Stable Value Funds & Black Swan Risk
Stable Value Funds are popular choices in retirement plans in general. They are usually marketed as vehicles investing in high quality fixed income securities with a focus on safety of principal and consistent returns. Many investors are attracted to the “guaranteed returns”. However, guaranteed does not mean risk-free. The guarantee is only as good as the party providing the guarantee.
Why Have A Stable Value Fund
Stable Value Funds are the result of plan participants desire to have a low volatility fixed income product that preserves capital, available to them. It is not feasible for retirement plans to hold individual bonds, which accomplish this goal, so Stable Value Funds were created to preserve capital and deliver consistent returns.
What Are Stable Value Funds
Stable Value Funds can be broken down into two categories, Guaranteed Investment Contracts (GICS) and synthetic GICS. A traditional Guaranteed Investment Contract, or GIC, is very simply a group annuity contract with an insurance company. Synthetic GICS are generally a portfolio of high quality bonds that are “wrapped” by book value contracts issued by financial institutions. The wrapper is insurance that allows participants to transact at book value.
The Book Value Mirage
The insurance wrapper allows plans to report assets at book value. What this means is that even when there are $88 of assets a plan can report $100 of assets, if $100 is the book value. The difference of $12 is protected by the wrapper from insurance companies.
Account Structure Differences
GICS are usually “General Account” products. The Stable Value product within the UFOA Annuity Fund, properly called the Great West Portfolio Fund, is an example of a general account product. The NYC Deferred Compensation Plan takes a different approach. The plan uses a commingled pool strategy of mostly synthetic GICS.
Ownership of the Assets
This is where it starts to get interesting. With synthetic GICS the plan retains the fixed income portfolio, the underlying investors own the assets. In the NYC Deferred Compensation Plan the assets are protected in separate accounts. In a general account product, like the Great West Portfolio in the UFOA Annuity Plan, the insurance company owns the assets. The underlying investor in a Fund like this purchased an annuity from the insurance company and that is what the investor owns.
Diversification
Traditional GIC investors are exposed to a concentrated credit risk of one insurer. Synthetic GIC investors are usually diversified across many different financial institutions (wrapper providers). For example, the largest holding in the Stable Income Fund in the NYC Deferred Compensation Plan is approximately 9.2%. General account products are 100% exposed to one insurance company.
What is the Black Swan Risk
Traditional investment risk measures like volatility (standard deviation) do not inform us of the riskiness of Stable Value Funds since:
GICS - The asset belongs to the insurance company and is indistinguishable from other assets
Synthetic GICS - They are reporting book values, not market values, so volatility is hidden,
We think its helpful for potential investors in these products to consider a worst-case scenario. A Black Swan is a very low probability event with disastrous consequences. Let’s consider what could go wrong:
GICS - Insurance company goes bankrupt. It is important for investors to understand that if an insurance company goes bankrupt they become a creditor in the bankruptcy process. Even if all or most of the assets are eventually returned, there could be a long period where everything is frozen.
Synthetic GICS - Book value vastly exceeds market value and the wrappers kick in. Consider a fund that has a market-to-book ratio of 88%, i.e., the actual value of the fixed income portfolio is 88% of what is reported. This means that if every single plan investor redeemed the Fund on the same day only 88 cents of every requested dollar would be available. The institutions that provided the wrapper would be relied upon to provide the other 12 cents.
Are These Risk Events Likely
No, and that is why they are potential Black Swan Events. What is in the investors favor is that the insurance industry is highly regulated, and credit ratings are generally strong. Still, investors should know what they own and be aware of the potential risks.
Conclusion
Wall St. will create any product investors want, for a price. Stable Value investors have traded away volatility for a book value mirage. In the case of GICS, insurance companies provide a contracted return to the investor, and keep what they earn on the assets over and above that amount. In the case of Synthetic GICS they directly charge a fee to financially engineer stability. Synthetic GIC investors generally have better diversification and own their assets. GIC investors have a concentrated risk to one insurer and give away ownership of the assets for an annuity contract. GIC investors are usually compensated with a higher return than their Synthetic GIC counterparts. Both types of investors should consider the Black Swan risk they are exposed to even if the probabilities are remote.
