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Financial Reform Postpones a Key Stable-Value Decision

July 20, 2010

Stable-value funds have typically been the go-to investment for retirement participants needing predictable returns. But while some providers are trying to improve the product, the newly passed financial reform bill has postponed the investment’s fate for more than a year while federal agencies determine whether stable-value funds should be classified as swaps. Swaps are derivatives where there is a contract between two parties; that contract’s value is based on something else, most often an underlying asset.

One of the major reasons for this sweeping financial bill was to better regulate this kind of transaction and to increase transparency to avoid another market meltdown.

Known as one of the largest overhauls of the financial system since the Great Depression, the Wall Street Reform and Consumer Protection Act, passed by Congress and signed by President Barack Obama on Wednesday, July 21, asks the Securities and Exchange Commission and Commodity Futures Trading Commission to study whether stable-value funds should be defined as swaps. The agencies have within 15 months to start the project.

If the agencies classify stable-value funds as swaps, then they need to determine whether the funds should be exempt from the law. Current stable-value contracts are automatically excused.

The decision, at least for now, to keep stable contracts intact is a relief, says Matt Gleason, head of stable value for Dwight Asset Management Co. Earlier versions of the bill threatened the existence of the investment, he says.

“Ultimately they’ll get it right,” Gleason says. “There might be additional regulation to improve transparency.”

Stable-value products, which make up about 25 percent of defined-contribution assets, are fixed-income products. The investments are protected, or “wrapped,” by a bank or insurer’s investment guarantee that agrees to pay the book value of the investment if the market value tanks.

It’s a very popular investment because it provides investors a guaranteed return that is higher than money market funds. The Hueler Stable Value Pooled Index showed a 3.07 percent one-year return as of April, compared with the 0.52 percent return for the Lipper Money Market average over the same period. The Stable Value Investment Association says that on average, about half of all 401(k) plans offer the investment and participants invest 15 to 20 percent of their assets in these accounts.

The wrap is a negotiated contract meant to hedge the risk of the bond investment. Earlier versions of the bill had many industry experts concerned that the broad definition of swaps would include the wrap portion of the stable-value investment.

Although legislators’ intent was to protect consumers from other risky swaps investments, experts say the actual language of the bill would have put wrap providers on both sides of a deal—advocating for the highest price in selling the wrap, yet as fiduciary of the plan, negotiating the best wrap price possible for participants. And without the wrap, the stable-value fund would simply be another fixed-income investment. “You can’t be a fiduciary on both sides of the deal. It’s engaging in a prohibited transaction,” says Diann Howland, vice president of legislative affairs for the American Benefits Council.

In addition to the study, the bill creates stricter financial regulation and transaction rules and is aimed at preventing another financial crisis. Despite positive returns for stable value when most other investment classes fell in 2008, wrap providers were slammed by the instability of the market and participants wanting book values.

Overall, the average yield for the investment declined, reaching 3.12 percent in 2009, compared with nearly 5 percent in 2007, according to Hueler Analytics Stable Value Pooled Fund Index. This steady downward trend started the dominoes tumbling. Funds increasingly relied on wrap contracts, and as a result, providers started re-evaluating their liabilities and began moving out of the business.

With fewer than a dozen wrap providers today, pricing for contracts is at a premium, hovering at about 25 basis points, compared with about 9 basis points prior to the financial collapse, says Marko Komarynsky, director of fixed-income manager research for Towers Watson & Co. But shifts are under way, benefiting the asset class as well as participants, Komarynsky says.

To ensure a higher-quality product, wrap providers are demanding more conservative investments, with more subsector restrictions than in the past, says Gleason of Dwight Asset Management. The company manages $45 billion in stable-value products.

To help reduce exposure for wrap providers, Dwight has come up with a new five-year term insurance contract. Under the contract, wrap providers would be responsible for a specific guarantee, and then would be able to renegotiate the terms in five years. Most contracts today are evergreen, meaning there are no predetermined maturity dates. Since this wasn’t working out for providers, Gleason says Dwight came up with this remedy.

“Clearly there are a number of issues in stable value,” Gleason says. “We’re trying to be a thoughtful leader in this asset space.”

Stable value certainly has a place in diversifying portfolios, but plan sponsors need to be aware of its underlying investments and wrap contract terms, Komarynsky says. A recent MetLife stable-value study showed a third of plan sponsors are not sure whether certain events would trigger market-value payments.

“It was such a boring topic a few years ago,” Komarynsky says, “But now, unless you are on top of it, you are really behind the game.”

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