W. Scott Simon
I could feel the tension rising in the examination room. It was the first time that I had visited my new ophthalmologist who was now busy checking my nearsighted eyes. We were chatting as is usual in such situations, and he asked what I did for a living. I replied that I was in financial planning. Uh, wrong answer. He actually stopped his examination and looked at me. At least I think he did because my eyes were dilated and still trying to adjust to the after-effects of his bright, probing light.
He then started a rant about something called “Executive Life,” “guaranteed investment contracts,” and “gigs.” The doctor was actually saying “GICs”–the acronym for guaranteed investment contracts–but before that day in his office, I had never heard the term, which was why I was trying to figure out what music gigs had to with his ranting.
The doctor then accused his investment advisors of leading him astray and that he was ruined as a result of investing in guaranteed investment contracts with Executive Life. He told me that he had planned to retire that year, but now he didn’t know how much longer he would have to keep working.
I felt a need to dispel the tension in the examination room and assure him that my work in the financial services industry had nothing to do with gigs. I had entered that industry only a few months before, so I was still very green. I believe that when the doctor found out I was in financial services, he naturally lumped me in with his own advisors who had led him so far astray. Despite my general protestations of innocence–accompanied, no doubt, by a summoning up of my most angelic countenance–I got the distinct impression that he thought I was a rat. Just like every other financial advisor no doubt.
Needless to say, that was my first–and last–visit to the ophthalmologist. I sure hope that he doesn’t have to work any longer. And that’s how I was introduced to guaranteed investment contracts.
Guaranteed Investment Contracts
A GIC, typically issued by insurance companies and banks, is a contract whereby the issuer guarantees to pay some stated interest rate over some stated period of time and to repay principal. This “guarantee,” however, is conditioned on the claims-paying ability of the insurance company issuing the GIC. In a time when municipal bankruptcy has been filed this year by a number of California cities, when my home state of California is effectively insolvent, and when the credit rating of the government of the United States has been downgraded twice in the last three years, it’s useful to place a GIC’s guarantees in proper context: They rest entirely on the full faith and credit of the insurance company itself that issues the GIC.
Stable Value Funds
Stable value funds invest primarily in GICs to create a diversified portfolio of high-quality, shorter-term (e.g., 3-5 years) fixed-income investments. Such portfolios include synthetic GICs, which are invested in fixed-income and money market instruments.
In a synthetic GIC, the investor (such as the sponsor of a 401(k) plan) retains ownership and control of the underlying investments and purchases a “wrapper” from an insurance company. The wrapper guarantees that principal will not go down in value and that the minimum return (i.e., the “floor”) will be something greater than 0%. In short, the insurance company designs the wrapper to protect principal and stabilize (or “smooth”) return.
The manager of a stable value fund can spread risk over multiple issuers of GICs. Other kinds of investment choices that are available to investors in stable value funds include traditional GICs (i.e., general account GICs), separate account GICs, and pooled GICs (invested, for example, with other plan sponsors in synthetic GICs, traditional GICs and separate account GICs).
A stable fund that is created, as noted, to provide a guaranteed return and smoothed income flow, is actually not a mutual fund but a fixed interest option offered in the form of a group annuity contract issued by a life insurance company.
Here’s how an insurance company that offers a popular stable value fund describes it:
“[The insurance company’s stable value fund] is offered through a group annuity contract issued by the insurance company]. Stability of principal is the primary objective of this investment option. [The stable value fund] guarantees a minimum rate of interest and may credit a higher interest rate from period to period. The credited interest rate is subject to change, up or down, but will never fall below the guaranteed minimum. The guarantees provided by the contract are based on the claims-paying ability of [the insurance company]. The assets are held in a separate account and are “insulated” from claims arising out of any other business conducted by [the insurance company] and can be used only for the benefit of plan participants. Withdrawals resulting from employer- initiated events, such as withdrawals following mass layoffs, employer bankruptcy or full or partial plan [replacement] may be restricted. Your stable value account balance is not guaranteed by the Federal Deposit Insurance Corporation (FDIC), by any other government agency or by your plan. This portfolio is not a registered investment under the 1940 Act and has not been registered with the Securities and Exchange Commission.”
Stable value funds are sold to sponsors of qualified retirement plans governed by the Employee Retirement Income Security Act (ERISA) such as 401(k) plans, and those not governed by ERISA (but sometimes by state law, which parallels the language of ERISA) such as 457(b) plans.
Many retirement plan participants like stable value funds because their returns are higher than money market funds and they preserve principal. They think of stable value funds as conservative investment options (just like money market funds), which are guaranteed by the plan itself, the Federal Deposit Insurance Corporation, or some other governmental agency. In reality, though, participants should not think of stable value funds as cash-equivalents (i.e., money market funds), but rather as short-term bond funds. After all, we know that stable value funds are riskier than money market funds simply because stable value funds have higher returns, thereby confirming once again the often overlooked, yet profound, link between risk and return.
Assets Held in a General Account or Separate Account
An important issue concerning stable value funds is whether the invested assets are held in the general account of the issuing insurance company or whether they’re held in a separate account. If the former, the assets are subject to the claims of the general creditors of the insurance company. If the latter, the assets are not subject to such claims because they are held in a segregated, separate account.
In my view, no ERISA plan should ever invest in a stable value fund whose assets are subject to the fund issuer’s general creditors. After all, the primary duty of fiduciaries under ERISA (and fiduciaries under ERISA-like state law) is to safeguard plan assets. Why would the sponsor of a retirement plan turn over plan assets to an outside entity and subject such assets to the entity’s creditors? One way to perhaps justify that would be to require the insurance company to sign off as a fiduciary to the plan and assume legal responsibility for the invested assets of the plan. Since no insurance company would ever do that, the fact remains that any plan investing in a stable value fund holding assets subject to an issuing insurance company’s general creditors would be classified as a general creditor in the event of trouble.
Investors in stable value funds such as fiduciaries of retirement plans often overlook this important “detail.” They should take note, however, that assets invested in junk bonds at Executive Life GICs were held in a general account and were lost. That’s why my ophthalmologist was so upset: He was just another general creditor in the mix who lost his retirement savings.
Illiquidity Risk
When Executive Life began failing in 1990 due in part to problems with the junk bonds in its GICs, investors started to bail out of them. So many people rushed to the exits at once that Executive Life couldn’t adequately redeem the GICs to pay them back in full. Such investors who had bought the GICs found that the money they had invested in them was, in effect, frozen. As a result, Executive Life failed and was seized by the government.
Some plan participants who had invested in stable value funds experienced similar problems in the economic downturn beginning in 2007. They were restricted by the providers of the stable value funds that they had invested in from withdrawing their money from them. These restrictions were put in place as a result of illiquidity in the underlying holdings in the portfolios of the funds as well as contract constraints placed on investors such as plan sponsors by the issuers of the funds.
Sometimes these restrictions took the form of a penalty such as how much of a “haircut” (i.e., the diminution in a plan account balance) must be taken by the investor who demands immediate liquidity (assuming that liquidity is even available at the time the investor demands the liquidity) to get out of the stable value fund investment option. In March 2011, the U.S. Government Accountability Office issued a comprehensive 73-page report entitled “401(K) Plans: Certain Investment Options and Practices That May Restrict Withdrawals Not Widely Understood” (GAO-11-291) that lays out these risks.
Fees
The disclosed management fee of a stable value fund is readily available. For example, that fee for the popular stable value fund described earlier is 90 basis points. But other more opaque fees are difficult to ascertain. For example, wrap contract fees, administrative expenses, and sub-advisory fees are not transparent. Fees embedded in GICs constitute an additional layer of “hidden” fees. It remains to be seen whether the disclosures required under ERISA sections 408(b)(2) and 404(a)(5) will help sponsors of ERISA plans get a better handle on all the costs, fees, and expenses associated with stable value funds.
Lack of Transparency
Speaking of opaqueness, a stable value fund is not a registered investment product under the Investment Company Act of 1940 nor need it be registered with the U.S. Securities and Exchange Commission. This means that a stable value fund is not subject to the rules for reporting underlying holdings, nor is it required to disclose fees, both of which are required of mutual funds. In fact, stable value funds don’t have to reveal much of anything about their activities (even though they are edging toward comprising nearly $700 billion in retirement plan assets).
This lack of transparency flies in the face of efforts by the Department of Labor to promote additional disclosures about the investment options offered to participants in retirement plans. Such opaqueness makes stable value funds the black holes of plan investment options.
Surrender Charges
When individual plan participants exit a stable value fund–apart from the “running for the exits” scenario in an economic downturn–ordinarily they can get back the “book” (i.e., full) value of their investment. But there are exceptions to book-value withdrawal. For example, if a withdrawal results from an employer-initiated event such as a plan sponsor’s decision to stop offering a stable value fund as an investment option in its plan, there may be a surrender charge (i.e., a “contingent deferred sales charge”) imposed at the time of termination of the fund. A surrender charge is often expressed as a percentage of plan assets, with that percentage declining over time. Many plan sponsors do not understand (or even know about) these costs (even though they are disclosed deep in hundreds of pages of legalese) until they appear out of “nowhere” when an employer-initiated event occurs.
The Future of Stable Value Funds
Many stable value funds have performed favorably in comparison to money market funds over the years. However, their relative attractiveness to participants in retirement plans vis-à-vis money market funds could very well decline given current foreseeable conditions in financial markets. First, the costs of insurance wrappers have increased and greater contractual restrictions have combined to reduce yields in stable value funds. In addition, as new cash flows are invested in the portfolios of stable value funds at lower reinvestment (interest) rates, the lower rates cause the amortized yields on the portfolios to move lower. The longer that interest rates stay at historical lows–thereby resulting in lower rates on new fixed-income investments–the lower the portfolio returns and the closer they get to the returns on money market funds. If this should occur, issuers of stable value funds might attempt to boost yield by taking on additional risk.
Speaking of additional risk, as noted, the profound link between risk and return is often overlooked. This inexorable link–higher return means higher risk–belies the validity of the comparisons made between stable value funds and money market funds in insurance company marketing materials. These comparisons show that stable value funds have higher returns than money market funds. But those higher returns are not created out of thin air by the Easter Bunny. They are there because of, for example, the restrictions placed on the liquidity of the assets invested in the stable value fund’s portfolio, which allows the insurance company to invest them for longer periods of time. Such restrictions and others, as noted, create higher risk. This higher risk means that stable value funds are actually short-term bond funds, not cash equivalent alternatives as they are often marketed to be. As such, the returns of stable value funds cannot be an apples-to-apples comparison to those of money market funds, because the two kinds of funds have different risk profiles.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.