The credit events in 2008 confirmed the complexity of stable value funds. Plan sponsors, receiving quarterly updates at the end of 2008 and early 2009 were surprised to find the market to book value ratio of their funds dropping quickly from 102-103% to 92-95%. Upon further scrutiny, a review of the underlying portfolio often revealed holdings that were long-dated, illiquid and sometimes unrated. How could this be? Weren’t stable value funds on the same end of the safety spectrum as money market funds? Without having to discuss a similarly surprising discovery about money market funds, suffice it to say that the stable value asset class was misunderstood. This realization of the complexities of stable value funds led to some issues in the market:
- Participants considered transferring money to a money market fund, if available
- Plan sponsors began to engage in searches for “safer” money market funds
- Wrap contract providers questioned whether low wrap contract fees justified the risk taken to provide book value withdrawal protection
The vast majority of participants and plan sponsors stayed with their stable value investments, because the alternative, money market funds, moved quickly into zero-return territory. Without a mass exodus, stable value managers were able to cope with their illiquid holdings and wrap contract providers did not suffer major losses while providing book value liquidity. The main consequence of this situation was a reduction in wrap capacity. Most wrap contract providers, typically banks, questioned the risk they were taking for a 7-10 basis point wrap contract fee. Coupled with higher bank capital requirements under Dodd-Frank and Basel III, many bank providers decided to withdraw from the wrap market. Ultimately, a few notable stable value funds closed because of this challenge in the wrap market. While the bulk of the fund closures appear to be behind us, the combination of lingering doubts about stable value longevity and the outlook for interest rates has left plan sponsors questioning the long-term viability of stable value.
We at PEI continue to take the view that stable value can be a good investment. While we acknowledge that this asset class is misunderstood by plan sponsors and participants alike, we think that if plan sponsors take the necessary steps to review and understand their stable value holding, they will discover the opportunities this asset class provides.
In a previous article, I summarized some important issues that plan sponsors should consider when reviewing stable value. While the process to evaluate funds may seem complicated at first, when viewed as any other fixed income asset class, the steep learning curve will soon level. Plan sponsors often question whether the costs to select and review a stable value fund justify the benefits, but one only has to look at the annualized 300 basis point spread that participants in stable value received over money market funds for the last three years to justify the analysis.
Current Challenges in the Wrap Contract Market
There are a few challenges for stable value fund managers with regards to the wrap contract. First some history: over the last 10 years, as stable value funds moved to a synthetic, wrapped fixed income portfolio, banks provided a large percentage of wrap protection. However, given the events of 2008, they reduced their level of involvement in stable value, and wrap protection has shifted back to the insurance companies, albeit at higher fees. The fees have increased to 20-25 basis points, which is a significant increase from a lower level prior to the events of 2008. On the other hand, when viewed in the context of the spread that stable value currently has over money market funds, it seems like a low price to pay for wrap capacity and principal protection.
In addition to higher fees, many wrap contract providers are requesting constraints on portfolio structures or extensions of the exit clause. You will recall that while participants have daily book value liquidity in a stable value fund, plan-wide terminations (through corporate restructurings or a change in investment manager) are subject to a time delay. Fund managers will exercise this delay if the portfolio is marked under book value, allowing them time to have holdings mature as opposed to liquidating below book value. This situation also affords fund managers the time to work off other illiquid assets at more favorable terms. Typically the term of this “put” is 12 months, but in the last couple of years, wrap contract providers have requested upwards to 36 months lead time.
Another challenge often posed by the wrap contract is the limitation of participants transferring between a stable value fund and a competing fund, often referred to as the “wash rule”. Participant reinvestment is usually constrained for 60 or 90 days, or competing funds may even be prohibited completely from the investment line-up.
A last issue related to the wrap contract for plan sponsor consideration is the comparison of wrap fees. As previously mentioned, fees rose as wrap capacity became limited. At this point they have appeared to stabilize. However, fund managers have not historically been transparent in reporting wrap fees, and obtaining this information from fund companies is difficult. Lately, given the awareness in the market with regards to wrap contract issues as well as pending legislation, fund managers have been more willing to share fee information. As a plan sponsor invested in or considering a fund, you will need to be aware of both the direct management fees and indirect fees associated with the wrap contract.
Looking forward given this background, there are two concerns for plan sponsors that continue to cause them to question the long-term viability of the stable value option:
- Long-term outlook for wrap contract capacity
- Outlook for interest rates
PEI has been providing in-depth analysis on stable value funds, and regularly engages in dialogue with a large number of stable value funds on these issues. Generally, we have learned fund managers are taking proactive steps to address these concerns to ensure the future of the stable value industry.
With regards to constraints in the wrap contract market, most fund managers are entering into proactive partnerships with providers to secure long-term wrap capacity. One benefit of banks exiting the wrap contract market is that wrap fees were driven up to a level that encouraged insurance companies to re-enter the business or expand current capacity. Fund managers have told us that they believe most of the surplus demand is currently being absorbed by the insurance providers. However, this does come with some restrictions. Wrap contract providers are working with fund managers to better understand and restrict the risks in stable value portfolios so that they are more willing to provide coverage. Fund managers have reason to be concerned, as wrap contract providers are requesting limitations on holdings with regards to credit quality and maturity. Structured products, such as asset-backed and mortgage-backed securities, are being limited. In some cases, insurance providers request a sub-advisory relationship on the fund. However, most fund managers we have spoken with think that open discussions and administrative flexibility have led to a more mutually-agreeable relationship with wrap contract providers. Overall, they believe these constraints will limit the risk in the portfolio while still providing for enhanced returns over money market funds.
Turning to the outlook for interest rates, we have discovered that fund managers are preparing for a point when interest rates rise. While stable value funds currently still enjoy a 250-300 basis point margin over money market funds, the spread has been narrowing, especially with the added portfolio constraints addressed previously. The longer interest rates stay low, that margin could continue to narrow further. However, most managers do not anticipate the gap to close completely, and think spreads will stay in a 150-250 basis point range. To combat this situation, funds have turned their attention to creating flexible fund structures that will benefit from a rise in short-term interest rates. Most managers have increased the amount of liquidity in their portfolio and shortened the overall duration. Some have purchased variable rate securities, and others are partitioning their portfolio into various liquidity and risk buckets, in an attempt to separate active risk management from liquidity optimization.
Based on our discussions, it seems that more than at any time, stable value fund managers are acutely aware of the balance between safety of principal and generation of return, and are restructuring portfolios to satisfy both ends of the scale. Some funds are considering moving to structures that are not fully wrapped, or that wrap the portfolio for participant withdrawals, but not plan withdrawals. While still too early to gauge plan sponsor reaction to a situation where a plan-wide withdrawal could occur at less than book-value, wrap contract providers welcome these additional attempts to reduce their risk.
If you are a plan sponsor that has a stable value fund, or is considering adding one to your investment line-up, it is important that you (or your consultant) discuss these issues with the stable value fund manager in order to assess their ability to confront these issues and ensure their long-term survival. Today, there is no excuse for a fund manager not to provide detailed information about their fund structure, and their strategy to manage around these critical issues. Clearly the extra work to properly evaluate a fund today is justified by the added return over the alternative money market fund, and with proactive steps by fund managers, the added return into the future.
 Revisiting Stable Value Investments, Marcia Peters, November 15, 2011.