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Interest Rate Risk Management Differences by Manager Segment

The Association's annual stable value fund investment survey provides a unique window on the differences in SV management styles by manager segments of the market. Four market segments were surveyed: in-house and external managers of individual funds, commingled pools managed by investment firms and banks, and commingled funds managed by life companies for their bundled or full-service defined contribution business. Each segment provides SV funds that offer principal stability along with high, relatively stable yields that track market interest rates reasonably well. Interestingly, the approaches that they take to achieve this result vary - especially when it comes to the management of interest rate risk within the fund.

Rising interest rates pose two potential problems for a stable value fund. The first is that the fund's blended rate credited to participants may lag the upturn in market rates, making the fund less attractive for new contributions and perhaps stimulating outflows. The second is a potential for market losses on participant withdrawals on contracts with participating wraps. Although any such losses are amortized through the wrap guarantee and reflected as a small deduction in the credited rate, they depress the blended rate and worsen the lag problem. Falling interest rates have the opposite effect on a SV fund - blended rates higher than market rates and potential market gains on participant withdrawals.

The longer the duration of the stable value fund, the greater the potential blended rate lag and size of any gains or losses realized on participating contracts. Managing interest rate risk is one of the major responsibilities of a stable value fund manager.

As the attached table illustrates, in-house and full-service managers have opted for fund durations of 3.2 and 3.7 years respectively - 8 to 14 months longer than the two other manager segments. One reason for the longer duration is the smaller cash position in their funds. In-house managers have only about 4 percent in cash and full-service managers less than 0.5% on average.

Both segments have opted for the extra yield that comes on average with a slightly longer duration and believe that its benefit outweighs any increased risk of rate lag. This really shouldn't be surprising, since rate lag isn't as much of a problem for them. In-house managers are less vulnerable to being replaced in an underperforming period than an external manager. Many full service funds credit a current or "new money" rate on new deposits and new sales rather than the aggregate portfolio rate.

External individual fund managers and pool managers, on the other hand, have lower fund durations (2.3 and 2.4 years respectively), partly as a result of the larger cash positions in their funds. The shorter duration helps keep the blended rate more current, important when it is the yield credited to new plans in the fund, as is the case with the pools.

Both the external manager and pool segments also use cash as the first layer after contract maturities to pay benefit payments. The cash buffer helps reduce withdrawal risk charges, which helps offset some of the cost of holding the cash. Greater reliance on participating contracts by both segments enhances yield via lower risk charges. With the shorter fund durations, there is less risk that rising rates will result in market losses on withdrawal activity under these par contracts.

Given all this, it may seem puzzling that full-service managers - the segment with the highest overall duration - also have the highest percentage of participating contracts. This is partially explained by the fact that 39% of the segment surveyed use the class-year or pro-rata by participant withdrawal protocol, in which participants' yields are generally affected only by their own contribution and withdrawal activity. There is little risk of one participant's actions influencing another's yield with this withdrawal protocol.

Clearly, there's far more than one way to 'skin a cat' when it comes to stable value fund investing. The SVIA survey provides some useful insight into the differences in style and portfolio structures utilized in the industry.

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