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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 Toward A New Model of Stable ValueBy Jeff Norris, Metropolitan Life Insurance Company Recent volatility in the equity and fixed income markets has directed new attention to stable value funds - those often misunderstood investment offerings of many defined contribution plans. Sometimes tagged as overly conservative, the intermediate-term-bond-yields-with-no-price-volatility characteristics of stable value now look, if not attractive, at least, well, sensible. Plan participants, as a result, are acting sensibly and reassessing both their "financial needs timelines" and their "personal risk profiles," and are rebalancing their portfolios, often increasing allocations to stable value. Stable value has long derived its identity from the fixed income world and, specifically from comparisons with money market funds, hence the reason for some of the conservative stigma. Of course, stable value returns have long trounced those of their money fund rivals. But must stable value remain a step-child to fixed income? We think not. In fact, the stable value asset class now has the opportunity to break out of its historical role as the conservative savings plan option and recapture the dominant position it held during the 1980s. In a reconstituted format, it can add significant value to participants by way of increased returns and reduced volatility when compared to other savings plan options. Before looking at how this might happen, a glance back at how the asset class evolved will shed some light on the challenges stable value will face. The Early Years of Stable Value The original stable value offering was an insurance company contract that was evergreen in design with return characteristics that matched those of the insurer's general account. By definition, this meant that contracts were largely backed by fixed income investments which were generally long in duration. These were functions of both regulatory constraints and the liability profile of the insurer. Interest rate volatility in the 1980s had a profound effect on general account-based products. When market rates went up, the result was a contractual rate that lagged. (Of course, in fairness a longer duration portfolio also results in lagging, that is, above-market rates when market rates fall). Why should this have been a concern? Well, in these early days of savings plans, the return on the fixed option was thought to have to be competitive with what participants and potential participants would see in a bank window. The savings plan was then seen to be competing with non-tax advantaged savings alternatives! It was feared that plan contributions might dry up if the bank CD rate was better than what could be obtained within the plan. Because in these days the fixed fund would often garner 75% or more of participant contributions, an attractive credited rate was deemed absolutely crucial to the overall viability of the plan. In this rapidly rising interest rate environment, insurance company providers worked to amend and restructure arrangements. Out of these efforts was born the GIC and also the specialty GIC consultant. The Birth of GICs With a fixed rate, fixed maturity product that now allowed for competitive bidding (no longer was the sponsor's fund underwritten by one provider) the GIC services business flourished. Insurers were still the only source of product and because stable value still looked more like a bond than any other investment, it remained very much tied to fixed income. Determined not to get caught long in duration, GIC consultants almost to a person favored short-term contracts. The objective was (and in many ways, still is) to beat money market fund returns, but stay short enough to capture interest rate movement. Rules of thumb recommending one-quarter to one-third turnover of the GIC portfolio each year soon proliferated. Perhaps the linkage of stable value with short duration fixed income returns served the stable value market and the defined contribution plan well in these early years. Double-digit returns on this conservative plan option no doubt enticed many employees to participate in the plan, fueling its popularity and growth. The importance of this can easily be lost in today's context of higher participation rates and more savvy employee investors. Managed GICs The evolution of stable value took another step forward in 1989 with the introduction of managed GICs (a.k.a. separate account GICs, synthetic GICs). These products were essentially visible, segregated portfolios of fixed income securities surrounded by a book value guarantee, also called a wrapper. For purpose of our analysis, the important things to note are: 1) for the first time, plan sponsors could have direct input into the composition of the assets supporting their contract and, 2) the book value guarantee was designed to smooth out the potential volatility of investment returns, a mechanism previously buried and unseen in the operation of the insurer's general account. So we now had the two components which ten years later can form the basis for our new stable value model -- asset choice and a smoothing function. And yet, the uses of managed GICs in recent years have continued to focus almost exclusively on fixed income securities. Within stable value, investment management mandates have been surprisingly limited. High quality, domestic securities benchmarked to intermediate duration indices overwhelmingly dominate managed GIC portfolios. Rethinking Stable Value One has to question now, however, whether the stable value conventions of today - borne out of the historical antecedents of defined contribution plan and stable value practices - need continue:
If the answer to any of the above
questions is no, it might just be time to re-tune our definition of stable
value. Maybe, it is time to ask a new question: what is stable value
anyway?
APPENDIX To determine the expected returns of adding non-traditional assets to stable value we examined several portfolio constructions shown below. Returns were calculated over the period 1989 - 1998.
While relatively straightforward to compare on a market value basis, the book value nature of stable value required that we artfully make and apply certain assumptions to these portfolios for purposes of comparing credited rates. These assumptions dictated the yield-to-maturity that we utilized in our standard rate reset formula and the duration over which we amortized market value performance.
* Portfolios A - E use the weighted average of these depending upon the
As a further exercise, the above numbers were recalculated utilizing a standard amortization period of 3.3 years, consistent with Portfolio A. This had the expected result of increasing both returns and volatility. Plan sponsors will want to consult with their providers to model the effects of various amortization schedules depending upon the assets they choose to include.
A final word of warning concerns the sine qua non of any analysis based upon an historical fact pattern. The past ten years, which provide the data for this examination have seen strong bond market returns coupled with a raging bull market for equities, both of which play a role in the results shown.
Read Next: Growth Predicted in the "Stable Value Investing GICs'99" Survey
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