Saturday, February 12, 2005

Stable Value - Win/Win or Win/Loose?

In today’s Barrons Jack Willoughby detailed the unraveling of stable value accounts (SVA) under the domain of the SEC. Despite the expiration of this segment of the stable value market, stable value investing remains a large and popular though functionally misunderstood part of the defined contribution marketplace. The article states “more than $350 billion worth of these funds rest in 401(k)s” and other sources suggest over 2/3rd of DC plans include a stable value option.

Who wins with SVA’s?
Similar to how you should evaluate any investment product, first understand the basic investment characteristics of the product and how the manufacturer, the distributer and the end investor make money. The goal is to gauge if the product’s economics are reasonably balanced by attractive investment characteristics that have real utility to investors. In other words... is the product bought or sold?

According the Stable Value Investment Association , SVA’s are designed to provide the safety of money market funds with the returns similar to intermediate bonds. This sounds very appealing and in fact may be…. depending on your time horizon, your “real” sensitivity to short-term market volatility and of course the design parameters of the particular SVA product available to you.

How do investors win?
Based strictly on general “asset class” parameters, structured products like SVAs should be attractive in the “short run” because as defined, they should (and most do) have a higher sharpe ratio (standard deviation/return) than either money markets funds ( SVA’s have higher returns similar risk) or intermediate bonds (SVA have similar returns less risk). As a long-term investment however, the attraction may fade and can indeed turn unattractive from a return perspective. Why is that? Because an SVA portfolio’s total returns should be those implicit in the underlying collateral less the insurance premiums paid over time to keep the portfolio valued at book in the short run. At the margin, investors should carefully evaluate if the perceived value they assign to short run price stability out-weights the lost returns due to the insurance costs. In theory, the volatility investors avoid in these products can be spent on additional higher returning assets such as equity. SVA investors can also win if the asset exposures and portfolio management of the SVA collateral is not available to them elsewhere and can generate realizable returns net of insurance cost in excess of intermediate bonds.

How do SVA manufacturers win?
SVA manufacturers win by their ability to collect very handsome revenues on a product that has very low fee transparency, very low consumer understanding and very low financial risk for them. Insiders recognize that guaranteed and stable value accounts provide high levels of ROI and can often subsidize other products whose pricing and attributes are more transparent to consumers. The SVA industry has had great success by over-marketing the portfolio value of short-term stability, by taking advantage of the laws of large numbers, by the natural laws of overwhelming investor conservatism and inertia and by designing contract constrains that work in their favor.

Since the 401(k) investing objective is generally long-term retirement investing, younger participants should be indifferent to the limited price volatility associated with fixed income investing since they will not be realizing any of the short-term volatility except on paper. However, the SVA industry focuses on safety (which by the way is usually defined as guarantee of principal..very few consumers focus on the credit risks associated with that guarantee) and panders to a naive and unproductive desire for “safety”. Participants should prefer the higher return characteristics of fixed income investments, unfettered by insurance costs, until they get close to retirement where price stability should then become a more important element in their asset allocation decision.

Companies that provide book value guarantees rent their financial capacity to deal with the conflict between meeting short-term liquidity requirements and maximizing long- term returns by investing in higher risk, longer duration and more illiquid categories of investments. These companies get paid premiums for absorbing these competing objectives and if they are good underwriters can pocket lots of the investment duration, credit and liquidity spread before posting credited rates on SVA’s.

To further reduce their risks, SVA sponsors must ensure that there is relatively small dollar turnover or low interest rate sensitivity in the SVA product. This is where the providers take advantage of investor’s natural conservatism and inertia (proclivity for many participants to keep their money in a safe investment and never touch it regardless of market conditions) and contract provisions that don’t allow competing accounts (i.e. money market accounts) or other restrictions on transferring money out of these accounts.

Many Defined Contribution SVA products are designed to be interest rate responsive so the risk of being “under water” is limited. This also tends to keep the account more competitive with money market rates in a rising rate cycle. The collateral behind these funds is normally higher credit quality and lower duration GICS and fixed income products. Unfortunately, this kind of SVA may offer the least long-term value to investors though they can certainly provide a very nice annuity to the sponsoring company. Long term-oriented investors with access to these “Win/Loose” accounts may be better off in an intermediate bond market index fund.

Some SVA’s might offer investors a Win/Win combination. Provided the underlying collateral pool offers access to markets and investments that smaller investors cannot access, provided portfolio management is effective, provided product cashflows have been beneficial and finally provided the fee structure and rate crediting process allow some of those advantages to leak through to the investor, then there can be a real and unique investing benefit from an SVA.

Generally, long horizon investors and those not particularly impacted by short-term volatility may not benefit from many stable value products. Unfortunately, that describes the average investor in these products. Consider one other perspective. Do prudent long-term oriented institutional investors (i.e. Pension plans) normally include SVA products in their asset allocations? Not usually. Why...as long term investors they find it uneconomic to pay up for short term volatility protection.

Investor Strategies -
Senior insurance executives I have known (predominantly actuaries who are ruthless at figuring out how to save a buck) invest their total personal fixed income allocations in a tax sheltered (401K) environment and keep the balance of their equities in non-tax advantaged accounts. This preserves the tax-advantaged nature of capital gains and allows income to grow tax deferred. The dissolution of stable value alternatives in an IRA environment may impact how you assess the value of rolling over 401(k) money into an IRA. If you happen to have access to an SVA in your 401(k), you should try to assess its productivity and utility to you.

As either a sponsor selecting an SVA or an investor considering an allocation, you should review the product parameters. If the collateral is shorter duration, very high credit quality and with credited rates highly correlated to money market yields etc you may be paying a lot for something of minimal long-term value. If you are accessing investments through the collateral pool which should have a higher intrinsic rate of return, and credited rates have been near or above high quality bond returns then you may have access to a risk/reward profile that you might want to retain. It is also important to understand the cashflows of the particular SVA product since portfolio return rates are sensitive to funding and distributions.

Other reading on SVA's:
Dwight Asset Management- SVA in a Rising Rate Environment

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