Table of Contents
This report was produced by the Advisory Council on Employee Welfare and Pension Benefit Plans, usually referred to as the ERISA Advisory Council (the "Council"). This report examines Stable Value Funds and Retirement Security in the Current Economic Conditions. The ERISA Advisory Council was created by ERISA to provide advice to the Secretary of Labor. The contents of this report do not represent the position of the Department of Labor (DOL).
The Council studied Stable Value Funds and Retirement Security in the Current Economic Conditions. The Council's purpose in studying stable value funds and other stable value investment products ("Stable Value Funds"), was to determine whether the Department should provide (i) requirements or guidelines to retirement plan service providers related to the design or marketing of Stable Value Fund investments; (ii) requirements or guidelines to plan sponsors and fiduciaries for selecting and monitoring Stable Value Funds; and (iii) information to plan participants to assist them in making informed investment decisions regarding Stable Value Fund investments in participant-directed plans.
The Council received testimony from ten (10) witnesses on July 22, 2009 and from eight (8) witnesses on September 16, 2009. These witnesses represented a wide variety of interested parties and viewpoints, including members of the stable value industry, such as Stable Value Fund managers and product providers, independent investment advisors, retirement plan consultants, employee benefits providers, employee benefits attorneys, and non-profit associations. The Council submits the following recommendations to the Secretary of Labor for consideration:
Recommendation 1: The Department should prepare and make available informal information, such as FAQs, best practices or other general guidance, targeted to plan sponsors and plan fiduciaries that would assist them in discharging their fiduciary duties when selecting, monitoring and making available plan investments in stable value products.
Recommendation 2: The Department should prepare and make available simple and concise educational materials targeted to plan participants that would assist them in the potential investment of their participant-directed investment account in stable value products.
*Patricia Brambley, Issue Chair
*Theresa Atanasio, Issue Vice-Chair
Elizabeth Dill, Council Chair
Marc LeBlanc, Council Vice-Chair
Mary Nell Billings
*Served on report drafting committee
The Council studied several interconnected issues related to Stable Value Funds. Within the scope of this report, the Council addresses, the questions presented to witnesses (along with a summary of all the witnesses' testimony), offers a description of Stable Value Funds and the investment's relationship to retirement security issues, and contains the Council's recommendations to the Secretary of Labor.
The Council's objective was to evaluate whether plan fiduciaries and plan consultants advising those fiduciaries might benefit from guidance on the fiduciary duties required in both (1) selecting, monitoring, and valuing Stable Value Funds and (2) providing information to participants about Stable Value Funds so that they may make better-informed investment decisions. In this regard, the Council examined the operation of Stable Value Funds, the intended purpose of Stable Value Funds, the historic performance results of these products, and risks associated with Stable Value Funds. In examining these issues, the Council focused on potential areas of improvement in the design of materials used to describe or market Stable Value Funds.
Ultimately, the Council sought to determine:
- What role the Department might take in mitigating any risks identified as unique to Stable Value Funds.
- Whether the Department's issuance of additional guidance might help plan fiduciaries and the consultants that advise those fiduciaries in choosing, valuing, and monitoring such funds.
- What role, if any, Stable Value Funds play with respect to a plan's ability to receive protection under ERISA Section 404(c).
- Whether current disclosures to participants regarding Stable Value Funds are sufficient.
- Whether it would be appropriate to include Stable Value Funds as a stand-alone qualified default investment alternative.
- If the Department should provide additional guidance on existing regulations relevant to Stable Value Funds in light of the current and projected future economic and demographic environment.
Questions for Witnesses
The witnesses received materials explaining the scope of inquiry. The Council asked the witnesses the following questions as a starting point to generate thought and discussion.
How do Stable Value Funds work?
Do plan sponsors and their consultants have adequate knowledge to understand whether a particular Stable Value Fund is an appropriate investment for their plan (e.g., do they understand the difference between book and market value)? Do they understand how fund managers are managing the underlying bond portfolio and how the manager is attempting to add value?
Are plan sponsors, consultants, and participants aware of the advantages and disadvantages of these investments?
What are the risks, if any, unique to these investments and how can those risks be mitigated?
Are Stable Value Funds suitable as a qualified default investment alternative (QDIA) in light of the current and future economic environment?
What characteristics of Stable Value Funds make selecting and monitoring them different from other investments?
Is there any reason why additional or different regulatory guidance is needed for Stable Value Funds compared to guidance for other investment decisions by fiduciaries?
Of which facts and issues should participants be made aware? Is more disclosure needed?
How is market value adjustment determined, when is it applicable, and how does it vary by product?
How are fees disclosed? What is an appropriate disclosure or, alternatively, is it sufficient just to know what the crediting rate entails?
Why are "competing funds," e.g., money market accounts selected by plan sponsors and do plan participants understand the need for an equity wash?
How are Stable Value Funds benchmarked for both book value returns and market value returns?
What is the role of the investment provider versus the plan sponsor or fiduciary in connection with disclosure?
What are Stable Value Funds?
The Council received significant testimony concerning the purpose, design and features of Stable Value Funds. Though there are differences among various Stable Value Funds in general, a Stable Value Fund can generally be labeled as a conservative, fixed income investment vehicle with an objective of preserving capital while providing a relatively stable rate of return that generally exceeds the returns provided by money market funds.
Frequently, a Stable Value Fund is a fixed income investment fund managed by an investment fund manager with a wrap contract that guarantees book value to participants for participant-initiated events, such as transfers to other investment options and plan distributions.
Fund managers typically invest in highly rated corporate debt and highly rated structured securities such as asset-backed securities, commercial mortgage-backed securities, residential mortgage-backed securities, and other similar fixed income investments. The fair market value of these Stable Value Funds fluctuates on a daily basis, but their book value or net asset value (NAV) does not fluctuate.
Overall, it is clear that Stable Value Funds are an important investment tool for retirement plans covered by ERISA, especially in participant-directed retirement plans, such as 401(k) plans. Stable Value Funds are an important tool in achieving a conservative, fixed income return while preserving capital.
Although the idea of providing a conservative return while protecting and preserving principal is a simple concept, the actual products themselves can be complicated. Because many of the core features of Stable Value Funds are similar to money market funds, many people think of them as the same. In actuality, there are many important differences between Stable Value Funds and money market funds.
Different Types of Stable Value Funds
Stable Value Funds are managed in different ways, including:
- Separately Managed Accounts. Separately managed accounts are customized to meet the objectives of a single retirement plan and do not include assets of other plans.
- Commingled or Collective Funds. These accounts are designed to combine the assets of unrelated retirement plans, enabling the investor to diversify and gain the economies of scale.
- Guaranteed insurance contracts (GICs). These investments are another managed arrangement in which the fund manager holds or invests in a single group annuity contract issued directly to the retirement plan and the plan sponsor receives a direct guarantee of principal and accrued interest from the issuer.
An important component of a Stable Value Fund is an insurance contract-known as "wrap contracts" or "wrappers"-that plan sponsors purchase from banks, insurers, or other financial companies. The wrappers generally guarantee that participants will receive principal and accumulated interest even if the bonds held in a fund's portfolio decline in value. In other words, the plan participants are able to transact at book value (principal plus accrued interest) rather than at the more volatile market value. Generally, if a stable value portfolio falls below the rate of return set by the wrapper, the insurer pays the difference.
There are numerous types of Stable Value Fund contracts; including traditional Guaranteed Investment Contracts (GICs), separate accounts contracts and synthetic GICs. Stable Value Funds may hold one contract type or a combination of contracts. Traditional GICs are contracts with an insurance company that guarantee a fixed rate of return backed by the assets of the insurer's general account. The contract guarantees the rate of return regardless of the performance of the underlying assets, which the insurance company owns and holds within their general account. Separate account contracts are contracts with an insurance company that guarantee a rate of return backed by assets held in a segregated account separate from the insurer's general account. The rate of return may be fixed, indexed, or reset periodically based on the actual performance of the underlying assets. The insurance company owns these assets, but the assets are set aside in a separate account for the exclusive benefit of the participating plan.
Synthetic GICs are contracts with a bank or insurance company that guarantee a rate of return relative to a portfolio of assets held in an external trust. The rate of return, which is based on the actual performance of the underlying assets, is reset periodically. The participating plans own the assets. Typically, these contracts are commonly referred to as wraps or wrappers.
Because of the protection provided by the issuer or wrapper, plan participants have long considered Stable Value Funds as one of the most secure investments they can make in their 401(k) plan accounts. Historically, Stable Value Funds have reliably provided a lower but steady return consistent with the preservation of principal. From January 1989 to December 2008, Stable Value Funds' net annual returns were 6.3% as compared with 4.1% for money market funds and 5.7% for intermediate government/credit funds. Fund net annual returns were 6.3% as compared with 4.1% for money market funds and 5.7% for intermediate government/credit funds.
Estimates indicate that somewhere between one-half to two-thirds of all defined contribution plans currently offer stable value options. Between 1997 and March 2009, Stable Value Fund asset allocations ranged from 17% to 37%, with allocations to Stable Value Funds peaking in the first quarter of 2009 (in part due to the decrease of asset values in other investments).
Recent Performance and Trends
Despite the relative stability of Stable Value Funds, these investment vehicles have not been immune from the recent economic turmoil. According to one estimate, the average Stable Value Fund returned 4.58% in 2008, far below the ten-year average. One, albeit extraordinary, example of this decline is the Lehman Brothers bankruptcy. In late December 2008, the Stable Value Fund that Invesco offered to Lehman Brothers employees lost 1.7% in value because of a fall in bond prices and because the wrap contract ended in response to Lehman's bankruptcy filing.
Recently, the market value of many Stable Value Funds has fallen below their book value. Additional recent developments in the Stable Value Fund market attributable to the recent economic turmoil include shrinking wrap contract capacity, increases in wrap fees, the emergence of a wrap issuer supply driven market, investment portfolio structure changes, tightened wrapper underwriting standards, fund credit uncertainty, and fund crediting rate divergence.
In connection with the Council's first recommendation, there are several important issues facing plan sponsors concerning the investment of plan assets in Stable Value Funds.
Fair Market Value Adjustments
The Council received testimony that plan sponsors must recognize that a significant feature of Stable Value Funds is the possibility of a fair market value adjustment. Most Stable Value Funds contain a fair market value adjustment provision for certain employer-initiated events.
The contractual provisions that allow participants to receive book value, even if fair market value is less, apply to participant-initiated transactions. In other words, upon the occurrence of certain employer-initiated events, e.g., plan terminations, employer bankruptcies, a decision to change recordkeepers who offer only proprietary Stable Value Funds, early retirement window programs and other employer orchestrated events that cause unanticipated cash flow disruptions and potential harm to remaining Stable Value Fund investors, most Stable Value Funds will not allow the plans or the participants to immediately receive the book value of the investment if the fair market value of the investment is less. Without such an adjustment, a large-scale withdrawal from a Stable Value Fund would impose a significant adverse impact on all of the remaining stable value investors and result in the Stable Value Fund issuer or wrap provider potentially incurring substantial losses. Since these are risks that cannot be anticipated or predicted, they are not susceptible to effective pricing methodologies by insurers and therefore are excluded from book value treatment under Stable Value Funds.
Need for Additional Information
The Council received a significant amount of testimony that many plan sponsors do not have an adequate understanding of the critical features of Stable Value Funds. In some cases, this lack of understanding is due to the plan sponsor's insufficiency of due diligence or basic understanding regarding the features of Stable Value Funds. In this regard, several witnesses suggested that it would be helpful if the Department could help disseminate informal information that would assist plan sponsors in determining steps to take and the questions to ask in selecting and monitoring plan investments in Stable Value Funds.
With regard to another closely related issue, several witnesses indicated that the plan sponsors' inadequate understanding of the critical features of the Stable Value Funds resulted from the inability of plan sponsors to be able to obtain important information regarding the Stable Value Fund. As a result of this condition in the marketplace, several witnesses suggested that it would be helpful if the Department could help directly or indirectly encourage transparency related to Stable Value Funds. Specifically, many witnesses suggested increased transparency to plan sponsors concerning the following features of Stable Value Funds:
- Feature of the Fund. Plan sponsors need a clear understanding of the material features prior to the selection a Stable Value Fund.
- Termination of Investment in Fund. Plan sponsors need information concerning any restrictions related to the plan sponsor's ability to terminate the plan investment in the fund, including terms and conditions of any market value adjustment feature. Without this information, a plan sponsor cannot determine the impact of eliminating this type of plan investment.
- Employer-Initiated Event. Plan sponsors need information concerning the events that may constitute an employer-initiated event that, if resulting in a material amount of participant withdrawals, can trigger a market value adjustment. Plan sponsors and plan fiduciaries are also struggling to determine how much disclosure is appropriate. Sponsors want to disclose enough information about Stable Value Funds to allow their participants to make informed decisions. On the other hand, fiduciaries do not want to confuse participants or create a situation whereby the provision of disclosure material has the unintended consequence of triggering withdrawals from the fund, which in turn results in a potential employer-initiated event.
- Underlying Assets. Plan sponsors need issuer specific information concerning the underlying assets of a Stable Value Fund. This information will help provide plan sponsors and fiduciaries with insight as to the risk/reward characteristics that will result in any variance between the fair market value and the book value.
- Wrap Provider. Plan sponsors need issuer specific information regarding the wrap contract provider(s). Ultimately, the financial stability of the wrap contract provider(s) may be a factor in the ability of the fund to be able to continue to make payments at book value when book value is greater than the fair market value of the underlying assets.
- Cost and Fees. Plan sponsors and fiduciaries need information concerning the administrative cost and other fee information related to the fund. This is an important factor in determining the efficiency and prudence of any plan investment.
- Actual Periodic Market Adjustment Information. Plan sponsors need information concerning the periodic fair market valuation of the fund as compared to book value. This would allow sponsors to evaluate any risk of a market value adjustment.
The above delineated information will improve plan sponsors' understanding of a Stable Value Fund portfolio composition, the current financial condition of issuers and wrap providers, the safeguards they have in place in the event of default, and the nature of the likelihood and significance of any potential fair market value adjustment or any other termination fees or penalties. Only with this critical information can plan sponsors adequately determine the appropriateness of selecting a particular Stable Value Fund or if such an investment meets the needs of the plan. The Council has heard testimony that these types of information may either not be readily available from wrap providers or fund managers or that plans sponsors do not know to ask for, or do not understand, the information that might be made available.
The Council heard testimony regarding the difficulties and complexities related to the valuation of Stable Value Funds. These concerns arise from a variety of reasons, including differences in the way Stable Value Funds are structured and delivered, issues related to the difficulty in valuing a fund's underlying investments (e.g., many Stable Value Funds hold privately placed fixed income investments or other hard to value asset backed securities), and determining the proper value of synthetic GIC or wrap contracts. The issue is compounded by differences in the way reporting is required for different purposes. For example, for Form 5500 purposes, current value reporting is required. Current value is deemed to be contract value for fully benefit responsive funds. For external reporting purposes, stable value investments, including fully benefit-responsive contracts, are required to be reported at fair value following generally accepted accounting principles (GAAP). So, for GAAP purposes, the difference between the fair value and contract value of fully benefit-responsive insurance contracts must be shown on the plan's statement of net assets available for benefits.
The Council understands that until the significant disruptions in the capital markets caused by recent economic events, the differences between contract value and market value were generally small. However, recent market conditions have caused these differences to widen. Moreover, due to the complexities of the arrangements, the expertise required and the difficulty in obtaining appropriate market value information (both with respect to the value of funds as a whole and their underlying assets), plan sponsors and participants often are not able to readily obtain or understand information about the value of the stable value arrangements in which they participate.
Despite these challenges, the Council has heard testimony that, for the most part, plan sponsors typically work well with service and product providers to gather fair value information. Certain circumstances present unique challenges that could require special attention to due diligence, additional controls, on-going monitoring and financial reporting. In these situations, plan sponsors, employers and fiduciaries may require additional assistance.
The Council heard significant testimony concerning issues that can arise when an employer or plan sponsor terminates its relationship with a Stable Value Fund provider. This can arise in several situations, including replacing the Stable Value Fund with a different fund, discontinuing the Stable Value Fund arrangement entirely, or moving to a new recordkeeper that only offers its proprietary Stable Value Fund. In these situations, a market value adjustment or other contractual mechanism such as delayed payment designed to protect the fund and its remaining participants and/or the product issuer can be initiated. For example, the Council received testimony that a plan withdrawing from a bank collective trust Stable Value Fund, when the market value is less than book value of the fund, commonly must choose between taking all of its funds at market value or waiting up to 12 months after serving notice of its intent to withdraw the funds (this commonly is referred to as exercising "a 12 month put"). During this 12 month period, the crediting rate on the funds is reduced so that at the end of the 12 month period, the market value and book value converge. This process assures principal preservation but results in a liquidity restriction. The Council also heard testimony that it is sometimes difficult for plan fiduciaries to obtain accurate market value information to be able to determine the ultimate cost of contract termination.
The Council also heard testimony that, when these transitional issues arise, there are solutions available to help fiduciaries manage them. For example, if a Stable Value Fund wants to replace a wrap provider, a new wrap contract can be obtained from a provider who is willing to wrap a portion of the fund's assets. This enables the fund to maintain book value without any adjustment. For more generic insurance company general account stable value accounts, a new general account provider may be willing to "book-up" the fund and amortize any difference in market to book value through adjustments in the crediting rate. Other transitional alternatives tailored to the particular arrangement are also available, but these are often complicated to explain (particularly to participants) who may be confused about why the crediting rate on their Stable Value Fund is falling at a time when short term rates under other fixed income investments are rising. In this regard, the Council consistently heard from witnesses about the need for the stable value industry to provide advance communication and disclosures outlining contractual terms and provider restrictions. This will help set appropriate expectations, reduce confusion in the marketplace and assist fiduciaries in selecting and comparing product types, features and structures.
The Council heard testimony from the Stable Value Investment Association (the "SVIA") regarding concerns about shrinking capacity of stable value product issuers/providers. This development has made it more difficult to obtain new products or expand existing stable value coverage. This phenomenon has been created by the 2008 economic events and disruptions in the capital markets and resulted in reassessment of risk exposure by stable value providers and the availability of some stable value investment contracts. As a result, the SVIA reported that some issuers are not accepting new deposits; some are exiting the market while others are considering entering the market. In response, Stable Value Fund managers and product providers are taking the following steps to address these issues: increasing cash reserves or "buffer" accounts, adopting more conservative investment guidelines, implementing shorter duration portfolios, and increasing the premiums for investment contracts or wraps in recognition of the increased volatility of the fixed income market.
To date, the Council is not aware of situations where an employer or plan sponsor has been unable to obtain or continue a Stable Value Fund as an investment option due to insufficient capacity among s Stable Value Fund providers.
In connection with the second recommendation, witnesses' testimony noted important issues facing plan participants concerning the investment of participant directed accounts in Stable Value Funds.
In general, several witnesses asserted that plan participants who direct the investment of their own retirement account do not have an adequate understanding of Stable Value Funds. As with plan sponsors, plan participants often view Stable Value Funds as the effective equivalent of a money market fund without appreciating the important differences. Many participants do not understand the difference between book value and market value and potential risks related to a fair market value adjustment upon the occurrence of an employer-initiated event, if and when it would occur. Many participants also do not understand that payment of plan funds invested in Stable Value Funds could be a delayed upon the occurrence of an employer-initiated event. The Council believes that this lack of understanding can be attributed to, in part, the fact that these events are not frequent occurrences and, therefore current disclosures to plan participants do not provide information describing these types of circumstances.
There was some dispute among the witnesses as to whether plan administrators or Stable Value Fund providers should be required to provide more detailed information regarding Stable Value Fund investments. Many witnesses testified that plan participants need more information and that plan sponsors or administrators should be required to provide a series of mandatory disclosures. Other witnesses were concerned that participants are already receiving too much information and that additional information would result in information-overload that might actually result in greater confusion and less information absorption by participants. In addition, some witnesses expressed concern that any new rules should not impose greater direct or indirect fiduciary burdens on plan fiduciaries than is higher than the existing standards. Instead, there are many types of complex investment vehicles, and Stable Value Funds are not so different from other plan investments so that the current regulatory framework is sufficient to address the fiduciary concerns.
There was, however, a substantial consensus amongst witnesses that it would be helpful if the Department prepared some general informational material targeted to plan participants that highlights some of the basic material features of Stable Value Funds. This type of general information would ideally be shorter and simpler than the information prepared and provided by the Department that is targeted to plan sponsors and fiduciaries as discussed above.
The Council heard testimony from a number of witnesses in response to its inquiry as to whether it would be appropriate for Stable Value Funds and similar funds designed to preserve principal, to be included as a stand-alone investment among those investments that are eligible for Qualified Default Investment Alternative ("QDIA") treatment. More specifically, the Council was interested in hearing testimony with regard to whether it should recommend that the Secretary reconsider the Department's decision not to include Stable Value Funds or other principal protected products as stand-alone QDIAs. Further, the Council was interested in evaluating the impact on participants that the dramatic change in economic conditions in the last year has had on participants' retirement security and if that impact would have been mitigated if Stable Value Funds were an eligible QDIA. If so, whether those circumstances warranted recommendations for changes to the Department's regulatory position with respect to QDIAs.
After hearing testimony on this issue, it was clear that several witnesses favored including Stable Value Funds as a stand-alone QDIA while others did not support changing the regulation to achieve that objective.
Those who urged change or regulatory reform argued that there are circumstances, life events or other factors where it would be appropriate for employers to have a stable value option available as the plan's default investment choice. For example, near retirees may want a "safe" or principal protected investment to assure that they do not suffer large market losses shortly before they retire. The events of the last year provide ample evidence of disrupted or substantially delayed plans for retirement for large segments of American workers whose retirement plan assets were too heavily exposed to equities. Other examples that were cited where Stable Value Funds would serve as an appropriate QDIA include high employee turnover businesses where market volatility could cause incremental losses in account values that are recognized when distributions are made to short-term terminated employees.
The Council also heard testimony that some employers may feel that it is important for their younger employees who may be new or unfamiliar with retirement savings, to have an initial positive savings experience. Otherwise, if savings' experience results in negative earnings (market losses) or severe market volatility (such as was experienced in 2008), they could be discouraged from continuing to participate or save in a retirement savings program. In effect, witnesses pointed out that there are several situations where employers may determine that for their workforces or for certain identifiable segments of their workforces, it is preferable to accept lower returns in exchange for less risk and volatility.
While the use of Stable Value Funds or other principal protected products as a plan's default investment remains solely the choice of the employer and the Preamble to the QDIA regulation makes it clear that the Department's failure to include stable value as a QDIA should not create a negative inference as to the prudence of selecting it as a default investment, employers remain hesitant to use it as a default investment. This arises because those investments included as eligible QDIAs within the regulation have legal certainty, and provide protection and comfort to employers who are concerned about their legal exposure and fiduciary responsibility for selecting investments for participants who have failed to provide affirmative investment instructions. Accordingly, a strong case was made for the Council to recommend that the Department reconsider its decision not to include Stable Value Funds as a stand-alone QDIA.
Other witnesses testified that the Department made the correct decision by not including Stable Value Funds as a QDIA. They pointed out that retirement plan investments are primarily long-term investments and that diversified investment products are the appropriate investments for these situations as they offer higher long-term returns. Supplemental testimony received by the Council for the record after the hearing dates disputes the extent to which this is the case, especially when the market downturn of 2008 is taken into account. Nevertheless, while the events of the last year were unanticipated and severe, opponents of reconsidering a change to the regulations to add Stable Value Funds as a QDIA point out that ample time exists to recover investment losses considering long-term investment horizons of most participants - even those nearing retirement. They also point out that participants who are more risk averse can certainly direct the investment of their retirement plan funds into more conservative choices and that employers can still designate Stable Value Funds as the plan's default investment in the absence of QDIA protection.
On balance, after consideration of all the testimony and based on the professional experience of Council members and what they believe to be in the best interests of achieving retirement security for American workers, the Council has decided not to make any recommendation to the Secretary with respect to reconsideration of its decision not to include Stable Value Funds as a QDIA.
Recommendation 1: The Department of Labor should prepare and make available informal information, such as FAQs, best practices or other general guidance, targeted to plan sponsors and plan fiduciaries that would assist them in discharging their fiduciary duties when selecting, monitoring and making available plan investments in stable value products.
Recommendation 2: The Department should prepare and make available simple and concise educational materials targeted to plan participants that would assist them in the potential investment of their participant-directed investment account in stable value products.
In addition to the submission of written testimony, the Council received testimony on the following dates from the following individuals (listed in order of presentation):
July 22, 2009
Jason Scott, Financial Engines Retiree Research Center
Gina Mitchell, Stable Value Investment Association
Marc Magnoli, JPMorgan Chase
James McKay, Ameriprise Trust Company
Gerald Katz, Diversified Investments
Cynthia Mallett, MetLife
James King, Jr., Prudential
Kathryn Solley and Linda Haynes, Seyfarth Shaw LLP
Donald Stone and Jennifer Flodin, Plan Sponsor Advisors
David Wray, Profit Sharing/401(k) Council of America
September 16, 2009
Jon Upham and Randall Long, SageView Advisors
Philip Suess, Mercer
Kelli Hustad-Hueler, Hueler Companies
Douglas Prince, Stifel Nicolaus
Michelle Weldon, PricewaterhouseCoopers
Susan Graef, Vanguard
Nell Hennessy, Fiduciary Counselors
Testimony of Jason Scott, Financial Engines Retiree Research Center
Financial Engines (FE) is an independent investment advisor offering advisory services to plan participants through their employers. Jason Scott, Managing Director of the Retiree Research Center at Financial Engines, stated FE utilizes Stable Value Funds in their recommended participant allocations - $1.5B is currently invested in Stable Value Funds out of their $20B under management.
A Stable Value Fund is a fixed income investment vehicle made up of two components: 1) an investment fund managed by an investment manager, and 2) an insurance contract designed to guarantee returns over a short period and to also permit participants to transact at book value. The higher returns come with the trade off of potential liquidity issues and possible restrictions imposed by the wrap provider on the plan sponsor. These restrictions can create challenges impacting plan sponsor decision-making and actions.
Wrap contracts are designed to cover all individual initiated redemptions, but not employer initiated redemptions. Recent market volatility leading to lower market values significantly below book value has increased scrutiny on plan sponsor behavior that might be considered employer initiated. The following could be considered employer initiated:
- Terminating a plan
- Replacing an underperforming Stable Value Fund
- Augmenting the plan lineup with a competing fund
- Communicating any information to participants that may result in incremental redemptions
Provisions in wrap contracts may limit a sponsor's ability to add new funds, whether a replacement fund or a competing fund, without voiding the wrap contract. Limiting participant communications is also an extremely critical issue for plan sponsors. For example, if the fund is significantly below book value, the plan sponsor from a fiduciary aspect should communicate this to the participants. However, the communications could void the insurance contract, which could be valuable to participants. This scenario creates challenges for plan sponsors for the correct course of action.
Mr. Scott made the following suggestions:
- The creation of standardized wrap contracts to improve transparency
- Required routine and timely disclosure of market value relative to book value
- Eliminate sponsor restrictions and develop a mechanism to address anything that hinders a sponsor from acting in the best interest of participants.
Testimony of Gina Mitchell, Marc Magnoli, James McKay, and Gerald Katz, on behalf of the Stable Value Investment Association
The Stable Value Investment Association was represented by four individuals from the stable value industry. Gina Mitchell, President of the Stable Value Investment Association (the "SVIA"), stated that SVIA's testimony focuses on separate account, wrap and pooled fund products but not general account insurance products since another panel is devoted entirely to that subject. Ms. Mitchell provided an overview of the current stable value market and discussed some things that plan sponsors and fiduciaries need to know about stable value. She said that sponsors need to know that Stable Value Fund provide consistent stable returns, principal preservation and immediate liquidity. Sponsors also need to understand how benefit responsiveness (withdrawals from the fund at book or contract value) distinguishes Stable Value Fund from other asset classes, how it is achieved and what rules and restrictions apply. Ms. Mitchell also noted that participants like Stable Value Funds because they are looking for principal protection, liquidity and stable consistent returns but need to recognize that even though stable value investments are low risk, they are not no-risk investments. For example, participants are exposed to interest rate and issuer credit risk. Finally, Ms. Mitchell testified that a wide cross section of participants like Stable Value Funds. In particular, Stable Value Funds have great appeal to low income workers who are just starting to save for retirement, individuals approaching retirement and more sophisticated investors who use it as a diversification tool.
Mark Magnoli of JP Morgan Chase discussed the performance of stable value in 2008 and 2009. He said that like most asset classes, assets in Stable Value Funds were hit hard in 2008 resulting in depressed market value to book value ratios. The ratio of market value to book value of the assets represents the plan's exposure to "wrap providers" who make the contractual book value guarantees under Stable Value Funds. Mr. Magnoli further testified that it was his view that showing the market value of a Stable Value Fund to participants would confuse participants because participants do not "trade" at market value. Rather they transact at book value, which is the only value they need to see. While there are situations that could arise (such as employer initiated events) where the book value guarantees would not apply, these are well defined, known in advance by plan sponsors and fiduciaries and the product is structured to avoid these occurrences as much as possible. They are treated as exceptions to book value withdrawal because they cannot be predicted, can impact investors and cash flows under the Stable Value Fund and can generate losses, which harm investors who remain in the fund.
James McKay of Ameriprise Trust Company testified that stable value was a good asset allocation diversifier over time, and also was effective to avoid short-term changes in a portfolio for people who are planning life events. This makes stable value particularly attractive for those approaching retirement, for example. He also said that, over time, Stable Value Fund returns are more consistent than (but approach levels equivalent to) intermediate term bonds. This is why stable value is a good diversifier and is evidenced by referencing Sharpe ratios, which demonstrate that stable value has a lower standard deviation of returns and less volatility than bonds.
Gerald Katz of Diversified Investments discussed the Financial Accounting Standards Board (FASB) rules that apply to stable value in order for a Stable Value Fund to be eligible for book value treatment. He pointed out that these rules require that in order for a Stable Value Fund or product to be eligible for book or contract value reporting, all participant-initiated transactions must be at book value. There may be a divergence of book value and market value of a fund and as market values change, book value will always show steady and consistent growth. By the time the portfolio matures, market value and book value will converge through the crediting rate reset formula contained in the contract. It is expected and anticipated that as interest rates change over time, the market value to book value ratio will go up and down. These differences are amortized in the crediting rate. Mr. Katz also discussed the disruptions to cash flow that results from various actions that plan sponsors could take. For example, the addition of new fund options, particularly some fixed income options, which were not taken into account when the fund was priced, could impact cash flows. This could have a negative impact on a Stable Value Fund and thereby certain restrictions may need to be imposed. These types of restrictions generally do not impact the ability to report a Stable Value Fund at book value under the FASB rules.
Several questions were raised for the panel involving the circumstances such as contract termination under which employers' and plan sponsors' actions could trigger a market value payout. Members of the panel responded that it was important for plan sponsors to recognize and understand the circumstances and consequences of certain actions. In addition, they need to understand that under most arrangements, immediate payouts trigger payouts at market value. Unlike other types of fixed income securities, stable value investments allow deferred payments at book value in accordance with contractual provisions. SVIA said that providers have no problem disclosing market value to sponsors and usually do so quarterly, and further that FASB had a full review of Stable Value Funds and clarified when and how to disclose market value. However, SVIA advised against disclosing market value to participants, stating that a general explanation would be more appropriate for participants.
The SVIA panel also responded to a question about the use of Stable Value Funds as a QDIA and recommended that stable value or principal protected products should be a stand- alone QDIA. SVIA pointed out that there are many situations where preservation of capital is the highest priority for participants. Plan sponsors should be able to respond to this need as they are in the best position to choose the appropriate default investment for their workforce. Even though the preamble to the QDIA regulation suggests that the use of principal protected products may be an appropriate default investment, plan sponsors have shied away from using them as defaults because they are not included among the funds that the Department has specifically blessed as QDIAs.
Testimony of Cynthia Mallett, MetLife
Ms Mallett started her testimony by describing the continued role that Stable Value Funds play in the fabric of our defined contribution system. Today Stable Value Funds represent over $575 billion in 401(k), 457, and 403(b) retirement plan assets. Even since the turbulent economic environment worsened in late 2007, Stable Value Funds have continued to offer a safe haven for plan participants. One recent survey indicated that the return on an average Stable Value Fund was a positive 4.2% during 2008. During the same period, overall participant 401(k) balances declined by 27.5%.
Stable value is an investment option designed to offer plan participants the greatest possible return consistent with protection of principal. The intended purpose of the Stable Value Fund is to allow participants to make transactions at "book value" (contributions made plus accrued interest minus previous withdrawals or transfers).
The first generation of modern Stable Value Funds were introduced over thirty years ago and the insurance company Guaranteed Interest Contracts (GICs) that emerged are still a mainstay today. These contracts feature an interest rate guaranteed in advance, guaranteed principal, a specified maturity date, and the ability of plan participants to make allocations to and from the funds at book value. The ability to make allocations at book value-also known as benefit responsiveness-is a feature of all subsequent stable value products. Insurance companies issue traditional GICs and the insurer backs the GICs with their general account. They contain a direct guarantee of principal and interest credited to the plan if the contract is held to its maturity date.
Later variations on the traditional GIC include the separate account GIC (SA GIC), which invests the contract's reserves in one or more separate accounts, and the synthetic GIC (also called a Trust GIC). The synthetic GIC differs from traditional GICs in two important ways. First, the plan investments are not held under a group annuity; they are held directly by the qualified plan trust. Second, the manager of the assets has to obtain a book value guarantee from another financial institution that will enable plan participants to transact at book value. This book value guarantee-called a wrap contract-imposes limitations on how the provider can invest the funds under the book value guarantee. Wrap contracts are provided by insurance companies, banks, and other financial institutions.
The attractiveness of Stable Value Funds lies in the demand for an investment choice that guarantees principal and accrued interest. Many investors feel that there should be protection from loss for at least some portion of their assets and the Stable Value Fund investment vehicle provides this protection.
Ms. Mallett then went on to discuss some important considerations for the fiduciary when selecting the investment, wrap contract, and provider structure for its Stable Value Fund. At a sponsor level, the most important consideration when making the decision to offer a Stable Value Fund is how to invest the funds. Stable Value Funds primarily invest in traditional or SA GICs or in Trust GICs. Larger plans typically use more than one type of contract. When evaluating a traditional GIC, the most important consideration for the fiduciary-along with the contract terms-is the insurer's financial strength rating since an insurer's general account backs the guarantee that is at the core of this product. When evaluating an SA GIC or synthetic GIC, the number of elements the fiduciary should consider increases and the fiduciary should give special care to the ability and experience of the fixed income manager in managing assets for a stable value program. The fiduciary must also understand and select the type of guarantee that will be in the best interest of its plan participants. Some key areas fiduciaries must examine in performing this due diligence include the following:
- Is stable value a core competency of the provider?
- What are the issuer's termination rights?
- How does the provider handle changing market conditions?
- How does the provider define and handle employer initiated events?
- Does the wrap provider have termination fees or penalties?
- How does the provider handle contract termination?
- How is the provider/wrap provider regulated?
Recent market volatility has caused plan participants to seek safety and stability in stable value investments. These economic events have stress-tested all aspects of the stable value system, but stable value has risen to the challenge. Ms. Mallett stated that plan participants have received consistent benefits and the rate reset mechanisms are working as intended. During this time, the FASB has implemented financial reporting and disclosure tools to expand plan asset disclosure. For example, the 2006 report known as AAG INV-1 offered a clear and uncomplicated statement of contract and market values as well as wrap values to plan sponsors for stable value contracts.
Under the existing ERISA requirements, a plan sponsor is to exercise its fiduciary duty as a "prudent expert." MetLife believes that the existing requirements are sufficient with regard to stable value selection, oversight, and communication, but that further communication to plan participants regarding these funds would be appropriate. For instance, most participants would not know that some actions taken by their employers could affect their ability to make transactions at book value. Current disclosures to plan participants do not provide information regarding these circumstances highlighting the need for expanded participant communication in this area.
With regards to default investments, MetLife strongly believes that Stable Value Funds should be included as a fourth QDIA without restrictions. This would provide new entrants into the pension system with the time to make longer-term choices without the risk of significant losses in the interim. Stable Value Funds are one of the lowest-risk investments offered by sponsors in 401(k) plans. It makes sense that investors allocate the first dollars saved to the safest investment choice as new participants become comfortable with the plan and balance gradually becomes meaningful. Ms. Mallett said that adding stable value to the QDIA structure would not take away any other present choices and would enable plan sponsors to address a wider range of plan participants. Further, by excluding stable value as an approved QDIA, she said the regulations encouraged sponsors and participants to select products that carried more risk. The market events of the past two years indicate that additional risk in pursuit of higher investment returns may not be prudent. For these reasons, MetLife believes Stable Value Funds should be approved as a qualified default investment alternative.
Testimony of James King, Jr., Prudential
Mr. King started his testimony by noting that the events of the last twelve months have underscored the importance of offering safe investment options in retirement savings vehicles such as defined contribution plans. Stable value products, with their relatively high returns, low volatility, and protection features such as capital reserves to back guarantees, provide a compelling solution and it is essential that they be classified as a qualified default investment option. Stable value products offer participants safety of principal and the ability to withdraw funds at book value while providing higher levels of returns than an intermediate bond fund and volatility similar to that of money market funds.
The unique insurance protection in Stable Value Funds allows them to deliver high returns with low volatility. Stable Value Funds combine an investment with an insurance contract that guarantees return of the investor's principal and accumulated earnings. Principal balances grow at the crediting rate promised by the Stable Value Fund provider.
Stable Value Funds minimize risk by (1) investing in high quality securities and (2) by providing an insurance contract that promises the return of participants' principal and accumulated interest earnings whenever they wish to redeem their investment even if the actual market value has declined.
A large component of the stable value market consists of the general and separate account stable value products. With general account Stable Value Funds, the sponsors invest their assets directly with the insurer providing the product. The insurer is both the investment manager and the guarantee provider. Plan sponsors and investment consultants need information to evaluate the benefits and risks of these general account stable value products. Separate account Stable Value Funds differ from general account Stable Value Funds in that the insurer invests the plan's assets in a separate account rather than the insurer's general account. Consequently, assets in the separate account can only be used to satisfy claims related to the investments made in the separate account and are insulated by claims on the insurer's general account.
In order to provide unconditional guarantees regarding the return of principal and accumulated earnings, all Stable Value Funds have rules regarding the timing and level of plan withdrawals to prevent rapid, large-scale outflows that would strain the provider's ability to meet its obligations. However, participants can remove funds at book value for transfers to other investment options under the plan and for benefit responsive purposes such as death, disability, retirement, and hardship.
Despite the recent economic hardships, stable value providers have still been able to meet their economic obligations. There are several reasons why. First, numerous government entities focused on ensuring that Stable Value Fund products are designed appropriately are involved in the regulation of stable value providers. Second, insurance companies must file annual and quarterly reports that state insurance departments use to evaluate whether there is any cause for concern about the company's finances. Third, the guarantees in Stable Value Fund products align the interests of investors and asset managers because stable value providers have an incentive to invest conservatively with high quality, diversified portfolios. If, despite these protections, an insurer's financial condition is critical, insurance law provides for supervision or liquidation of the company. In Connecticut, policy claims are the first category of claims. If the insolvent insurer's assets do not fully satisfy policyholder claims, all states provide Guaranty Association protection.
Testimony of Kathryn Solley and Linda Haynes, Seyfarth Shaw LLP
Ms. Solley and Ms. Haynes are partners at the law firm of Seyfarth Shaw LLP. They reviewed challenges of selecting, monitoring, and communicating Stable Value Funds in DC plans. While some larger 401(k) plans offer SVFs through the separate accounts, most offer a commingled fund. Stable Value Funds are commonly viewed as comparable to money market mutual funds, but differ significantly. There are specific legal restrictions on the securities in which a money market fund may invest while Stable Value Funds have no restrictions. By law, money market funds may only suspend redemptions in very extreme situations while SVFs have no restrictions.
- Most plan fiduciaries lack the power to negotiate special terms to protect their plan participants or the fiduciaries themselves. The level of due diligence for Stable Value Fund selection is qualitatively different from the due diligence in selecting a mutual fund. Unlike mutual funds where there is a variety of sources regarding their current and historic value, the only source of Stable Value Fund information is the vendor. Even so, 401k investment options are potentially unique to each plan. Therefore, a new Department regulation would be problematical and perhaps unduly restrictive. "Best practices" guidance and factual information would be helpful.
The Department has indicated that it is important for a fiduciary to monitor investment options and service providers, but has issued little substantive guidance on monitoring. The DOL has a significant body of educational information and guidance on its website, publications and seminars. More specificity is needed on the restrictions on a participant's ability to invest or withdraw including restrictions relating to competing funds and plan sponsor actions that could trigger such restrictions. The Department's best practice guidance should also suggest that fiduciaries understand the following:
- Market to book value ratio and how it compares to that ratio for comparable Stable Value Funds
- Composition and diversification of the underlying fixed income portfolio
- Identity of the "wrap" providers and its financial stability
- Percentage of the Stable Value Fund held by large
- Need for follow-up questions and investigation depending upon initial responses.
Stable Value Fund selection should start with the plan's investment policy, which sets the parameters of investment options, and the benchmarks against which the selections should be measured. Investment policy statements are described in the Department's Interpretive Bulletin 08-2. That bulletin notes that the fiduciary is obligated to follow the investment policy statement. Often, the investment fiduciary is likely to be an employee of the sponsor. Unless the plan is large, a professional investment advisor does not assist the fiduciary in this selection and the fiduciary largely relies on the vendor. For smaller plans, the absence of a professional advisor is not a defect in the fiduciary process per se. The bulletin should be revised to explicitly stress the importance of investment policy statements for defined contribution plans and, as appropriate, refer to the relationship with ERISA 404(c). Many plans, typically smaller plans and those in a bundled arrangement, do not have investment policy statements or lack a detailed statement.
Assuming a plan has an investment policy statement, the statement typically lacks specific selection and monitoring criteria for each asset class. Commonly, plan fiduciaries use material supplied by vendors or Morningstar or the like. For commingled funds, such as Stable Value Funds, there is no prospectus and fund documents are not likely to be provided before selection, especially if the plan does not employ an investment advisor. The plan fiduciary should understand all available information sources. Investment policy statements could identify the prospectus and other information sources by investment type and describe how monitoring the investment options entails reference to those sources. The Department should provide guidance for identifying, evaluating and categorizing investment options that are not mutual funds.
Ms. Haynes addressed two main participant communication issues: (1) communications that could cause distributions to be made at market value instead of book value; and (2) the level of detail a fiduciary should communicate to participants. Plan fiduciaries struggle with what to communicate to participants because what they say may trigger a market value event. The wrap contract language concerning participant communication market value events can vary greatly - with some provisions being very bare boned and others providing more details. In many situations, it is unclear whether providing factual information concerning a Stable Value Fund in a participant communication is a market value event. Specifically, plan fiduciaries are concerned that the wrap issuers will view withdrawals that result from a new participant communication as market value event withdrawal with a significant negative impact on participants. If the DOL issued official guidance requiring participant disclosure of certain information concerning Stable Value Funds, then plan fiduciaries could meet participant need for information without fear that such a communication is a market value event.
On the second issue, it is difficult for fiduciaries to gauge the level of detail to provide to participants. The Department should issue guidance requiring that fiduciaries provide a summary profile for Stable Value Funds, as discussed in DOL Adv. Op. 2003-11A that includes:
- Information concerning the composition of underlying fixed income portfolio. Participants should understand the nature of the Stable Value Fund, the market forces that could impact its value and the risks associated with that fund.
- Identify the wrap providers and the portions of the portfolio they guarantee so that participants can understand their potential exposure if a wrap provider experiences financial trouble.
- Explain in general terms the situations where withdrawals will be made on the basis of a market value instead of book value.
Testimony of Donald Stone and Jennifer Flodin, Plan Sponsor Advisors
Donald Stone, President and Co-Founder of Plan Sponsor Advisors ("PSA"), and Jennifer Flodin, Chief Operating Officer and Co-Founder of PSA, spoke on a panel on behalf of PSA. PSA is a registered investment advisor and retirement plan consulting firm. Mr. Stone stated that PSA works with plan sponsors on a daily basis in connection with Stable Value Funds for all types of defined contribution plans and, from this experience, he would conclude that the vast majority of plan sponsors (regardless of the size of the plan sponsor) are generally unfamiliar with the complexities of the product. He particularly noted that plan sponsors tend to focus on the product's crediting rate and not the credit risks and lack of transparency in, e.g., guaranteed insurance contracts (GICs).
Jennifer Flodin focused her remarks on the need for more transparency with respect to the fees charged by Stable Value Fund providers, including the explicit fees charged for the wrap and underlying investment products in synthetic GICs and the fees and spread revenue earned by GIC providers.
Together, Mr. Stone and Ms. Flodin recommended that:
- The Department recommend that fund fact sheets be enhanced to include fee information on amounts charged (i.e., fees for wrapper, underlying investment and spread revenue) and outline potential risks associated with the product.
- Stable Value Funds not be included as a QDIA other than perhaps for a sub-population of the workforce (e.g., employees nearing retirement).
- Awareness should be increased of the current limitations for 403(b) plans using Stable Value Funds as 403(b) plans can only use fixed annuities. The Department does not have jurisdiction to address this restriction.
- The Department should raise awareness of the duty of plan sponsors to carefully evaluate and monitor Stable Value Funds as they would evaluate any other plan investment option and that Stable Value Fund vendors will need to provide plan sponsors with sufficient information for plan sponsors to make informed decisions.
Testimony of David Wray, Profit Sharing/401(k) Council of America
Mr. Wray began by describing the attributes of the typical Stable Value Fund and by noting that Stable Value Funds have performed extremely well in the recent difficult economic times. They have met their principle guarantee commitments and have exceeded the return expectations when compared to money market funds. While there has been some concern about the market-to-book gap, the positive cash flow into these funds and the relative short duration of their underlying investment is closing the gap. And, while rising wrap fees have led to reduced net returns, plan sponsors are still finding that their participants benefit from the unique aspects of this investment.
PSCA urges that the Council not provide requirements or guidelines to plan sponsors and retirement service providers for the design or marketing of these investments. This would require the Department to impose its judgment at a set point in time, overriding accepted investment theories that are constantly evolving. This would also result in one-size-fits-all products and freeze innovation.
PSCA also believes that the Council should not provide requirements and guidelines to plan sponsors for selecting and monitoring Stable Value Funds. The fiduciary standard applicable to plan sponsors recognizes that the requirements and guidelines for prudent decision-making are constantly changing and that flexibility to adapt to changing conditions is necessary. If the DOL determines the specifics of the fiduciary process for the selection and monitoring of Stable Value Funds, the DOL will also be pressured to determine the specifics of the fiduciary process for selection and monitoring of all retirement plan investments. That will lead to a redefinition of the fiduciary responsibility of plan sponsors.
Nor should the DOL specify the disclosures that must be made to plan participants to aid them in making decisions regarding these investments, Mr. Wray said. Government-specified information is legalistic, resulting in a communication regimen that is unintelligible for most workers. Rather, the DOL should possibly focus on helping employers and their plan's service providers develop and deliver plan-related information that is actually helpful for participants.
Mr. Wray said the Council should develop and publish lists of best practices for use by plan sponsors in the selection and monitoring of Stable Value Funds. The Council could ask the major investment-consulting firms for their suggested list of best practices and synthesize these lists.
Testimony of Jon Upham and Randall Long, SageView Advisors
SageView Advisors is an investment advisory firm operating in the mid market. Mr. Upham opened by stating that he is not against stable value products, but he would like to see much more disclosure and education of participants and plan sponsors regarding their risks. His testimony focused on 3 areas: the selection of stable value products by plan sponsors, participant education, and termination of stable value products.
Selection of stable value products by plan sponsors:
Mr. Upham stated that stable value products are often proprietary to the plan administrator/record keeper, so that plan sponsors are frequently only offered one stable value option (without any money market product option). Thus, due diligence is often lacking compared to the selection of other fund options, particularly for small plans. In addition, Mr. Upham believes that many plan sponsors do not read and/or do not understand the nature of stable value products, especially regarding termination. He recommends that there be more guidance on standardized disclosures for stable value products so that they can easily be compared side by side.
Education of employees/participants:
Mr. Upham emphasized that participants have difficulty in understanding stable value products, often thinking that they are equivalent to money market funds when they hear the words "stable" and "guarantee". He recommends that the DOL work with the Stable Value Investment Association to draft an easy to read description of stable value products that explicitly compares them to money market funds (which participants tend to understand). He prefers to have an industry set of best practices rather than regulation, and is wary of penalties for not following these best practices.
Termination of stable value funds:
Mr. Upham reiterated his earlier statements regarding the lack of plan sponsor knowledge of termination procedures and thus the need for more guidance on termination disclosures at the time of fund selection. He also made several suggestions that will help facilitate transitions from one carrier to another. These included requiring the old carrier to provide both data and a portion of the revenue sharing to the new carrier during the 12 month transition period. In the event that the market value is substantially lower than the book value, Mr. Upham's instinct would be to not immediately disclose this to participants for fear of triggering panic. Rather, he recommends that plan sponsors start considering the process of termination.
Testimony of Philip Suess, Mercer
Mercer and Suess are Stable Value Fund advocates, but always recommend that sponsors offer more than one fixed income option under a plan. Phil reviewed Stable Value Fund origins in Guaranteed Investment Contracts (GIC). He concludes that Stable Value Funds have worked, except for specific employer initiated events. Most participants have gotten book value access and positive rates of return. Mercer believes that Stable Value Funds should be a QDIA option, subject to disclosure caveats and perhaps limiting them to persons/new employees age 50 or older. Persons close to retirement may not be able to tolerate the volatility of a diversified portfolio.
A Stable Value Fund is a complicated contractual agreement as well as an investment. There is a trade-off on the guarantee in the form of liquidity restrictions and restrictions on underlying assets. Inclusion of a Stable Value Fund is not an irrevocable decision as some seem to perceive, but sponsors often do not understand the transition and termination issues. Mr. Suess said it would help if the Department offered best practice guidance on what sponsors should understand and what questions they should ask, when adopting a Stable Value Fund.
Disclosures should clearly state the investment is not risk free. It must explain when book value may NOT be paid, since this is a Stable Value Fund's primary attribute or attraction. Among other things, disclosures should explain that cash flows in and out affect the credit rate going forward.
Mr. Suess is concerned a lack of sufficient supply now and in the future to accommodate Stable Value Fund demand (or other low risk defined contribution plan options). He suggests that bond funds may be too volatile for participants. Stable Value Fund supply has been very constrained. There are no new products and many current products are not accepting new funds or participants.
There is also a lack of guarantors in the market place. Only three GIC writers possess double AA credit quality and only 3 or 4 currently offer wraps. Last year, wrap providers were surprised by valuation issues, and having to put up capital. Market conditions that lead to scarcity have mitigated but supply has not returned, he said.
Sponsors and participants want the return guarantees, but if capacity is always questionable, they may hesitate to get or stay in. In addition, market competition may not temper fees and liquidity restrictions. He also noted that the variety of potential Stable Value Fund regulators - including state insurance commissioners, bank regulators, or SEC regulators of separate accounts - fuels potential provider uncertainty.
Testimony of Kelli Hustad-Hueler, Hueler Companies
Ms. Hueler is the Founder and President of Hueler Companies, an independent consulting firm assisting plan fiduciaries and trustees with research, product selection, and ongoing oversight of their stable value investment funds. Hueler Companies tracks approximately 85% of professionally managed stable value pooled funds. Based on that research, Ms. Hueler defined a Stable Value Fund as a diversified pool of high quality, fixed-income instruments constructed with insurance company or bank contractual agreement. These contracts, which are fundamental to the construction and function of stable value investment funds, transfer risk away from the individual either to the issuing entity or through crediting rate mechanism designed to spread fluctuations of principal over time. This risk transfer protects participants from losses due to market volatility and interest rate shifts.
Since the 1980's, these funds have produced significant benefits for participants in qualified plans, which explains why many plan fiduciaries offer this option and why many plan participants choose the option. Even amidst the recent economic turmoil, Stable Value Funds have provided a safe-haven for millions of participants in a volatile market.
The stability of these products is most important to participants reaching retirement age. This demographic suffered the most out of those who were dealt an unanticipated blow to their retirement savings during the recent economic downswing. Given this demographic's need for stable investment options, preservation must become a higher priority as they approach and enter payout phase.
It is also important that the industry continue to advance communication and disclosure outlining distinctions between contract/product type, advantages/disadvantages, and specific provider restrictions. This will help set appropriate expectations, reduce confusion in the marketplace, and improve fiduciaries' understanding of these products.
Best practice reporting is a valuable and attainable method to achieve transparency and disclosure. Best practice reporting for fund evaluation and oversight already exists. One example is Hueler's Stable Value Pooled Fund Universe database. This database is voluntary and participation is free. Data requirements are standardized, appropriate disclosure protections are enforced, and ongoing data validation is part of the reporting process. This universe covers a majority of the pooled funds available today.
Fiduciary evaluation and oversight cannot be accomplished by reviewing mere snapshots of return, duration, and credit. Rather, portfolio-level data is required, Ms. Hueler said. This data should include the following information: cash flow, contract types, sector allocations, percent exposure by provider, book-to-market ratios, duration, credit, etc. This data is currently available in every fund manager's system and can easily be delivered to fiduciaries and their consultants with protections against unwarranted source disclosure.
Having access to a broad pool of data that is timely, presented in a historical context, and aggregated for historical analysis allows fiduciaries to spot trends, track portfolio changes, and make informed decisions. The market meltdown has spurred a substantial number of requests for expanded reporting. For the industry to succeed in creating broad-based best practices reporting, the Department must take a leadership role.
Ms. Hueler then discussed the appropriateness of Stable Value Funds as QDIA. According to Ms. Hueler, the Department must consider two questions before this issue can be resolved. First, one must ask whether the existing QDIA rules have improved retirement security for ALL plan participants. Given the importance of retirement security and given that fiduciaries will favor Department safe harbor investment options, the QDIA must provide participants with this type of security. Second, one must ask whether the current QDIA language affords fiduciaries the flexibility necessary to offer a qualified investment default alternative that adequately protects principal for all participants. It is imperative that QDIA rules protect the interest of all plan participants along the demographic continuum.
Testimony of Douglas Prince, Stifel Nicolaus
Douglas G. Prince is a Managing Director with Stifel, Nicolaus & Company, Incorporated, an independent investment advisory firm serving qualified retirement plans. Mr. Prince testified that Stable Value Funds are a common investment option in retirement plans and have been in existence for a number of decades. He also stated he thinks they will continue to be offered in participant directed plans in the future, even though the recent economic crisis has brought attention to the way Stable Value Funds are managed. He thinks that Stable Value Products should continue to be available, but he suggests there should be more disclosure about the construction, makeup, fees, and risks of these funds so plan sponsors and participants can make more informed decisions.
The risks to Stable Value Funds include 1) Insurance risk, 2) Investment risk, 3) Employer Risk, 4) Income risk, and 5) Lack of insurance contract wrap capacity. These risks can be mitigated through more transparency in the system and a more standard method of reporting results and portfolio holdings.
Mr. Prince does not believe Stable Value Funds are a suitable QDIA for long-term investment allocation since there is no diversification. For plans with automatic enrollment and significant turnover in the first few years of employment, he does think it might make sense for those participants with a short time period in the plan.
He stated the provider is the only entity in a position to provide disclosures for Stable Value Funds including information on the market and book value, the fees associated with the product, and any amortization of prior losses. This information is needed to provide transparency for these products.
Mr. Prince would like to see a list of best practices, but not regulatory action, made available to plan sponsors in selecting and monitoring Stable Value Funds as well as more participant information disclosed. A common format for participant disclosures would be helpful. Fees are disclosed by vastly different methods or not disclosed at all. Fee disclosure represents a significant area for improvement and should include management cost to oversee the portfolio; wrap insurance costs; spread yielded on the underlying instruments purchased; general and administrative fees; fees paid to others; and amortization of losses in the portfolio against the crediting rate.
The best practices tool should contain the following:
- Different types of Stable Value Funds
- Not the same as Money Market Funds
- Fees and expenses
- Sample participant disclosures
- Liquidity issues and disclosures
- Underlying holdings
- Experience of the management team
- Current total value
- Names and credit ratings of the insurance providers
Testimony of Michelle Weldon, PricewaterhouseCoopers
Michele Weldon, CPA testified on behalf of the American Institute of Certified Public Accountants' Employee Benefit Plan Audit Quality Center's Executive Committee.
Ms. Weldon reviewed the complexities in choosing, valuing and monitoring stable value funds and their reporting on the annual Form 5500 and financial statements. She noted that there can be different requirements for different reports.
For the Form 5500, stable value fund investments, contracts and synthetic investment contracts are reported at current value, like other plan investments. If they are fully benefit responsive contracts, they are reported at contract value, which is principal plus accrued interest net of expenses, benefit payments and payments to contract holders.
For external financial reporting and audited financial statements, stable value investments, including fully benefit responsive contracts, are reported at fair value following generally accepted accounting principles (GAAP). However, contract value is the relevant measure for determining the value of fully benefit responsive contracts as part of the net assets available for benefits of a defined contribution plan. The difference between fair value and contract value will be a line item adjustment.
Disclosures under GAAP for fully responsive benefit contracts include the nature of the investment contract and how they operate, the average yield on investments and the rate credited to participants.
Plan accountants work with plan sponsors to help them understand the operation of the different types of stable value investments.
Determining the current value and the fair value of stable value investments can be difficult for plan sponsors who are responsible for accurately reporting investments on the Form 5500. In practice, plan sponsors turn to service providers for assistance in the process of determining these values and while they can do so, they should still understand the valuation process and have sufficient information to evaluate and independently challenge the investment valuation.
Plan sponsors typically receive monthly reports from services providers showing the contract value of their stable value investment accounts and they may also receive the monthly fair value information, depending on the nature of the product and the service provider.
For annual financial reporting purposes, information regarding the fair value at the end of the year is available. The process may be different depending upon the type of stable value investment, which can be a fund product, direct holdings or a specific managed account for the plans. In some instances, if there are unrelated investment managers, the plan sponsor may have to go to each manager to obtain the fair value information. For the most part, the information is provided to the plan sponsors without difficulty but unique investments or different arrangements may require additional work with the service providers.
The valuation process can involve an array of methodologies because stable value investments cover a wide variety of different products. As a result, there are different assumptions used and professional judgments made in determining the value of these investments. Plan sponsors should have an understanding of the underlying products so they monitor and work with the service providers in reviewing the mechanics of the valuations.
Ms. Weldon reviewed the three different approaches to determining fair value: market approach, income approach and cost approach. The market approach is the one most often used, especially for synthetic investment contracts where the market price of a similar wrap product will be obtained. The cost approach is similar but uses the replacement cost rather than the market price. The income approach uses complex models similar to those used to value options and is not used much in valuing stable value investments.
Synthetic investment contracts are more difficult to value than stable value insurance contracts because both the underlying investments and the wrap contract are valued.
Fair value may be difficult to determine for certain products, especially the evergreen group annuity contracts issued by insurance companies. These products operate similar to a savings account with the insurance company providing interest rates determined periodically but there is no maturity date for the contract so using discounted cash flows may not be a reasonable valuation method.
Ms. Weldon observed that plan sponsors, for the most part, work well with service providers to gather fair value information at the end of the year but certain situations continue to provide unique challenges.
In response to a question from the Council asking whether she would favor having the DOL issue some best practices for questions that plan sponsors should ask providers, Ms. Weldon thought it would be a helpful tool.
Testimony of Susan Graef, Vanguard
Susan Graef is head of the Stable Value Management Group at Vanguard. Vanguard manages over $27 billion in stable value funds for approximately 1400 institutional defined contribution plans. These assets are managed either in commingled pools or as client separate accounts.
Ms. Graef began her testimony by describing Vanguard's disclosures for stable value funds. Vanguard believes that different disclosures should be used for plan sponsors and plan participants as plan sponsors require additional information to perform their fiduciary duties. She recommended that the Department provide a best practices or Q&A type of educational piece that would explain stable value basics and include the following points:
- Stable Value Funds are not a substitute for money market funds but rather a short- to intermediate-term fixed income fund alternative.
- Stable Value Funds can pay off at less than book value on account of "plan events" such as significant layoffs, divisional sales or plan sponsor insolvency.
- In addition to considering book value/market value differences in evaluating Stable Value Funds, plan sponsors should look at the credit quality guidelines of the fund's portfolio manager as well as the fees and sales charges involved with the fund.
- Plan sponsors should be aware of the implications if the sponsor wants to change the plan's stable value option.
Ms. Graef next addressed the question of whether Stable Value Funds should be a QDIA and stated that Vanguard does not believe that they should be a QDIA. She explained that stable value lacks the characteristics needed for QDIA, e.g., portfolios that are diversified and balanced across multiple asset classes, which are expected to earn higher risk-adjusted returns over time. She cautioned against making such change on account of recent market events, which she viewed as an extraordinary, once-in-a-generation event. She stated that stable value is not an appropriate QDIA for any subset of the employee population.
In response to other questions from Council members, Ms. Graef stated that:
- Vanguard suggests that plan sponsors transitioning to new stable value providers tell plan participants that there is a book to market value difference when one exists.
- Plan participants rely on the Vanguard call center for their questions. Vanguard provides fund commentaries when asked.
- One-third of Vanguard defined contribution plan clients only offer money market funds. Another one-third only offer Stable Value Funds. The last third offer both.
- The "plan event risk" (i.e., a plan sponsor initiated event that releases the wrap provider from its obligation to ensure book-value payments) should be lower in commingled Stable Value Funds than in separate accounts.
- Capacity in stable value funds is an issue on account of plan flows responding to recent market events.
Testimony of Nell Hennessy, Fiduciary Counselors
Nell Hennessy opened her remarks by explaining how in her experience as a fiduciary, her firm has encountered many stable value situations and that employers do not have a clear understanding of the risks inherent in the stable value contracts. She stated that most employers see stable value as being roughly equivalent to the money market fund.
She said that many participants see the stable value fund operates like a savings account and, therefore, that they fail to see the risk that would be apparent if they knew the market value. From an employer's standpoint there is also no clear realization of the circumstances in which they may not receive market value. Therefore, it would be useful to the plan sponsor community if the Department could develop a clear, neutral (non-sales) format that would explain the circumstances under which sponsors may not receive full market value.
Ms. Hennessy then discussed the crediting formula for stable value contracts, noting that while this may not be something to put before the participants, it is something that sponsors should have explained to them in clear, easy to understand, narrative (rather than in a mathematical formula) form. She commented that in the past year, the stable value industry has done a good job in trying to minimize the exposure to interest rate volatility.
Anticipating a question that had been asked earlier by Council members regarding potential fiduciary exposure in notifying participants of significant differences between book and market values, she noted that the Department had never specifically addressed the question; however, she cautioned that requiring too much disclosure could have the effect of destroying the wrap coverage.
Council member Helmreich asked Ms. Hennessy to clarify the second recommendation that appeared in her written testimony regarding disclosure of the differences between book and market value and whether the disclosure she referenced would apply to plan sponsors or participants. She indicated that she believed it would apply to information to be disclosed to sponsors and suggested that perhaps this topic could benefit from the input of the insurance regulators. Council member McCaffrey asked whether there were implications under 404(c) for disclosure to participants. She replied that she believed some of these issues would be addressed through the work in which the Department was already currently engaged. She also noted that there are currently so many unresolved questions regarding the protection offered under 404(c) that this may not offer a great deal of comfort.
She went on to say that in dealing with the differential between book and market value by announcing it to participants, the net result would be losses that would have to be borne by the remaining participants (who did not leave while they could still get the full book value). Mr. McCaffrey went on to ask about whether she had an opinion as to whether the simple activity by the plan sponsor to give participants that information could trigger the contractual provision restricting employer actions that would result in participant withdrawals. Ms. Hennessy noted that while she was aware that such provisions exist in stable value contracts, she was not aware of those provisions having been exercised.
Turning to a question about whether in implementing her recommendation to help plan sponsors understand the risk, the Department should opt for something that is short and easy to read. When asked by Council member Haber whether there should be a different explanatory document for insured versus the synthetic product, she said that it may be appropriate to place them in different sections of the same document, but that it is not necessary to produce multiple documents.
Council Chair Dill asked Ms. Hennessy about whether stable value funds should be a QDIA, she explained that it may have limited utility for certain participants and that the question may be linked to target date funds. Council member Koeppel asked whether participants just entering the plan may benefit from a positive experience that could be derived from such an approach. She noted that this could be particularly useful for participants who had not yet vested in the employer contributions (following which they could be moved to a target date fund), or for the very old employees (most of whom take their money when they retire). She observed that for the newer employees, the experience of most plans is that such employees will typically cash out their accounts when they leave their employer.
Council member McCaffrey asked whether that meant that it would be beneficial if, as anticipated will be discussed by the Council subsequently, plan participants were prohibited from withdrawing funds when the change employers. She said that this would be a very important step towards ensuring worker retirement protection.