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Challenges of Measuring Performance for Stable Value Funds

The following piece was posted in the Spring 2001 Journal of Performance Measurement "Reader's Reflections" section (Vol 5 No. 3).

With approximately $250 billion in assets, Stable Value Funds are the most popular conservative investment option in defined contribution pension plans.  These funds offer principal protection with higher long-term returns than money market funds.

Stable value funds achieve their objectives by assuming interest rate and credit risk similar to an intermediate duration bond fund, but combine the underlying investment portfolio with “benefit responsive” contracts issued by banks and insurance companies.   These contracts guarantee that any individual plan participant is entitled to withdraw his/her balance at the stable “book value,” which reflects net deposits plus interest, instead of the liquidation value of the underlying portfolio. 

Historically, stable value funds invested predominantly in Guaranteed Investment Contracts (GICs) from life insurance companies. GICs are privately negotiated contracts that have a stated fixed interest rate and maturity date.  These contracts effectively embed the stable valuation, benefit responsiveness, and investment vehicle into one package.  There exists no secondary market for GICs.  Today, while GICs remain a component of many stable value funds, they now share the market with unbundled products that combine marketable fixed income assets and companion benefit responsive contracts. 

Due to  of the lack of marketability of traditional GICs and the fact that participants receive book value returns, the stable value industry has not, to date, adopted Association for Investment Management and Research-based methodologies for measuring and presenting marked-to-market performance.  In fact, the AIMR-PPS (Performance Presentation Standards) specifically identify GICs as assets that can be excluded from marking-to-market in compliance with AIMR-PPS principles and still permit an entity to claim compliance.

Stable value funds have two distinct audiences. 

1. Plan participants. Participants are, at all times, entitled to their book value, regardless of the portfolio’s underlying market value.  As a result, the primary audience for the returns of stable value funds, the participants, should see valuations that are consistent with their entitlement, namely, all reporting to participants should be done based on book value results.  Book value return series and volatility measures are appropriate for helping participants make asset allocation decisions.  Third-party providers of asset allocation models should also use book value returns in constructing their models.
   
   
2. Plan sponsors. The second audience includes plan sponsors who wish to hire and evaluate stable value fund managers. Specialty stable value fund managers have expertise in designing funds, negotiating benefit responsive contracts, and managing daily liquidity.  They also make active investment decisions for the underlying pool of assets.  As one part of the manager evaluation process, plan sponsors should evaluate the manager’s investment decision-making ability with market value-based performance data.   This information has not been available in the past.

To broaden the acceptance of stable value, enhance professionalism and bolster self-regulation, the stable value industry has worked toward adopting market value-based standards for presenting total return performance results intended for the plan sponsor audience. The Stable Value Investment Association (SVIA) has sponsored a task force of industry members since July of 1997.  After several years of discussion and dialogue, the industry is ready to embark on formal discussions with AIMR to determine workable methodologies that reflect the unique circumstances of stable value funds.  A February, 2001 Board of Directors meeting of the SVIA resulted in a vote in favor of initiating SVIA-sponsored discussions with AIMR to develop a workable performance measurement and presentation framework for stable value funds.

The path toward performance measurement has been strewn with controversy, as various constituencies have genuine concerns that market value-based performance measures will change the nature of these successful funds, which are defined by their lack of market volatility. 

The original rationale for forming the task force was the recognition that book value returns, alone, do not enable plan sponsors to evaluate the success of their stable value funds’ returns. There are three reasons why a fund’s stated book value return does not provide adequate information to gauge the success of a manager’s investment decision-making for a fund:

• Gains and losses offset over time to produce a stabilized net return, masking price volatility and risk levels.  This delayed gain/loss recognition impairs timely and meaningful evaluation of active investment decisions.
• The portfolio guidelines underlying the book value contracts can vary widely from 1.5 year duration to 4 years or more, and from AAA quality to sizable holdings of below investment grade debt.  Yet all the funds tend to be categorized as “stable value,” regardless of underlying investment strategy.
• Participant-initiated cash flows, deposits or withdrawals, have a material effect on the book value return series.

Each of these facets has a material, independent effect on stable value fund returns, yet are not under the control of the stable value manager.

Reactions to the Task Force efforts have been generally positive within the industry.  Yet, there remain numerous issues unique to the stable value market.  The challenges we face are threefold:

1. Performance measurement challenges
2. Presentation challenges
3. Public relations/perceptual challenges

Performance measurement challenges unique to stable value include the following:

• Determining the fair market value for GICs is difficult.  First, there is no secondary market. Analogies with other illiquid asset classes are relevant, such as private placements, venture capital, and real estate.  Since these are not asset classes with valuation methodologies familiar to most stable value managers, there exists a broad call within the industry for specific guidance and some degree of standardization in methodology to prevent abuses. The broad concepts of consistency and disclosures are not yet satisfactory to much of the industry – many want more guidance.  Last, since GICs are privately negotiated with non-standard cash flows, most existing pricing systems have difficulty in determining the fair value by discounting cash flows.
• Valuing the benefit responsive feature is a challenge.  The task force recommendation was to present returns both before and after the effect of benefit responsive contracts. This difference will reflect a fee and at times, an insurance component.  However, the insurance component, if called upon for a claim, could complicate calculation of returns.
• Somewhat different from GICs, there is a significant part of the industry that invests in general account obligations of insurance companies in which the interest rate is reset each year.  Unlike GICs, which have pre-set cash flows that can be discounted, a fair value of these general account contracts is even less readily available.

Presentation challenges include:

• Effective date.  For the performance measure to be accessible to the industry, it is not feasible to re-create 5 or 10 years worth of history of all cash flows and investment decisions.  The data simply has not been collected or maintained for most managers or plans.  The stable value industry hopes to develop an agreed-upon effective date unique for these funds that will enable most managers to comply.
• Disclosures unique to stable value have been recommended by the Task Force.  Suggested disclosures include portfolio investment characteristics, book value returns, percentage of assets with estimated market values, wrap contract provisions, cash flow histories, book to market value ratio, and certain statistics about benefit responsive contract terms.

Public relations issues/problems of perception

• There are misconceptions that the measures to assess managers would replace book-value measures of a fund’s overall success, which could detract focus from the book value returns earned by participants.  A suggestion to combat this confusion was to name the measure “Stable Value Manager Comparison Performance Measure”.
• Some within the industry were alarmed that presenting a market–based performance measure to participants would be confusing.  In fact, we easily reached a consensus that total return performance measures are for the exclusive audience of plan sponsors and their consultant advisors.  Since participants are not entitled to the portfolio’s market value, that information could indeed be misleading.
• There exists concern that new performance measures could incent managers to take more risk and use those returns as a marketing tool against those firms with more conservative profiles.
• Plan sponsors have asked for assistance with benchmark selection.
• Will there be value to plan sponsors?  This effort has been predominantly driven by the investment management community, as few plan sponsors seek this information.

The Stable Value industry looks forward to beginning its dialogue and welcomes insights we gain from dialogue with those who can help address our unique issues.

Also contributed:  Paul Donahue, Director Product Development, PRIMCO Capital Management and Gina Mitchell, President, Stable Value Investment Association.

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