One Billion Dollars of Hidden Losses in NYC DCP’s Stable Income Fund
The Stable Income Fund is a crowd favorite across NYC Deferred Compensation Plan account types. In aggregate, 29.5% of total plan assets were invested in the Stable Fund, or $7.7B (Billion) of $26.2B, at year end 2022. In stark contrast, the Bond Index Fund only holds about 4.4% of plan assets even though this AA rated Bond Fund was offering the highest prospective returns in over a decade. Currently, the average yield-to-maturity (a forward return estimate) on the Barclays Aggregate Bond Index, which the fund passively follows, is approximately 5.3% and is substantially higher than the 2.47% current credited rate of the Stable Income Fund. The Stable Income Fund is clearly the favored “fixed income” investment within the plan. A metric used by Analysts of Stable Value Funds to calculate the health of a Stable value/income fund is the market-to-book ratio. This metric compares market values to reported values.
Market-to-book Ratio
The 2022 Annual Report does not disclose a market-to-book ratio. However, we can gather the necessary information from throughout the report. The Annual Report tells us that the “fair value” of Stable Income Fund assets was approximately $7.75B, at the end of 2022. The 2022 Annual Report also discloses that the market value of these assets is closer to approximately $6.68B, a significant difference of over $1B dollars. Equipped with this data, we can now calculate the market-to-book ratio:
(Source: NYC Def Comp Annual Report, Author Estimates)
At the end of 2022 the market value of the Stable Income Fund was about eighty-six cents per reported book dollar. That is, for each dollar reflected in a participant’s balance, the market value was actually about $0.86! The reported account values are a mirage, a result of a book value accounting rule that permits these funds to ignore market pricing. Is this a smoking gun lying in plain sight? Not at all. In fact, Stable Funds were designed to purposely provide this mirage to investors. To understand why, you need to understand book value accounting.
Book Value Accounting
The Stable Income Fund is allowed to report at book value. That means if the fund purchases an asset for $100, and after a month it is worth $110 or $90, they report the asset at $100. Most underlying assets in the Fund are “synthetic GICS (Guaranteed Investment Contracts)”. These synthetic GICS utilize a wrapper contract or wrappers to insure that participant can transact at the reported book value. The wrapper contracts are generally insurance companies that agree to make up any deficit in the account, i.e., they are on the hook for the difference in the market-to-book value. With these wrappers in place, the accountants permit funds to report at book value rather than market value. They can report fund value of $1 when the market value is only $0.86.
You may recall that in early 2023 many small banks were in trouble because of “unrealized losses” on “held-to-maturity” bond investments. This mini banking crisis was enabled in part by book value accounting rules. When banks declare that some of its investments will be “held-to-maturity” then gains or losses driven by changes in market values of the bonds do not flow through the income statement, instead they are ignored. Why? Because when an institution can hold the security until it matures the fluctuations in prices are meaningless assuming (no credit risk) they will receive face value at maturity. This only works when the securities can truly be held to maturity. Bank runs made holding until maturity impossible for some banks, and when the held-to-maturity securities with unrealized losses must be sold, losses become very real. This caused some banks to fail as the realized losses were in some cases enough to completely wipe out bank equity.
Stable Value Funds are designed to withstand market-to-book ratios that fall below one. If the securities can be held to maturity they should ultimately receive face value, and the ratio should revert to one.
What if Everyone Withdraws from the Stable at Once?
If all investor funds were redeemed from the Stable Income Fund at the end of 2022 the redemption request would have been for $7.7B, but the market value of assets would have only been $6.7B, they’d be $1B short to pay everyone. This is where the wrap contracts kick in. The insurance companies would be on the hook to make up the billion-dollar shortfall. In theory, this all works out and everyone recovers $1 for $1. Nevertheless, we must acknowledge that there is a credit risk exposure to the insurance companies.
In practice, the Stable Income Fund has two advantages over banks:
1. The assets (deposits) are stickier. There generally aren’t runs on Stable Value Funds and the Fund tends to grow over time as the size of the plan grows over time.
2. The wrap contracts. This added layer of protections wasn’t there to protect the banks, but it is in place to protect Fund investors.
Historic Returns 2011-2020 – Low Inflation
This decade was defined by a low inflation low interest rate environment. The Stable Income Fund delivered returns slightly in excess of CPI Inflation. We calculated that the fund had average (compound) returns of 2.35% Vs. average inflation of 1.75% for a “real return” of 0.6%. The real return in excess of inflation is an estimate of real wealth generation. Summary returns follow:
(Source: NYC DCP, Bloomberg, Author Estimates)
Historic Returns 2013-2022 – Resurgent Inflation
We’ve experienced resurgent inflation post covid and include the most recent decade to see the impact. From 2013-2022 the Stable Income Fund Return now trails inflation by 0.57% per year. The Fund has not kept pace with inflation and has failed to preserve wealth for the investor. The results follow:
(Source: NYC DCP, Bloomberg, Author Estimates)
Future Returns
Calendar year 2021 was the first major inflationary one in many years, and during that year the Stable Income Fund credited rate fell from 2.4% to 1.8%. Again in 2022 we had substantial inflation and the credited rate fell again from 1.8% to 1.7%. Thus far in 2023 the credited rate has started to increase but note the significant lag time. The credited rate was 2.0% on January 1 and raised to 2.25% on April 1, and 2.47% on July 1.
Today the entire US Treasury Curve is over 4.4% and over 5% at the short end from 1 month out to 2 years. We believe, based on a rule of thumb estimate, that it will be a few more years before the Stable Income Fund catches up to current market rates – although we can’t know this for sure. That said, investors should ask themselves why they are earning 2.47% on a Stable fund over the next quarter when they could be earning over 5% in a superior US Treasury security.
Conclusion
A whopping 29.5% of the total assets in the enormous $26.2B NYC Deferred Compensation Plan are allocated to the Stable Income Fund. The $7.7B reported value of the Stable Income Fund masks the $6.7B underlying mark-to-market value of the fund by approximately $1B and equates to a market-to-book ratio of 0.86. Is this a smoking gun masking some hidden losses? Not at all, it’s quite the opposite. The opacity of the product was something that investors and plans asked for. In essence, investors asked to trade away volatility risk (the daily changes in values) for credit risk (that the wrappers will satisfy their obligation), and Wall Street created the product for them for a fee. The wrappers allow the Fund to report fund values at book value and purposely ignore changes in market value. As time goes by, the market-to-book should revert back to one assuming this is a held-to-maturity issue. From 2011-2020 the Fund provided mediocre returns slightly outpacing CPI inflation. However, the most recent rolling decade ending in 2022 saw the Fund deliver returns that slightly trailed inflation. Importantly, in the two years that inflation exploded (2021, 2022) the Funds return declined, highlighting the lag time inherent to these Funds ability to raise crediting rates in response to changes in market rates. Investors should consider why they are invested in these products when short-term US Treasuries are paying over 5%. We think the real winners here are the wrap providers collecting the insurance premium.
