Although the 10-year Treasury rate dropped back below 3 percent in early December, there’s still a strong likelihood rates will move higher in 2019. I asked John Faustino, AIFA, PPC, Chief Product and Strategy Officer at Fi360, a fiduciary education, training and technology company, for his thoughts on what advisors should consider with stable value products for a rising rates scenario.
Wealth Management: How do the different types of stable value contracts—traditional guaranteed GICs, separate account GICs and synthetic GICs—perform in short, intermediate and longer-term periods of rising rates?
John Faustino: Fixed income portfolio values decrease as interest rates increase, but the insurance wrappers associated with stable value funds make them less susceptible to day-to-day rate changes than non-insurance wrapped funds. While guaranteed investment contracts generally have longer durations than other vehicles, and with more interest rate exposure, stable value funds’ legal structures don’t have a direct impact on those investments’ relative performance in periods of rising interest rates.
From an investment perspective, the longer the duration, the more sensitive a fixed income portfolio’s value is to interest rate changes. Stable value funds’ insurance wrappers insulate them from loss of capital associated with rate increases. However, rate increases decrease the market-to-book ratios of stable value investments, which tends to result in a lower crediting rate (yield). Fiduciary advisors need to be conscious of the impacts sustained rate increases may have on stable value funds. Persistent interest rate increases combined with long duration portfolios can create meaningful differences in stable value fund market-to-book ratios. When this occurs, the importance of strong insurance provisions and backing becomes more critical.
WM: What factors should consultants and plan sponsors consider in light of rate-change sensitivity and the oversight of a plan’s stable value funds?
JF: They should consider these factors when evaluating stable value funds:
Market-to-book ratio: A ratio greater than one is preferable. A ratio lower than one indicates that the value of the investments has fallen below the dollar amount contributed by participants, or the book value. Participants who are withdrawing cash from the fund are now relying on the insurer or wrap providers to cover the difference between market value and the book value of the total contributions. That said, market-to-book ratios move over time based on cash flows, interest rates and underlying portfolio performance, and being below one for a short period of time is not in and of itself a sign of trouble.
Duration: Longer duration portfolios are more susceptible to interest rate risk.
Put provisions/payout terms: How much time must pass before all the participants can receive their funds at full value? This is known as the “put” provision and is critically important for the advisor and the plan sponsor-client to understand. For some funds, the withdrawal provisions are inflexible—there is always a market value adjustment or there is always a 12-month put. Other funds give the plan the choice between the two options.
Relative crediting rate: What is the current crediting rate paid to participants and how does it compare to the rate paid by other stable value funds and the yield earned on money market funds? What has the crediting rate looked like over the past one, three and five years? While not typically the case, it’s possible for money market funds to yield more than stable value funds, especially in periods of rising interest rates. Those periods of money market outperformance don’t typically last more than six months. Many stable value funds have put provisions that require some period of notice before switching to a competing product. If the period of money market outperformance is expected to be less than the time it takes to switch, all else equal, it’s not prudent to move.
Fees: What are the product’s relative fees? How are they determined?
Insurance terms: What protections are being offered by the stable value product? Is a minimum crediting rate guaranteed?
Insurer ability to pay: Which financial institutions are wrapping the fund or the bonds owned by the fund? What are the most recent credit ratings and outlooks on these companies from rating agencies? Knowing the financial condition of the wrap providers is an essential step in evaluating the overall risk of the fund.
Fixed income management expertise: Who is/are the underlying fixed income portfolio manager(s)? Plan sponsors should select fund managers with a large, dedicated team to stable value products and fixed income expertise. What is their risk-adjusted track record compared to appropriate benchmarks and peer group through various interest rate environments? Having multiple subadvisors can provide participants with diversification of manager risk. In the event the stable value fund changes the subadvisor, it’s imperative that thorough manager due diligence is performed.
For additional information, consider reading the Stable Value Investment Association’s article about stable value’s performance in periods of rising rates.