Guaranteed investment contracts
Types of contracts and strategies
The cornerstone of most stable value funds has been the Guaranteed Investment Contract; an obligation of the insurance company, typically issued through the insurers general account, which provides a fixed rate and fixed maturity. Banks have been active in this market, from time-to-time issuing Bank Investment Contract generally as a deposit obligation with a fixed rate and maturity. Alternatives to Bank Investment Contracts and Guaranteed Investment Contracts exist in response to plan sponsors desire for added diversification, credit enhancement, and greater control over the underlying assets. Most of these latter structures fall into two broad categories: separate account contracts offered by insurance companies, where a separate portfolio of assets is owned and managed by the insurance company for the benefit of the plan, and synthetic investment contracts offered by both insurance companies and banks, where a separate portfolio of securities is owned by the plan and wrapped by a third party financial institution to provide book value accounting treatment. Stable value investment contracts differ from traditional fixed income instruments in three ways.
First, those issued to qualified plans by insurance companies and banks generally are exempt from registration as a security. Second, the majority of investment contract products enjoy amortized cost accounting treatment. This accounting basis provides an investment whose principal value remains stable and does not fluctuate with changes in interest rate levels. Third, investment contracts provide an equivalent put option at the participant level. The participant can exercise this put back to the issuer at any time at book value.
Coincident with the introduction of a new generation Synthetic Investment Contract stable value alternatives has been the development of appropriate alternative investment strategies. The buyer or seller now has the opportunity to choose along a risk spectrum from a single security strategy, often referred to as a buy or hold Synthetic Investment Contract, strategy, including immunization, constant duration or evergreen, and other controlled volatility investment strategies. The marketplace has witnessed almost 20 years of declining interest rates. This decline has produced lag effect for investors in stable value funds as rates declined below the portfolios blended yield. Should rates trend significantly upward, the positive lag effect in the stable value portfolio could be replaced with a negative one. To guard against the possibility of disintermediation, stable value investment managers employ investment strategies to minimize the effects of significant changes in the yield curve.Stable value investment contracts
.The rapid information and widespread use of defined contribution pension plans in the United States over the last 15 to 20 years has significantly impacted the United States financial markets.
A key feature of a stable value asset is its treatment from an accounting standpoint. According to Generally Accepted Accounting Principles, stable value instruments can be held at contract value, provided that established criteria are met. Contract value is the acquisition cost of the contract plus accrued interest, adjusted to reflect any additional deposits or withdrawals. This is also referred to as book value. Book value accounting eliminates the market value fluctuations experienced by other asset classes and contributes to the high, risk adjusted returns of stable value instruments.
Initially, traditional guaranteed investment contracts were the dominant stable value instrument. The perceived risk in these products was minimal and they faced little, if any, competition until the insolvency of several major guaranteed investment contract issuers. While these defaults proved to be a great challenge to an industry unaccustomed to such difficulties, they also proved to be the catalyst for tremendous change resulting in the development of a new generation of products, popularly known as synthetic guaranteed investment contracts. Investors, and ultimately plan participants, now benefit from a broader variety of products, providers, and strategies.Guaranteed investment contract index methodology
A fact finding mission was established to interview prominent investors, brokers and academics on how Guaranteed Investment Contracts should be priced, measured and monitored for risk and reward behavior. It was determined that the book value accounting was sacred as one of the great benefits of a Guaranteed Investment Contract and so it should not be tampered with or endangered in anyway. More importantly, every Guaranteed Investment Contracts purchase does receive the purchase yield as its return provided it is never sold. By definition, this meant that every Guaranteed Investment Contracts purchase must be held full term or we would have a contradiction of pricing benefits. If a Guaranteed Investment Contract was to be sold or liquidated it would need a sales price. This would be difficult to assess and certainly not in the best interests of the sacred accounting benefits of a Guaranteed Investment Contract. By holding each Guaranteed Investment Contract to maturity, we would avoid any pricing conflicts.
Based upon our investigation, it was found that the Guaranteed Investment Contract volume for any period of time was simply based upon the highest yields available.The highest yields would win the Guaranteed Investment Contract business for that day. It was also obvious that few Guaranteed Investment Contract issuers won most of the volume on any given day. As a result, our sampling showed that the ten highest yields would win almost all of the Guaranteed Investment Contract business on any given day. It was also obvious that after the highest five fields, the remaining yields were quite similar. In order to compare the Guaranteed Investment Contract index data to other indices and markets, it was obvious that this index series must be month end data. It was decided to take the highest ten yields for the last business day of each month as the purchase yield for the new month.
Given some of the credit problems with Guaranteed Investment Contract issuers, it was decided to install qualitative filters so the Guaranteed Investment Contract index would always be a high quality Guaranteed Investment Contract index.The future of guaranteed investment contracts
Where Guaranteed Investment Contracts will go from here is an often debated topic. There has clearly been a move to alternative products such as synthetic Guaranteed Investment Contracts and separate account Guaranteed Investment Contracts in the last several years, but it is difficult to tell to what degree this trend is cyclical versus secular.
Plans do seem to continue to put considerable value on the benefit-responsiveness guarantees in all of these products. Perhaps the most likely outcome for traditional Guaranteed Investment Contracts is that they will continue to be an important component of most stable value options, varying in their degree of use as compared with other products as the markets, plans and their participants all go through their cycles.Other Articles
