Stable value funds, with nearly $540 billion of assets as of 2010, are unique investment offerings found almost exclusively in 401(k) and other defined contribution plans. The products growth has paralleled the expansion of defined contribution plans in the decades following the passage of ERISA and has evolved significantly since that time.
The years before the financial crisis were rewarding times for stable value investors, as they enjoyed respectable returns with low fees. Today, the tides have changed and there are noteworthy developments in the industry worth a fiduciary’s attention. Among the challenges are capacity constraints in the insurance wrap industry, regulatory uncertainty, a lower yield environment, along with the potential for rising interest rates.
Background
The popularity of stable value funds is simple to understand. The investments offer the principal stability of a money market fund with the yield characteristics of intermediate-term bonds. In addition, the price stability provides a conservative investment alternative which offers excellent diversification opportunities to plan portfolios and a desirable investment alternative for participants with short-term needs.
Stable value managers generally invest in high-quality, investment grade fixed income (or traditional guaranteed investment contracts) with maturities ranging between two and five years. To provide a stable price for plan participants, the product is often combined with an insurance wrap contract. This insurance, typically offered by a bank or insurance company, is fundamental to the stable value industry. It allows retirement plan participants to purchase and withdraw their savings at contract value (under most circumstances), even when the market value of the product’s portfolio stands below its book value.
Before the financial crisis, the capacity in the wrap market was plentiful, as many providers were willing to guarantee contract value liquidity for stable value funds. This elevated competition drove down the cost of insurance into the single-digit basis point range.
Current Challenges in the Industry
Since the global financial crisis, the dynamics of the wrap industry have changed significantly. The crisis caused instability in the financial markets not seen since the great depression. As investors sought shelter from the market turbulence, they pursued safety of principal at the expense of nearly all other once traditionally-viewed conservative investments. This led to a dramatic widening of credit spreads for many of the fixed-income securities (and a corresponding drop in value) held in stable value portfolios. The result was an abrupt drop of the product’s market-to-book ratios, often reaching below 90%, where insurance companies stood as the backstop for the gap that ensued. The combination of elevated risk and reduced premium revenue caused many wrap providers to reassess this block of business. Eventually, many companies walked away after an orderly winding down of their operations.
The financial crisis also precipitated a cry for regulatory reform to address what many believed to be its root cause. Of note, 2010’s Dodd-Frank Wall Street Reform law calls for stronger regulation of the over-the-counter derivatives market by requiring their execution on an exchange or through a clearing firm. The law calls for a further study to determine whether stable value investments would find themselves subject to the new law.
If the products are ultimately subject to the regulations, the likely result would be an increase in fees, as reforms would require the products to adhere to these new reporting and clearing standards. These regulations (and Basell III guidelines) also raise capital requirements for banks and prompted many depository organizations to reassess their exposure to the wrap market and ultimately, exit the market to focus on their core businesses.
The regulations however, do not apply to insurance companies and as a result, many insurers have entered the market to fill the void. Wrap providers today are charging considerably higher fees than what were charged before the financial crisis due to limited capacity and a renewed recognition of the risk associated with insuring product liquidity. Furthermore, many insurers are using this scarcity in capacity as leverage to secure asset management services for company subsidiaries.
Historically, stable value managers’ performance has compared favorably with their counterparts, money market funds. The shorter maturity securities in which money market funds are limited to is the primary reason for their performance shortfall. Additionally, a nearly continuous decline in interest rates since the early 1980s has provided ballast to returns of the longer-maturity fixed-income securities held in stable value funds.
Today, many in the industry are concerned that stable value funds might not benefit from the same set of financial circumstances that they have enjoyed in the past. In time, interest rates will rise. When they do, money market funds’ yield will move upward more quickly. This inflection point for interest rates, when money markets potentially outperform, creates vulnerability for stable value managers. Rising interest rates may prompt investors to reassess their investment options and presents a scenario of potential cash outflows from stable value funds (and into money markets) at precisely the time when their market values may dip due to the rise in rates. Although this yield arbitrage will likely be short lived, the risk is basis for many wrap insurers to more closely monitor manager’s investment guidelines and more tightly restrict competing investment option language (restricting similar investments like short-term bond funds) in the product’s contracts.
Conclusion
Through the decades since their inception, stable value funds have provided a sound, competitive and conservative investment for retirement plan participants. However, this historical assessment should not bread complacency for plan fiduciaries. Several high-profile stable value managers have terminated their products in the face of these challenges in recent years. North Pier expects further evolution of the industry in response to the forces discussed. Potential reforms could include further tightening of investment guidelines, lower-risk portfolios, longer-term benefit payouts, higher fees and other structural changes to the products to compensate for today’s risks. These issues should oblige plan sponsors to review their stable value strategies to understand their associated risks.
Legal Corner
Appeals Court Finds Fiduciary Insurance Coverage Does Not Cover Claims Against Employer as Settlor
The New York Court of Appeals recently dismissed a claim made by IBM against its excess insurance coverage carrier, Federal Insurance Co. (Federal). IBM had sought reimbursement from Federal due to losses incurred in a prior suit asserting that the company’s amendments to its pension plan (Cooper v. IBM Personal Pension Plan) were age-discriminatory. IBM settled with the plaintiffs in that lawsuit for $319 million.
After exhausting the $25 million limit in its primary policy issued by Zurich America Insurance Co. (Zurich), IBM turned to Federal for additional claims. Federal’s policy was a “follow form” policy that paralleled the terms and endorsements of the Zurich policy. Federal claimed that the language in the Zurich policy stating, “Any breach of the responsibilities, obligations or duties by an insured which are imposed upon a fiduciary of a Benefit Program by [ERISA]” covers ERISA violations by an insured acting as an ERISA fiduciary. Therefore, when the courts held that IBM acted in a settlor capacity by amending its pension plan, IBM’s claims were not covered. As a result, the Appeals Court found that Federal was entitled to summary judgment in the action.
Fiduciary actions are made by those who exercise control or management over plan assets and have discretionary authority over its operation. These decisions tend to cover a plan’s administrative and managerial aspects including determining plan eligibility and selecting investments. Those fiduciary decisions are held to an elevated code of care and are governed by ERISA standards.
Not every plan decision is subject to ERISA’s fiduciary rules. Specific issues relate to how the plan matches to the objectives of the plan sponsor. When plan decision makers enter into these “business-judgment” type decisions, they are generally exempt from ERISA’s fiduciary rules and are acting in a settlor capacity (even when they are plan fiduciaries in other roles).
Examples of actions that would be considered settlor functions are:
Choosing a plan type and determining its design;
Creating, terminating or amending a plan;
Deciding what class of employees would be eligible for coverage;
Requiring employee contributions or changing the amount of employee contributions.
More complex plan issues are often a combination of settlor and fiduciary issues. It is important that plan sponsors discern which role they are assuming for each related decision. It may be advisable to separate decisions made in a settlor capacity versus those made as a fiduciary to provide clarity of the role assumed.
This case highlights the importance of understanding the dual roles of retirement plan committee members. Managing retirement plans call for serious consideration of the meaning and consequences of each decision.
PIER-Points
Finally, Plan Sponsor Disclosure Rules Become Effective
After first proposed in 2007, on July 1, 2012 the long awaited 408(b)(2) Regulations finally became effective. The much anticipated rule is intended to promote transparency in retirement plan service arrangements by requiring disclosure of and organizations fiduciary standing, compensation and conflicts of interest to a responsible plan fiduciary. The regulations apply to every service provider who anticipates at least a $1,000 in compensation from the covered plan including investment advisors and brokers, recordkeepers and plan administrators, legal and auditing and other plan services. Participant-level fee disclosure regulations which become effective August 30, 2012 and require the disclosure of all direct expenses charged to participant accounts.This marks an important inflection point in the retirement services industry. North Pier applauds the arrival of the long overdue and anticipated regulation. The resulting protection of the interests of plan sponsors by promoting transparency and disclosure is paramount for the industry and will ultimately benefit America’s workers.
North Pier has always held that every sponsor has a right, and an obligation, to clearly understand its plan fees and the fiduciary standing of the organization it has hired to advise them. Finally, the law requires it.
By: Brant Griffin – August 1, 2012
The State of Stable Value
Stable value funds, with nearly $540 billion of assets as of 2010, are unique investment offerings found almost exclusively in 401(k) and other defined contribution plans. The products growth has paralleled the expansion of defined contribution plans in the decades following the passage of ERISA and has evolved significantly since that time.
The years before the financial crisis were rewarding times for stable value investors, as they enjoyed respectable returns with low fees. Today, the tides have changed and there are noteworthy developments in the industry worth a fiduciary’s attention. Among the challenges are capacity constraints in the insurance wrap industry, regulatory uncertainty, a lower yield environment, along with the potential for rising interest rates.
Background
The popularity of stable value funds is simple to understand. The investments offer the principal stability of a money market fund with the yield characteristics of intermediate-term bonds. In addition, the price stability provides a conservative investment alternative which offers excellent diversification opportunities to plan portfolios and a desirable investment alternative for participants with short-term needs.
Stable value managers generally invest in high-quality, investment grade fixed income (or traditional guaranteed investment contracts) with maturities ranging between two and five years. To provide a stable price for plan participants, the product is often combined with an insurance wrap contract. This insurance, typically offered by a bank or insurance company, is fundamental to the stable value industry. It allows retirement plan participants to purchase and withdraw their savings at contract value (under most circumstances), even when the market value of the product’s portfolio stands below its book value.
Before the financial crisis, the capacity in the wrap market was plentiful, as many providers were willing to guarantee contract value liquidity for stable value funds. This elevated competition drove down the cost of insurance into the single-digit basis point range.
Current Challenges in the Industry
Since the global financial crisis, the dynamics of the wrap industry have changed significantly. The crisis caused instability in the financial markets not seen since the great depression. As investors sought shelter from the market turbulence, they pursued safety of principal at the expense of nearly all other once traditionally-viewed conservative investments. This led to a dramatic widening of credit spreads for many of the fixed-income securities (and a corresponding drop in value) held in stable value portfolios. The result was an abrupt drop of the product’s market-to-book ratios, often reaching below 90%, where insurance companies stood as the backstop for the gap that ensued. The combination of elevated risk and reduced premium revenue caused many wrap providers to reassess this block of business. Eventually, many companies walked away after an orderly winding down of their operations.
The financial crisis also precipitated a cry for regulatory reform to address what many believed to be its root cause. Of note, 2010’s Dodd-Frank Wall Street Reform law calls for stronger regulation of the over-the-counter derivatives market by requiring their execution on an exchange or through a clearing firm. The law calls for a further study to determine whether stable value investments would find themselves subject to the new law.
If the products are ultimately subject to the regulations, the likely result would be an increase in fees, as reforms would require the products to adhere to these new reporting and clearing standards. These regulations (and Basell III guidelines) also raise capital requirements for banks and prompted many depository organizations to reassess their exposure to the wrap market and ultimately, exit the market to focus on their core businesses.
The regulations however, do not apply to insurance companies and as a result, many insurers have entered the market to fill the void. Wrap providers today are charging considerably higher fees than what were charged before the financial crisis due to limited capacity and a renewed recognition of the risk associated with insuring product liquidity. Furthermore, many insurers are using this scarcity in capacity as leverage to secure asset management services for company subsidiaries.
Historically, stable value managers’ performance has compared favorably with their counterparts, money market funds. The shorter maturity securities in which money market funds are limited to is the primary reason for their performance shortfall. Additionally, a nearly continuous decline in interest rates since the early 1980s has provided ballast to returns of the longer-maturity fixed-income securities held in stable value funds.
Conclusion
Through the decades since their inception, stable value funds have provided a sound, competitive and conservative investment for retirement plan participants. However, this historical assessment should not bread complacency for plan fiduciaries. Several high-profile stable value managers have terminated their products in the face of these challenges in recent years. North Pier expects further evolution of the industry in response to the forces discussed. Potential reforms could include further tightening of investment guidelines, lower-risk portfolios, longer-term benefit payouts, higher fees and other structural changes to the products to compensate for today’s risks. These issues should oblige plan sponsors to review their stable value strategies to understand their associated risks.
Legal Corner
Appeals Court Finds Fiduciary Insurance Coverage Does Not Cover Claims Against Employer as Settlor
After exhausting the $25 million limit in its primary policy issued by Zurich America Insurance Co. (Zurich), IBM turned to Federal for additional claims. Federal’s policy was a “follow form” policy that paralleled the terms and endorsements of the Zurich policy. Federal claimed that the language in the Zurich policy stating, “Any breach of the responsibilities, obligations or duties by an insured which are imposed upon a fiduciary of a Benefit Program by [ERISA]” covers ERISA violations by an insured acting as an ERISA fiduciary. Therefore, when the courts held that IBM acted in a settlor capacity by amending its pension plan, IBM’s claims were not covered. As a result, the Appeals Court found that Federal was entitled to summary judgment in the action.
Fiduciary actions are made by those who exercise control or management over plan assets and have discretionary authority over its operation. These decisions tend to cover a plan’s administrative and managerial aspects including determining plan eligibility and selecting investments. Those fiduciary decisions are held to an elevated code of care and are governed by ERISA standards.
Not every plan decision is subject to ERISA’s fiduciary rules. Specific issues relate to how the plan matches to the objectives of the plan sponsor. When plan decision makers enter into these “business-judgment” type decisions, they are generally exempt from ERISA’s fiduciary rules and are acting in a settlor capacity (even when they are plan fiduciaries in other roles).
Examples of actions that would be considered settlor functions are:
More complex plan issues are often a combination of settlor and fiduciary issues. It is important that plan sponsors discern which role they are assuming for each related decision. It may be advisable to separate decisions made in a settlor capacity versus those made as a fiduciary to provide clarity of the role assumed.
This case highlights the importance of understanding the dual roles of retirement plan committee members. Managing retirement plans call for serious consideration of the meaning and consequences of each decision.
PIER-Points
Finally, Plan Sponsor Disclosure Rules Become Effective
North Pier has always held that every sponsor has a right, and an obligation, to clearly understand its plan fees and the fiduciary standing of the organization it has hired to advise them. Finally, the law requires it.
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