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Is Wrapper Capacity a Concern?

The bitter taste of recent equity losses is still fresh in the minds of many participants and money market yields remain at historic lows. Fortunately for the Stable Value industry, that means Stable Value funds continue to grow as investors look for positive investment alternatives.

The Hewitt 401(k) Index reports that $660 million in 401(k) assets flowed into GICs/Stable Value funds from equity funds during the first quarter of 2003. The Hewitt Index tracks the asset allocation of 1.5 million 401 (k) investors' $68 billion in savings through their employer-sponsored defined contribution plans over 13 investment options. This growth slowed a little in the second quarter of 2003, but most of the inflows to equity came from traditional fixed income, not Stable Value. This is on the heels of a strong growth year in 2002 for Stable Value. According to the Hewitt 401(k) Index, GICs/Stable Value, funds now account for over 25 percent of assets. That is now a larger share of the 401(k) pie than company stock or large cap equity investments. However, Stable Value still lags equity investment overall.

With all the recent growth, is wrapper capacity becoming more of a concern? The answer depends on how you look at the question. From a total dollar perspective, there seems to be no capacity issues at all since - so far, at least - supply has kept up with demand. From the perspective of the total universe of wrappers available, the answer is not quite so clear.

There are simply fewer wrappers available today. One of the major reasons for this is the downward pressure on wrap fees seen over the last five to ten years. As fees have come down, some wrap providers, especially insurance companies, have made the determination that wrap business is no longer attractive and have scaled back this business or simply stopped writing it altogether. So the real issue is wrapper diversification not dollar wrapper capacity in the overall market.

Mergers and acquisitions have also decreased the number of wrappers available and, in many cases, the consolidation strains established capacity limits within plans. Another factor is that many managers have established minimum rating requirements, diversification limits, and other restrictions that may effectively shrink the universe of wrappers available to them - even if the wrappers are willing and able to write the business. The potential problem is compounded if the business to be wrapped is of a riskier nature; for example, if the manager wants a non-participating wrap or if the underlying assets have competing funds exposure, which could present an arbitrage opportunity. Few, if any, wrappers will want this riskier business because of the underwriting difficulties it presents.

The emergence of Stable Value mutual funds had many industry observers hoping that the higher fees available from these funds would entice more wrap providers back, especially insurance companies, which use to be the main provider for Stable Value funds. There are a number of factors, however, that have prevented many companies from entering or re-entering the wrap business. Among them: the current uncertainty around how the Security and Exchange Commission views Stable Value mutual funds; arbitrage concerns since such funds have constant exposure to competing funds; the current low rate environment; and the fact that mutual funds are a new and yet unseasoned market for Stable Value. For all these reasons, only a limited number of wrappers are currently willing to wrap Stable Value mutual funds and, of those that do, most have caps on the amount of this business they will underwrite.

So, the potential wrapper capacity issue is only a matter of total dollar capacity in the mutual fund market. In 401(k) and other defined contribution markets there is not a dollar capacity issue, but rather limited diversification resulting from the shrinking universe of wrappers available over the past five years. This is especially true if plans want diversification between bank and life insurance wrappers, because of the few insurance companies and handful of bank wrappers in the market. Bank wrappers may start to feel this tension too as their market share continues to grow.

If the current level of low fees continues or even drifts a little lower, it is likely that managers will have an increasingly smaller universe of wrappers to choose from. This could make wrapper diversity very much an issue for everyone - plan sponsors, managers, and participants alike - in the near future.

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