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Home > Library > Stable Times > Volume 3, Issue 3
The quarterly publication of the Stable Value Investment Association
Third Quarter 1999 • Volume 3 Issue 3
DC Plan Brokerage Accounts:
Rened Challenge for Stable Value Providers
By Randy Myers
The growing popularity of self-directed
brokerage accounts in defined contribution plans is reviving an old challenge
for the stable value industry: how to prevent plan participants from arbitraging
their stable value funds during periods of rapidly rising interest rates.
For many years, the only such arbitrage threat came from money market
funds and other very short duration bond funds. When interest rates spiked,
participants in 401(k)s and other defined contribution plans had an incentive
to swap money out of their medium-duration stable value funds and into
cash equivalents. Had they done so, they could have forced their stable
value funds to make benefit payments when the market value of the fund
was less than the book value. The economic loss associated with higher
rates would be transferred to the remaining participants in the stable
value funds or the issuers.
To prevent this risk-free arbitrage, plan sponsors have long imposed an
"equity wash" requirement on plan participants who want to switch
out of a stable value fund and into a so-called "competing fund."
Competing funds are usually defined to include money market funds and
other fixed-income funds with very short duration. Equity wash rules say
that money cannot be transferred directly from a stable value fund to
a competing fund; instead, they must be transferred to an equity fund
first and held there for a minimum period of time, usually 90 days. Therefore,
the participant must expose themselves to the possibility of negative
returns in an equity investment in order to capture the higher returns
available in the competing fund.
Today, self-directed brokerage accounts are broadening the need for equity
wash rules. While brokerage accounts are not a "competing fund"
per se, they can function that way since participants can invest in money
market funds via brokerage accounts. In fact, most self-directed brokerage
accounts are set up so that contributions must go into a money market
fund before being channeled into other assets, such as stocks, bonds or
mutual funds. Accordingly, most plan sponsors have bowed to the demands
of stable value issuers (including traditional GICs and synthetics) and
agreed to classify their brokerage accounts as competing funds. (Stable
value contracts are typically written so that issuers must be informed
when a new investment option is offered within a DC plan, and to provide
for an equity wash in the case of competing funds.)
Brokerage Accounts: A New Issue For Stable Value
This issue wasn't even on the radar screen for most plan sponsors until
very recently. Five years ago, so few of them offered brokerage accounts
in their DC plans that Spectrem Group (then Access Research Inc.), a financial
services consulting firm in San Francisco and Windsor, Connecticut, didn't
even keep tabs on them. Now it does, and in last year's survey it found
that approximately 7% of the nation's 401(k) plan participants could access
a brokerage account and that approximately 17% of those who could had.
That's up from 4% and 13%, respectively, in 1996.
"I think the use of brokerage accounts will continue to grow modestly,"
says Jeffrey Close, Spectrem's director of marketing. "We see it
used most often at two ends of the DC-plan spectrum: smaller, professional
services type companies, and very large employers who simply want to provide
as many options as possible to their employees."
Equity Wash Rules: A Way to Handle Competing Fund Issues
While equity wash rules are commonplace, they're not always popular with
plan sponsors.
"Plan sponsors who've never had competing funds in their plans sometimes
aren't familiar with the equity wash requirement, and aren't pleasantly
surprised to find out about them," observes Kim McCarrel, a senior
portfolio manager with stable value manager PRIMCO Capital Management
in Portland, Oregon. "We've seen a number of them really struggle
for a way to get around it, but I've never seen anybody do it."
"I wouldn't have put an equity wash requirement into our plan if
the issuers hadn't forced me to, because I just don't like to put restrictions
in our plan," says Don Butt, vice president of operations and defined
contribution plans for U S WEST Investment Management Co. "But I
know in this case we would have lost access to a significant portion of
the bidding universe for stable value contracts if we hadn't done it."
Are Brokerage Accounts An Arbitrage Opportunity?
So far, arbitrage between stable value funds and brokerage accounts hasn't
actually been a problem, although it's hard to tell if that's because
equity wash rules work or because interest rates haven't moved sufficiently
to test them.
"We don't see money draining out of stable value funds to go into
other equity funds and then into brokerage windows," says McCarrel.
"What we see is that between 5% and 15% of plan assets eventually
migrate to the brokerage accounts, but usually not in the form of large
lump-sum transfers. People just start putting new contributions into the
brokerage account."
Accordingly, McCarrel says there's been no need as yet for her firm to
increase its allocation to cash in its stable value portfolios.
Although most industry insiders say they've never seen a defined contribution
plan that didn't have an equity wash rule to protect a stable value fund
from competing-fund arbitrage, Marc Magnoli, a vice president in pension
derivatives at Chase Manhattan Bank, is familiar with plans that have
no transfer restrictions between the stable value fund and the brokerage
account option.
"The issue for us is the stable value manager's ability to manage
liquidity at least one level above the contracts," Magnoli notes.
"If an equity wash is unacceptable, other sources of protection are
available, such as having multiple tiers of liquidity, imposing fees for
transfers, or having transfer prohibitions tied to interest-rate trigger
levels. The downside to these alternative strategies is that they either
reduce the fund's duration and hence expected returns, or are more difficult
for the plan sponsor to administer and for the participant to understand."
Magnoli says he's also seen plans that have an equity wash but allow direct
transfers between competing funds once per year. The problem with this
arrangement, he says, is that it becomes "a very expensive proposition."
Why? Because the fund must be structured to have a significant percentage
of its value in liquid investments on the dates that correspond with direct
transfers. Additionally, issuers must price their stable value products
higher to reflect the additional risk that such an arrangement carries
for them.
"Wrap fees are based on the premise that participants, on the whole,
will make investment decisions that are, for the most part, independent
from changes in interest rates," explains Scott Carter, a vice president
with Deutsche Bank. "Since the risk is dependent on two variables,
interest rate increases and benefit responsive withdrawals, the probability
of a payment by the issuer is reduced. Adding a competing fund increases
the risk that participant behavior becomes more dependent on just one
variable - interest rates. It's debatable to what extent an equity wash
will impact the additional risk that a self-directed brokerage imposes.
But in the end, if the risk becomes dependent exclusively on interest
rates, wrap fees will begin to approximate the value of the interest rate
protection that is provided," concludes Carter.
For now, it would appear that most participants in the stable value industry
see equity wash rules as largely unavoidable.
"An equity wash remains the cleanest, simplest, best-accepted method
of protecting stable value issuers," says Magnoli. "Everyone
in the industry is familiar with the equity wash provision, and there's
not a lot of controversy."
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