A Fine Line: Can Wrap Contract Provisions Become Too Restrictive?

By Randy Myers

The stable value industry sailed through the financial crisis of 2008 with minimal disruptions. Market-to-book-value ratios for the average stable value fund fell during the market downturn and have since recovered on average to better than 100 percent. Throughout the market volatility of the past three years, investors in stable value funds continued to enjoy steady returns that outperformed those available from money market funds.

Still, banks and insurance companies that issue stable value wrap contracts–contracts that assure investors they can withdraw their money at book value under certain circumstances, even if a fund’s market value declines–were chastened by the turmoil in the financial markets. After seeing some of the underlying bond portfolios decline, some wrappers concluded that the wrap business was putting them at more risk than previously imagined. Some, wrap providers, for a variety of reasons, even exited the business.

In the aftermath, many of the remaining wrap providers have been revisiting the terms of their contracts: raising prices, imposing stricter investment guidelines on stable value managers, and tightening rules that spell out how investors can switch in and out of stable value funds and competing investments, especially during periods of rising interest rates.

All this has prompted stable value managers and some investment consultants to warn that wrap providers must be careful that their efforts don’t drive retirement plan sponsors to remove stable value funds from their 401(k) plans.

“I don’t think it’s fair to assume sponsors as a group will continue to accept ever-increasing requirements on the asset class,” Winfield Evans, leader of investment strategy for Aon Hewitt’s defined contribution outsourcing business, told participants at the 2010 SVIA Fall Forum. “Some will, some won’t,” he said.

“There are wrap contracts out there that have decent and good terms, and then there are some in a grey area, and then there are some that, from our perspective, provide very little coverage,” added Steve Ferber, a senior vice president and investment strategist for fixed income manager PIMCO, during a roundtable discussion of stable value issues that closed out the Fall Forum. “Someday, sponsors are going to be surprised by how little protection there is in some of those contracts.”

Susan Graef, a principal with investment fund manager Vanguard Group, suggested that the discussion over tighter contract terms should revolve around the concept of risk management versus risk avoidance. While risk managers at banks and insurance companies are concerned about the long-term or “tail” risks associated with stable value contracts, she argued, stable value managers and their plan sponsor clients also want to see that they are getting something for their wrap contract dollars.

Graef noted that insurers routinely pay out for losses associated with events such as hurricanes and floods, “catastrophic events that are costly for insurers.” And plan sponsors, she said, view wrap contracts as a form of insurance. “But when we outline what they do,” she said, “the question we get is, “What are we paying for?’ Because the contracts don’t cover this, this, or this.”

Warren Howe, managing sales director for wrap issuer Metropolitan Life Insurance Company, said his company hasn’t really changed its contracts over the past few years. “We understand that plan sponsors and participants need these, and we haven’t gone to our documents and really changed them to start carving out things to give us protection,” he said.

Many wrap providers have changed their contracts. Robert Whiteford, managing director in the pension/insurance derivatives product group at Bank of America Merrill Lynch, said there are good reasons for those changes, too.

During the last financial crisis, he said, the wrap industry found a fairly high level of correlation among stable value managers between pushing the envelope on investment guidelines and underperforming when the financial markets were stressed. “In a number of cases, managers who performed very well for years, over decades in some cases, blew up right at the end,” he said. “We had to find a way to rein this in. Even though you are always in some ways fighting the last battle, you’d better at least fix the things you’re aware of, and then try to figure out the next things that could go wrong.”

“We do take real risk,” he said. “I don’t know what losses people have experienced in recent years, but I do know that their potential for losses was there, and there is still some potential for losses in this business. We do perceive ourselves as taking a fair amount of risk. If this were not so, we would not have seen a few of the people who used to be here leaving the business. And we see no rushing in (by others).”

Whiteford said the most common change wrap providers have made to their wrap contracts is to demand that stable value managers adhere to tighter credit standards in their investment portfolios. That requires them to emphasize higher-quality fixed income assets in their portfolios. Wrap issuers also have been pushing for greater diversification in stable value investment portfolios, he said, albeit while eliminating some of the “more exotic” investments, such as non-agency mortgages and exotic asset-backed securities.

Apart from the issue of whether wrap contracts are fair and will alienate plan sponsors, PIMCO’s Ferber noted that simply having enough wrap capacity to support the stable value industry remains a big concern.

“We’ve got a lot of demand out there that needs to be taken up by new wrappers,” agreed Whiteford. “Those of us who are in the business have to get ourselves in a position where we can expand again, and then we have to find some people who are not in it to enter the business.”

One way to make the wrap business more palatable to banks and insurers, Whiteford said, might be to borrow a page from the playbook of the bank-owned life insurance market. Like the stable value market, he noted, it employs wrap contracts and book-value accounting. Unlike the stable value market, however, many of the wrap contracts in the bank-owned life insurance market limit the amount that an issuer could have to pay out. While those limits are based on worst-case scenarios, they do cap tail risk. “If that could be applied to this business, you have a whole new game,” Whiteford said. “We’re exploring that, and we’ve encouraged others to consider it, too.”