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What Price a STIF?

During the1990’s, the practice of using a STIF or cash component of a stable value fund became almost universal.  Because the STIF and cash flows on contract maturities pick up the first layer of contract withdrawals, their presence produced lower risk charges and therefore a higher interest rate on the stable value contracts.  For most of the 1990’s this also meant a higher stable value portfolio rate.

In the 21^st century, however, things are different.  Yield curves are steeper, increasing the cost of substituting a STIF for longer-duration contracts.  Stable value fund cash flow volatility is higher and more likely to be the result of changes in stock prices than interest rates, lowering risk charges.  Today, the cost of the STIF may well be greater than its benefit.  Perhaps it’s time to reevaluate the use of fully-guaranteed contracts instead of STIFs.

Looking back, it’s easy to see why STIFs became so prevalent.  In the early 1990’s, blended rates on SV portfolios were well above the yields available on new stable value investments, as chart 1 illustrates.  Using a STIF to pay benefits and transfers prolonged the life of the higher-rate contracts already in the fund.  Also, as SV funds grew, the number of contracts in most funds ballooned.  It became both a logistical and administrative hassle to tap so many contracts for small routine fund outflows. 

In the second half of the 1990’s, the gap between portfolio and new investment yields narrowed appreciably.  However, yield curves flattened at the same time, so the cost to the portfolio of investing in short-term assets was relatively small. 

Many stable value issuers now require that a fund contain a STIF as a condition of underwriting the withdrawal risk.  Most, if not all, issuers consider a stable value fund without a STIF or comparable reliable cash flow buffer to be high risk.   Contract risk charges have often been estimated on the basis of this level of protection, and funds without a STIF may find it difficult to find a diversified portfolio of providers.

Chart 1
Comparation of SV Blended and Spot Rates

A  STIF makes sense for the SV fund only if the aggregate risk charge reductions on the stable value contracts in the portfolio exceed the average yield sacrifice for holding the short-term assets.  The cost of cash relative to the medium-term assets in the SV portfolio going forward is now higher than in the 1990’s, while the risk of losses on the first layer of stable value fund withdrawals has shrunk over time.    

Higher relative costs of the STIF. The yield curve during the last half of the 1990’s was exceptionally flat in historical terms, as can be seen in Chart 2.  Many think that the short-to-medium term segment of the curve is quite steep currently;  in fact, it’s not that far above the 22-year average.  With rising interest rates expected, there is little likelihood that we’ll see the same degree of flatness in yield curves going forward that we experienced in the late 1990’s.  Spreads of 150 basis points or more between 3 month and 5-year Treasuries imply a significant yield sacrifice on the STIF relative to medium-term contracts.

Chart 2
Spread: 5-year vs. 3-month Treasury

Lower charges for bearing withdrawal risk.  When buffers were first introduced, DC plans and stable value cash flow risks were both very different.   As recently as 1993, the size of the average stable value fund was about 70 percent of all the plan’s equity funds combined.  The phenomenal returns on stocks during the second half of the 1990’s changed that picture dramatically, however.  Even after two years of negative stock returns, the average plan’s equity holdings as of 9/30/2001were four times the size of the average stable value fund. 

Chart 3
Average Plan Holdings of Equity & SV

Source: Pensions & Investments and Landmark.

Stable value’s large allocation percentage was a major stabilizing influence on cash flows.  Inflows to stable value funds in 1993 were large and a negative cash flow history was rare.  Had all 1993 participants opted to increase their total stock allocations by 5 percent with funds from the stable value option, about 7 percent of SV assets would have been withdrawn.  The same decision today would move 20 percent of the assets out of the fund.  Day-to-day SV cash flow volatility is higher today simply because the stable value fund is so much smaller relative to the rest of the plan.

Note that this higher level of cash flow volatility hasn’t necessarily increased the risk of loss to those bearing withdrawal risks.  When SV cash flows were routinely large and positive, the only factor other than a plan event deemed strong enough to produce negative cash flows was interest rate arbitrage.  Risk charges consequently assumed that paying withdrawals would result in losses on stable value contracts, most of which were then non-participating.

Today’s higher level of volatility is influenced primarily by stock price changes.    Sustained stock price declines on balance produce inflows to SV funds, and sustained stock price increases produce outflows.  Since there is no solid evidence that stock prices have any positive correlation with rising interest rates, the induced cash flow volatility is as likely to produce gains as losses on stable value withdrawals – except of course, in the low-probability extreme interest rate rise scenario.  Experience on the first or “buffer” layer of withdrawals will be cyclical, but there is little reason to expect aggregate losses in this portfolio tier over time.  It is in the deeper layers of the SV portfolio - those that are only likely to be tapped when market rates are well above the SV portfolio rate - where those bearing the withdrawal risk can expect losses on balance.

Moreover, withdrawal risk derived from company stock can be diversified across an issuer’s entire portfolio of contracts – unlike the systematic withdrawal risk from a major interest-rate run-up.  The volatility of an individual stock is twice as high as that of the market as a whole.  In fact, market movements account for less than 20% of the volatility of an individual stock price¹.  SV cash flow volatility due to plan-specific factors like rumored layoffs or participant demographics are also diversifiable by the SV issuer.  This means that the aggregate level of withdrawals is smaller for the issuer than for the plans, so the issuer has a lower liquidity cost.

Stable value has gradually evolved from an asset class where financial institutions assumed the market value risks on contributions and withdrawals to one where the fund itself is assuming a great deal of interest rate risk through STIFs and participating contracts.  However, the economics of the situation appear to be changing.  There is renewed potential for financial institutions to diversify withdrawal risks assumed on a non-par basis, thus providing a significant benefit to client funds. There is also a greater relative cost to the fund of maintaining its own liquidity base.  We encourage the industry to answer the following questions:

What is the likely volume and relative probability of equity-induced stable value withdrawal volatility relative to interest-rate-induced volatility?

What is the correlation of equity-induced withdrawal activity with interest rate movements and is it the same in rising and falling interest rate periods?

How much of the equity-induced cash flow volatility is expected to come from company stock funds or sector funds?  How well diversified are those risks in the issuer’s portfolio?

What are the relative costs of maintaining a STIF in a stable value fund likely to be going forward?

Is there value to using non-participating guaranteed contracts to assume the first tier of withdrawal risk?

Eliminating the STIF does create a need for a mechanism to pay transfers and benefits without tapping multiple contracts.  Surely a creative manager can solve that problem in return for a higher portfolio yield - or a provider in return for a greater market share.

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