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Home > Library > Stable Times > Volume 5, Issue 2  The quarterly publication of the Stable Value Investment Association Second Quarter 2001 • Volume 5 Issue 2 An Innovative Use of Wraps - for AARPBy Jack Ellison, Treasurer, AARP and Wendy Cupps, Executive Vice President, Pacific Investment Management Co (PIMCO) Stable value funds are very popular with defined contribution investors, who appreciate their stable earnings rate and principal protection. Use of book value wrap contracts, which provide these benefits, has increased significantly in the past 10 years. The attractive features of book value wrap contracts can also be applied outside the traditional defined benefits market. PIMCO's work with AARP provides an interesting example of one such application. Like many 501(c) (4) organizations, AARP relies upon revenues from its investments to fund a range of operating activities that benefit its members and to provide a reserve for future needs and funding for longer-term strategic objectives. AARP budgets for investment returns on a calendar-year basis, and plans its services and activities accordingly. The process is governed by a Board policy, which requires that revenues meet or exceed expenses in any budget year. Since AARP must report investments at market value (SFAS No. 124), income from investment gains and losses (both realized and unrealized) may fluctuate significantly, which makes budgeting difficult. Given AARP's balanced budget requirement, short-term losses on its investment portfolio can threaten its ability to fund important member programs. AARP's challenge has been to balance its long-term investment and planning horizon against the need to achieve short-term revenue objectives. AARP has the additional challenge of maintaining and enhancing membership programs through higher investment returns while meeting internal budget requirements. In order to meet these competing objectives, AARP had historically invested in short-term Treasury bonds. To enhance returns, AARP revised its investment policy so that it could employ an intermediate time horizon for assets not required for short-term liquidity needs. However, extending duration of fixed income investments introduced higher volatility, which made annual budgeting more challenging. As a solution, AARP undertook an extensive review of its investment policy with its investment consultant and portfolio manager, and, as a result, embarked on three major initiatives to enhance the investment pools:
The wrap also allowed AARP to broaden the investment portfolio without an increase in volatility. AARP lengthened the duration of the fixed income portfolio to match that of the Lehman Aggregate Index; distributed quality discretion more broadly to include investment grade securities as well as limited allocations to B and BB issues; and expanded sector exposures to include additional issuers, issues and limited use of derivatives. While purchasing a wrapper for a separately managed, diversified fixed income portfolio is common in the stable value marketplace, what is not so typical is to see wrap coverage used with a significant equity allocation, or for budgetary purposes outside of the defined contribution environment. Wrapped equities have been a topic of interest and discussion in past Stable Times, but rarely has a significant allocation to equity actually been implemented within a wrapped structure. AARP, its investment consultant, and its manager modeled the potential effects of adding equity extensively. They determined that a 30% equity allocation with a wrapper could enhance long-term returns without a significant increase in volatility. AARP's Board agreed that the addition of wrapped equity was appropriate to meet their objectives and was within their risk tolerance. While this made sense from an investment perspective, it still required additional work to get wrappers comfortable with the risks of wrapping 30% equities in this structure. The wrappers had two main concerns initially. First, they needed to limit the potential impact of withdrawals on the earnings rate, given that a single employer would be making cash flow decisions rather than a diverse group of 401k participants with more random objectives and behavior. The wrappers wanted to protect themselves from a scenario in which AARP would withdraw funds when market was significantly below book value, a greater concern given stock market exposure. A withdrawal under these circumstances might cause the earnings rate to erode and force wrappers to "pay up" to maintain their guarantee. AARP wanted the ability to withdraw periodic interest and the wrappers similarly wanted to protect themselves by limiting such withdrawals to a reasonable level. Several mechanisms which were proposed proved to be limiting under multi-scenario modeling. Ultimately, AARP and the wrappers agreed on an annual withdrawal limitation, with a lifetime cap, that provided protection for the wrappers and ensured that AARP would not be unduly limited from accessing its funds, particularly when market value is above book. The wrappers' second concern was to limit volatility from significant equity exposure. Several proposals were offered by the wrappers, including: a) capping the crediting rate to build a cushion during periods of strong equity performance that would protect the rate in periods of poor returns; b) limiting the impact from equity exposure by not incorporating equity characteristics in the crediting rate reset; c) resetting the rate more frequently; and d) limiting the equity exposure. After extensive modeling and discussion, AARP and the wrappers agreed on a 30% limit (including international equity exposure) and a floating crediting rate cap to provide a cushion and avoid excess rate volatility. Given this unique application, many of the standard wrap contract terms had to be adjusted or significantly revised. This was largely a result of having a single entity controlling cash flow decisions and a large equity component in the portfolio. As one example, a Treasury test, often used to provide a trigger point for immunization that protects the wrapper from periods of severe underperformance, was not sufficient for protecting the wrap in a portfolio with high equity exposure. Factors critical for the success of this application were:
Organizations that face similar challenges or have similar objectives may also be able to benefit from the innovative use of wrappers on their investment portfolios.
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