios too seriously," explains Karl P. Tourville, a Managing Partner at Galliard Capital Management. "I would say that now is not the time to look at new asset classes...The participants out there are expecting rock solid returns. Who am I, as a manager, to decide that they need equity exposure?"

Indeed, participants are choosing a stable value option for its predictable return and the safety of their principal. They are "savers" who want to avoid risk. The recent, stock market volatility may only increase their aversion to equities.

"We as an industry should be very careful about `diversifying' into equities or other new asset classes. While the returns associated with these asset classes may be uncorrelated with interest rates, they are also apt to introduce unanticipated volatility into a stable value fund," concludes Jacqueline Griffin, the Chief Actuary at Diversified Financial Products.

Stable Value Enters Mutual Fund and IRA Markets

Bankers Trust recently launched two stable value mutual funds. "One was developed for the institutional market and the other was developed for the IRA market, the individual market," Psome explains. "The landscape is definitely shifting towards a mutual fund provider environment and stable value was the only option...not covered in mutual fund format."

The format is a "liquid bond portfolio" that does not have the traditional guaranteed investment contract, or GICs, that would fall into an illiquid basket. Equities can add greater liquidity. The duration in the portfolios is slightly longer than a traditional stable value fund and the funds have a "global wrap." The funds have their own ticker symbol that participants can check on-line or in their daily paper.

"On the IRA side, we think this is really something that folks are going to be excited about when they retire if they've enjoyed the luxury of a stable value fund in their plan," Psome predicts. The IRA option allows participants to move their assets into a fund that is less risky than an equity fund and will generally outperform a money market fund, by about three percent, over time.

"The biggest boom for stable value, as an industry, will come from the ability to tap the IRA and the IRA-rollover market which is somewhere around $115 billion which now moves into money market funds," Psome asserts.

Global Outlook for Stable Value

New markets for stable value products were also a part of the symposium's focus as well. While the financial services industry is eyeing the globe, much of the world has yet to discover stable value investments.

"I see a lot of demand for guaranteed products internationally," states Galliard's Tourville. "There's interest in Japan, there's interest in Canada, there's interest in Latin America...I would say that the future looks bright for managers who look beyond traditional markets."

Looking North to Canada

The Canadian market is sizable, but still dominated by defined benefit schemes. As of 1997, $528 billion, in Canadian dollars, was held in defined benefit plans. In 1986, 92 percent of the workforce had their retirement assets in a defined benefit plan. That number has declined to 87 percent in 1997. However, there has been a dramatic rise in mutual fund assets, which have increased in Canadian dollars, from $187.5 billion in 1996, to $289.8 billion this year.

The market, nevertheless, presents some unique issues for stable value, not the least of which is that GIC providers in Canada already offer some innovative products that allow investors to participate in equity markets while guaranteeing the investor's principal.

These are "GICs with guts," according to John Appleton, a Senior Vice President and Senior Investment Consultant with Fidelity Institutional Retirement Services. Typically, these GICs carry maturities of two to five years with a rate that can be tied to the Morgan Stanley World Index, the Standard & Poor's 500 Index or the performance of the Toronto Stock Exchange. The products are sold to both individuals and institutions.

"Compared to the bold Canadians, we in the U.S. seem to be accepting of a very reduced role of GICs in retirement investing," Appleton says. "They had GIC products that appealed to young people."

There are also regulatory hurdles that providers face, according to Jennifer Northcote, a Partner at Stikeman Elliott, a Toronto law firm. First, the regulation of securities and investment products is left, primarily, to Canada's ten provincial governments which, increases the complexity of operating in the market and may increase the costs. For example, like the U.S., investment advisors and dealers are required to be registered. In addition there are prospectus requirements to consider.

"Typically, for offshore products or U.S. products being managed outside Canada or sold in private placement in Canada, legal practitioners are of the view that portfolio managers of the product do not have to be registered in Canada," Northcote remarks. Ontario is the exception to this registration rule.

"If you sell an offshore mutual fund to an Ontario resident, you are deemed to be advising that Ontario resident," Northcote says, and need to consider advisor registration requirements.

Most important is the foreign content limitation Canadian law places on pension schemes and tax-deferred plans. A maximum of 20 percent of assets, by cost, may be invested in non-Canadian property. Canadian investment managers continue to lobby to change this restriction.

"The managed product market is becoming more and more competitive," Northcote states. "The fees are dropping, principal protection is varying...insurance products are offering more re-set options and shorter maturities."

Looking to the Old Country, Europe

The European market also received significant attention from SVIA Forum participants. The January 1, 1999 launch of a common currency for 11 European countries is expected, in some circles, to create a huge market and a powerhouse economy.

"The possibilities are dazzling," says Jonathan L. Mercier, a Partner at Turco and Mercier, a law firm. "I'm not going to tell you how to make a killing in this market or who are going to be the winners and losers because quite frankly I don't know. That is very hard to predict. What is easy to predict is you ought to see some real dramatic changes in that market over the next couple of years and there ought to be some real, dramatic opportunities."

The European pension market, according to Mercier, has some $3.0 trillion in assets. Those assets are held, largely, in defined benefit plans. GIC products, Mercier notes, were originally a tool for the defined benefit market. The picture, however, is not entirely rosy. The United Kingdom holds one third of those pension assets.

"It is also the one that has a pension system that is most similar to the one we have in the United States," Mercier remarks. "In the United Kingdom, they are committed to equities...It's a big market, but it's not the best market in the world from a stable value perspective."

There is a growing movement towards defined contribution plans in Europe, according to Mercier, with defined contribution plans making up roughly ten percent of plans in the United Kingdom. The launch of a common currency may speed the development of a defined contribution market. Employees may come to expect pension assets that are portable not just from employer to employer, but across national borders.

"It is very, very hard to provide meaningful portability if the basis for your pension program is a defined benefit scheme," Mercier says. "It is much easier to provide portability if your core pension program is a defined contribution. I do think that, over time, it is going to move Europe...to a defined contribution scheme. It is not going to happen quickly."

Another driver towards defined contribution plans is underfunding of defined benefit plans. European public plans, like the U.S. Social Security system, are pay-as-you-go. They use a "book reserve" method, according to Maarten Nederlof, a Managing Director at Deutsche Bank Securities. In other words, they simply make note of the liability.

The result is Europe faces staggering liabilities. Germany's unfunded pension liabilities are equal to four times its gross domestic product, according to Dr. Lars Norup, Head of Northern Europe Derivatives Marketing at Greenwich Natwest. In France, those liabilities equal three times that country's gross domestic product. In contrast, the U.S. liability is equal to three percent of our nation's gross domestic product.

"Many of them are actually technically bankrupt if you use U.S. accounting standards," says Nederlof. "One of the key issues is if pensions are going to start really funding up and investing in capital markets what are they going to invest in? It turns out that the corporate bond markets and equity markets in Europe are really rather small."

In Germany, for instance, bank lending accounts for 99 percent of corporate funding. In contrast, 36 percent of corporate funding comes from bank lending for the U.S. Additionally, European pension funds are restricted in where they can invest. Lacking cash, some European governments are enacting policies that favor private plans, according to Nederlof.

The dearth of investment products could be an opportunity for stable value. "Europeans just don't dig stocks the same way that Americans do," Nederlof remarks. "Europeans tend to prefer guaranteed pensions...For the most part, fixed income instruments, interest savings accounts, annuities tend to really dominate pension schemes in Europe...We know Europeans like guaranteed investments, in theory, therefore they should be much more interested in stable value type products compared to the U.S."

Entering the European market, however, and competing there will not be easy, according to Dana Troxell, a Vice President with the Goldman, Sachs Asset Management Advisory Group. Europe comprises, roughly, one third of the global investment management market and 80 percent of those assets are managed by European banks and insurance companies.

"It's become a very capital intensive game," Troxell reports. "What will rise in importance is brand identity and access to capital...For those companies looking to expand abroad, it's going to be a very, very tough fight...We believe that international expansion -- Europe, Asia, Latin America - is going to be considerably more difficult than we thought three or four years ago."

Media Challenge: Getting Coverage in a Bull Market

Charlie Ruffel, Editor-in-Chief of Plan Sponsor magazine, challenged the industry to seize these new market opportunities. He urged participants to learn from the success of large mutual funds who have used branding to establish market position, noting that the bull market has also played a role in their success. "They've done that on the back of aggressive branding," Ruffel asserts.

The financial press is starry-eyed over equities advises David Albertson, the Editor of Employee Benefit News. Albertson notes its hard to get the press to focus on stable value in a "smart equals stock" environment.

That is changing, according to SVIA's Chairman John E. Milberg, a Senior Vice President of the Institutional Products Group at the Pacific Life Insurance Company. "If you think back about what's happened in our industry, there's been some good things and some bad things," says Milberg of SVIA's ten-year history. "I believe the media stories are now in our favor...We have come a long way and it's a positive path...."

U.S. Social Security Participants: Another Market?

Depending on the result of Social Security reform, the U.S. may become a very large market. One reform proposal would establish a personal retirement account for each U.S. worker and fund those accounts with two percent of annual earnings up to Social Security's current limit of $68,400. By one estimate, that plan would create 147 million accounts.

Social Security was signed into law in 1935 and established as a pay-as-you-go system with contributions from current workers and their employers funding the benefits of retirees. The system has generated surpluses since 1983. However, there as always been significantly more workers than retirees. Those surplus funds have been invested in U.S. Treasury bonds. The estimated revenues for the Social Security Administration in the 1998 calendar year, excluding Medicare income, will reach $426.7 billion. The system will have a surplus of $57.6 billion in 1998.

The ratio of workers to retirees hit its peak in 1950 with 16 workers for every retiree, according to a 1997 "white paper" from Towers Perrin, a benefits consulting firm. It has shrunk to 3.3 to 1 in 1996 and is expected to fall to 1.8 to 1 by 2030. In 2013, income will fall below benefit payments and the system will begin spending down its surplus. By 2032, Social Security will have income to pay only 75 percent of its promised benefits.

Key public interest groups agree on the need for Social Security reform. In fact, the American Association of Retired Persons (AARP) who has over 30 million members supports Social Security reform. Organized labor has also signed on. In August, the Executive Council of the AFL-CIO, which represents some 15 million workers, endorsed "seven fundamental principles" that should guide reform.

Agreement stops there. The debate is just beginning on the extent of the Social Security's problems and potential solutions.

Michael Tanner, the Director of Health and Welfare Studies at the Cato Institute, a conservative think tank, put Social Security's unfunded liability at $10.0 trillion. While U.S. Senator Rod Grams, a Minnesota Republican, tagged the liability at $20.0 trillion.

"What we do agree on is that we need some pre-funding," says Dr. Wendell Primus, the Director of Income Security at the Center on Budget and Policy Priorities, a liberal think tank.

Tanner argues for individual accounts only. Primus supports a government run trust that invests broadly in financial markets. Grams argues for a "fully, personalized retirement system" with up to ten percent of earnings invested with a government-approved provider. "In my plan, we call for setting up a board to create rules and regulations that these companies would have to abide by," Grams says. The funds could only be used for retirement.

"I think we should be looking for reform probably past the year 2000," predicts Senator Grams. Kenneth J. Kies, a Managing Partner at PriceWaterhouse Coopers and the former Chief of Staff of the Congressional Committee on Taxation, sees a more immediate possibility.

"My own view is if we don't get this done in the first nine months of next year the window will close," Kies says. The current budget surpluses, give Congress room to take up a tough issue like Social Security reform.

"President Clinton's going to be looking for his legacy," Kies states. "The president is clearly very aware of how he could be portrayed in history and it is not a pretty picture. Social Security reform may well prove to be his chance to redefine his place in history."

Role of Pension Reform Unclear in Social Security Debate

How the pension industry will fare in the Social Security debate is an open question. The industry was unable to move legislation through Congress this session despite some 50 to 60 bills pending, reports Lynn Dudley, Vice President at the Association of Private Pension and Welfare Plans.

"I was disappointed there was no pension legislation this year," Dudley says. "On the other hand, I was not really surprised. In order for pension legislation to be passed you've got to have a lot of people singing from the same sheet."

Market Outlook: More Volatility in Equities & Low Interest Rates

According to Edward S. Hyman, the Chairman of ISI Group, 1999 will see more volatility in equities and low interest rates. "The feeling that I have for next year is that it's going to be a tough year," Hyman predicts. "There are probably a half dozen markets that are signaling that something is coming."

A Look at the Life Insurance Industry

A recent study by Moody's Investors Services found the life insurance industry on solid financial ground when comparing GIC and bond default rates as well as recoveries. "What it shows is that the life insurance industry does pretty well," Keven W. Maloney, a Vice President and Senior Analyst at Moody's. "We think the life insurance industry is a high quality industry, and definitely the highest in the financial services industry."

The cumulative life insurance insolvency rates from 1988 to 1997 were just above investment grade credits and substantially better than corporate bonds. Also, GIC default rates since 1980 were less than both investment grade defaults and all corporate bonds. Recoveries in the life insurance industry were exceptional, Maloney found. GIC investors in Executive Life, Mutual Benefit Life and Confederation Life, on a discounted present value basis, recovered an estimated .70, .96 and .90, respectively, on the dollar excluding any state-guaranteed payments. Bank loans, the next closest category, paid .70 cents on the dollar.

However, Maloney sees challenges ahead for the industry. He cautions, "We're seeing very low levels of growth in life insurance sales with a lot of companies chasing too few customers. The insurance industry also has a mixed record on customer service and cost control."

SVIA Honors Murray Becker

Murray Becker recognized as the founder of stable value was honored at SVIA's Forum. Mr. Becker, who currently serves as Vice President at J.P. Morgan, reflected on the origins of stable value. "In 1972, a client asked me to develop a safe product for plan participants. . . ;Out of this we built an industry," muses Becker.

Becker had some advice and hopes for his colleagues as he approached his upcoming retirement at the end of this year. "Stable value investments have to be good for the customer. We have to make money at it too...There's always a role for a traditional product that guarantees principal and preserves a much higher rate of savings. At J.P. Morgan, we have seen plan sponsors return to stable value to the tune of $4.0 billion in just the past four months."

Please note J.P. Morgan is hosting a retirement party on December 7 for Murray. For more details, see page xx of Stable Times.

SVIA Effort on Proposed Class Exemption For Synthetic GICs Explained

SVIA is seeking a Department of Labor class exemption for synthetic GICs. The proposed exemption, when granted, will permit a synthetic GIC issuer, or an affiliate, to also manage the assets of the contract. Currently, synthetic GIC issuers encounter ERISA prohibited transaction constraints when seeking to manage assets and provide a synthetic wrapper. ERISA section 406(a) prohibits party-in-interest transactions and 406(b) bans what might be called self-dealing. The exemption request comes at a time when, increasingly, plan sponsors want one-stop shopping, increased efficiency and reduced costs for plan participants.

"We're hearing from members that there is a trend line towards wrappers and managers being one and the same," says Alfred A. Turco, the Chairman of SVIA's Government Relations Committee and a Partner at Turco and Mercier, a law firm. The Labor Department is concerned about the potential of abuse, specifically, self-dealing or fiduciaries using plan assets for their own benefit.

Al Turco and Steve Saxon, a Principal at the Groom Law Group, explain that the Department's concern with potential self-dealing can be overcome through some give up of discretion by the GIC issuer and with greater disclosure to the plan. However, if the disclosure requirements are too extensive or onerous, plan sponsors will be less inclined to buy synthetic GICs.

"We want stable value products to be offered in 401(k) plans and other defined contribution plans consistent with other products out there. We are more than happy to provide meaningful disclosure just like anybody else," explains Saxon. "However, if we end up with disclosure requirements that go beyond 404(c), that creates a problem for everyone," concludes Saxon.

Picture captions

The conference was not entirely serious. Politics, in a lighter vein, also emerged over the course of the two-and-a-half day meeting. The Capitol Steps, a comedy troupe comprised of former Congressional staffers, was the featured entertainment during the welcoming reception. Chris Matthews, the host of CNBC's Hardball and the Washington Bureau Chief for the San Francisco Examiner, and Mike McCurry, the former White House Press Secretary, were the luncheon speakers.

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