LANDMARK STRATEGIES
PO Box 804             
Whately, MA 01093 
413-665-4638           


Stable Value and GICs

by Judy Markland
President, Landmark Strategies

a chapter in the
Pension Investment Handbook
by Aspen Publishers
updated 2002

Contents 

Introduction:  The Origins of Stable Value

The Basics of Stable Value
Q1 What is a stable value fund?
Q2 Why are stable value funds such popular investments for defined contribution participants but not for institutional investors?
Q3 What types of people should invest in a stable value fund?
Q4 How does the performance of stable value funds compare with that of other conservative options for defined contribution investors?
Q5 How is a stable value fund invested?

Types of Investment Contracts
Q6 What is a GIC?
Q7 What is a synthetic GIC?
Q8 How does a synthetic wrap work?
Q9 What types of risk protection do synthetic GICs offer?
Q10 Who are the largest providers of synthetic GIC wraps?
Q11 What are the advantages of synthetic GICs compared with those of traditional GICs?
Q12 What is a universal wrap?
Q13 What is a separate account GIC?
Q14 What is a bank investment contract?
Q15 What is a muni-GIC?

Stable Value from the Issuer's Perspective
Q16 What risks do stable value contracts pose for the issuer?
Q17 How do stable value issuers protect themselves against stable value risks?
Q18 How are stable value contracts priced?
Q19 What is underwriting for a stable value contract?

Deposit and Withdrawal Features of Stable Value Contracts
Q20 What is a benefit-responsive contract?
Q21 What are the withdrawal protocols for stable value contracts?
Q22 What is a competing fund?
Q23 What are the various types of deposit features for stable value contracts?
Q24 Why do investment contracts require timely payment of contributions and impose a penalty when timely payment does not occur?   

Investment Characteristics of Stable Value Contracts
Q25 What are the investment risks in a stable value asset?
Q26 What are the withdrawal protocols for stable value contracts?

Considerations in Purchasing a Stable Value Contract and Managing a Stable Value Portfolio
Q27 How is a stable value investment purchased?
Q28 How does the investor evaluate credit risk on stable value assets?
Q29 What are the primary firms providing financial ratings on insurance companies and banks?
Q30 Why does the investor care about credit risk if GICs and other stable value investment contracts are guaranteed?
Q31 What happens if a stable value asset defaults?
Q32 What protection is available in the case of downgrade or default on investment contracts?
Q33 What are the investor’s concerns about assuming interest rate risk in stable value funds?
Q34 What termination provisions apply to stable value contracts?
Q35 What considerations are important in purchasing a synthetic wrap contract?
Q36 What are a plan’s investment management options for a stable value portfolio?
Q37 What are the pension accounting rules for stable value investments?
Q38 Are stable value contracts derivatives under FASB Statement 133?
Q39 Do stable value funds qualify under ERISA Section 404(c)?
Q40 Are stable value contracts registered?

 

Introduction: The Origins of Stable Value

             Stable value funds are one of the most popular investment options in defined contribution plans and the most popular conservative or fixed income option.  This popularity stems from the fact that they offer participants the principal stability of a money market fund with average returns comparable to those of an intermediate-term bond fund.  The market value risk on participant transactions (the risk of any gains or losses on assets sold to pay benefits to participants at book value) is borne by a high-quality financial institution which issues the investment contracts that fund the option.  This principal stability makes the asset class and excellent diversifier of investment risk as well as a good investment option for funds which may be needed in the relatively near term.  The recent turbulence in investment markets demonstrates the importance of these characteristics.

             The stable value asset class is unique in being found almost exclusively in 401(k) and other defined contribution plans.  It evolved from GICs and other group annuity contracts sold originally to defined benefit plans.  Pension accounting rules gave these contracts book value treatment, which made it possible to extend principal protection to participants.  Issuers are uniquely able to underwrite this benefit in defined contribution plans because of the arbitrage constraints which can be imposed by plan rules [See Qs 19, 22] and deterrent effect of losing company matches and tax benefits from switching out of the plan.

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The Basics of Stable Value

Q1 What is a stable value fund?

        Stable value funds are options offered by 401(k) and other defined contribution plans, typically as the most conservative investment option.  These funds are invested in GICs and other medium-term fixed-income investment contracts which offer participants the ability to withdraw or transfer their funds subject to plan rules without any market value risk (risk of principal loss as interest rates rise) or other penalty for premature withdrawal.  The issuer of the investment contracts, a high quality investment institution, provides this book value liquidity on participant transactions and also guarantees principal plus accumulated interest and an interest rate for a specified period of time.
            In the past the stable value option was usually called the GIC or guaranteed option.  However, since the advent of many new types of investment contracts for these funds, fund names such as stable value, fixed income, or interest income are more frequent. 
            Historically, stable value has been the most popular conservative defined contribution investment option.  A 2001 Hewitt Associates survey  reported that 69 percent of defined contribution plans offered a stable value option. 
        As of year-end 2001, allocations to stable value funds were 29 percent of plan assets in those plans where it was offered, according to a survey by the Stable Value Investment Association .

Q2 Why are stable value funds popular with defined contribution participants but not institutional investors?

            No other medium-term investment offers liquidity without any market value risk or interest rate penalty, and this favorable risk/return tradeoff is only available to defined contribution plan participants, which explains why their relative popularity is limited to this investment group.   Stable value investment contracts do not provide principal  safety to the pension plan contractholder.  Investment contracts in defined benefit plans must generally be reported at market value (see Q 37), and plan-initiated withdrawals from the contracts are honored either at market value or at the lesser of book or market (see Q 34).   In fact, because stable value contracts are non-assignable private placement investments which cannot be readily traded or marketed by the contractholder, they have less liquidity than corporate bonds of similar yield and credit rating.  This gives them a slightly worse defined benefit risk/return profile than other fixed income investments, accounting for their low concentration in defined benefit plans (see Figure 1).
 

 

figure 1

Q3 What types of people should invest in a stable value fund?

            The stable value option is attractive to two types of defined contribution participants:  those seeking principal safety and those seeking to diversify their investments.  Many of the largest plan balances are owned by retirees or those nearing retirement who may need the security of knowing that their assets are protected from market value risk.  Many younger participants lack savings outside the plan and need assets with principal safety to cover contingencies.  Others may intend to use their balances in the near term to invest in a home or education, alternative ways to invest in their retirement security.  Stable value funds offer this principal safety in combination with a good rate of return.
            In addition, the principal stability offered participants by stable value funds provides better diversification with equities than other conservative investment options typical in defined contribution plans.   This means that overall portfolio risk to the investor can be reduced by investing in a combination of stable value and equities.  (see Q4).

Q4 How does the performance of stable value funds compare with that of other conservative options for defined contribution investors?

    Stable value funds tend to have average returns comparable to those available on medium-term bond funds, but with much less volatility in annual earnings.  Because the option is invested in medium-term assets (see Q 5), the returns are higher on average than those available on a money market fund.  This is illustrated in Figure 2, which  shows that over the period 1983-2000, the stable value portfolio had returns well in excess of the 6-month certificate of deposit and far less volatile returns than the intermediate government bond index, which experienced a loss in one year during this period.   

            The five-year GIC Index compiled by Deutsche Asset Management consists of a portfolio that invests monthly in a stable value instrument with a maturity of 5 years and is held to maturity, so that the effective duration of the portfolio is about 2.5 years.  The average return for this index over the last ten years was 7.02 percent, compared to 6.77 percent for the Lehman Intermediate Government Index and only 5.00 percent for the money market proxy.
            The low volatility in stable value returns increases the diversification benefits it offers with other typical investment options for defined contribution plans, especially common stocks.  One measure of good diversification between asset classes is a low correlation of returns, showing that the performance cycles of the assets differ.  Table 1 shows that stable value returns have a much lower correlation with stock market movements than bonds.
            This low correlation means that stable value investors may have a higher concentration of equities at the same level of downside risk  than if they invested in a market value bond fund.  In fact, a 401(k) investor with a 10-year time horizon could shift from a portfolio with 40 percent invested in a medium-term bond fund and 60 percent in common stocks to one with only 30 percent stable value and 70 percent in stocks with a 95 percent certainty that annual losses would not be increased. Not surprisingly, expected returns are higher on the stable value/equity portfolio as well, 14.4% per year compared to 14.37% on the stock/bond mix.1

                        Table 1

Correlation of Returns with the S&P 500
correlation coefficients; annual returns 1987-2001  

Ryan Cash

 .24

Intermediate bond funda

 .36

5-year maturity Stable Value Fundb

-.04

 a Lehman Intermediate Government /Credot  Bond Index;    bDeutsche Asset Management GIC Index

 The low correlation with stocks also means that stable value investments are better choices for balanced and life cycle funds than are bond funds, since they offer greater diversification at similar return levels.  

1“Stable Value Basics”, Stable Value Investment Association web site, http://www.stablevalue.org/public/SlideShow/Slide6.htm

Q5 How is a stable value fund invested?

            Stable value funds invest in high-quality, fixed income investment contracts such as GICs (see Q 6) and synthetic GICs (see Q 7), generally with a credit quality of A or better (see Qs  28 and  29).   Most funds purchase investment contracts with durations of three to five years and maintain their overall stable value portfolios at a duration of 2-3 years.  This produces yields substantially above those available on money market funds in most interest rate environments, while keeping the portfolio responsive to market interest rates. 
            A well-structured portfolio produces ample cash flow each year to both fund benefits and permit reinvestment at the interest rates then prevailing.  This is typically accomplished with a laddered maturity structure, a series of growing scheduled contract maturities that extends over several years so that the maturity in each period is expected to remain roughly the same proportion of the portfolio.
            Many stable value funds also have a cash or short-term investment fund (STIF) component.  Maintained at a fixed percentage of the fund - usually between 5 and 15 percent, depending upon the volatility of the plan’s cash flows - the STIF provides a buffer for the investment contracts paying participant withdrawals and reduces risk charges on stable value contracts; however, because the STIF assets have very short-term maturities, they typically yield substantially less than the investment contracts.
            Weighing the relative cost of withdrawal risk charges or maintaining the STIF is a key stable value fund management decision.  STIF buffers first became popular in an environment of relatively flat yield curves; in a steep yield curve environment, there may be little or no incremental yield benefit.   The STIF must be large enough to cover the sizable variability in any single plan’s investment transfers and benefits over time.  However, since GIC and synthetic wrap issuers are able diversify much of this plan-specific cash flow volatility across a large number of plans, their risk charges only cover the more systematic or interest-rate induced risks (see Qs 16 and  20).

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Types of Investment Contracts

Q 6  What is a GIC?

            A GIC is a a group annuity contract issued by a life insurance company to a tax-qualified pension plan as an investment.  The acronym refers variously to guaranteed interest contracts, guaranteed investment contracts, and guaranteed insurance contracts.   A GIC is a private-placement investment, with specific terms and contractual provisions negotiated at the time of purchase.  GICs come in many varieties, but all provide for a guarantee of principal and accumulated interest and most offer a guaranteed interest rate for some period of time.   In addition, all GICs offer the pension plan the right to purchase annuities for plan participants.  Interest rates on GICs are quoted at an annual rate, as though interest payments occur once a year, rather than on a semi-annual coupon basis as is typical for bonds.
            The most typical GIC is a zero-coupon instrument which offers a guaranteed or predetermined rate of interest applied to all funds under the contract.  The accumulated value is paid at maturity.  In this traditional contract, the issuer assumes all of the credit and interest rate risks on the assets used to back the annuity contract and the market value risk on any participant withdrawals.  Although GICs originated as a defined benefit plan investment, most today are issued to defined contribution plans, where they offer plan participants the ability to withdraw their funds (subject to plan rules) for benefits or transfers to other plan options at book value.  The life company issuer underwrites the market value risk on this popular withdrawal feature (see Q 16).
            GICs are relatively illiquid at the contractholder or plan level, which has limited their popularity in defined benefit plans;  however, in periods of very high interest rates such as those experienced in the early 1980s, GICs’ zero-coupon feature and excellent call protection are popular with defined benefit investors, who value the ability to lock in both the high coupon and reinvestment yields.

 Q 7  What is a synthetic GIC?

            A synthetic GIC is an investment for tax-qualified, defined contribution pension plans consisting of two parts:  an asset owned directly by the plan trust and a wrap contract providing book value protection for participant withdrawals prior to maturity.  An alternative to a traditional GIC in a stable value fund, a synthetic GIC unbundles the GIC’s investment and insurance components.  A plan that invests in a traditional GIC owns a group annuity contract, and the insurance company owns and retains custody of the assets backing the contract.  Under the terms of a synthetic GIC, the plan has custody of the asset and negotiates separately for the wrap contract providing the book value insurance protection.  The synthetic instrument is diagrammed in Figure  3.

     figure 3

            Almost any type of fixed income asset or group of assets may be used as the synthetic asset:  a single bond or other security; a share in a mutual fund or other commingled investment option; or a portfolio established specifically for the synthetic.  The accompanying wrap contracts are issued by high-credit quality banks and life insurance companies, institutions with the capital base to support the wrap risk (see Q 16). The contracts come in many different legal forms: group annuity contracts (issued only by insurance companies), interest rate swap agreements , asset purchase agreements, investment management agreements, and others.
            Synthetic GICs were first introduced in the late 1980s by banks and investment managers anxious to capture a share of the rapidly growing stable value market.  By replicating the traditional GIC’s book value payment feature for participants, synthetic GICs were granted similar book value accounting treatment by many accounting firms.  Synthetic GICs provided the investor with a means of diversifying away from the single-industry concentration posed by GICs.   The need to diversify became a driving force in the stable value market after the financial difficulties of Executive Life and Mutual Benefit in 1991 and 1992, respectively.  Synthetic GICs now make up slightly more than 50 percent of all stable value portfolios. 

 

Investment Mix of Stable Value Portfolios 

 (12/31/2000)
  Cash 5.0%  
  Traditional GICs1 40.4%  
  Synthetic GICs 50.9%  
  Separate Account GICs 3.4%  
       
1 includes life company full service general account contracts
Source:  Stable Value Investment Association

            Under the terms of a typical synthetic GIC, the plan trustee has one contract with the asset manager and another with the wrap provider.  At the time of purchase, all parties agree to specific investment policy guidelines (such as the duration of the assets and their credit quality), and the wrap agreement stipulates that book value benefits will only be paid as long as these guidelines are followed. Typically the wrap provider and the asset manager are independent firms, but under some circumstances they may represent a single company or corporate affiliates.           

Q 8  How does a synthetic wrap work?

            The synthetic wrap contract maintains a book value asset or fund balance for the underlying asset and credits interest on that book balance.  Any market value gains or losses are amortized over a multiyear period, usually either the time to maturity or the duration of the asset(s) being wrapped, and the crediting rate (the dollar-weighted average of the yields on the book values of the stable value fund assets)  is adjusted by this amortized gain or loss.  This amortization process maintains the yield and principal stability that plan participants desire.  Yields are credited at an annual effective rate.
            The wrap provider agrees to maintain principal and accumulated interest on the synthetic asset at book value and guarantees the crediting rate for the period until the next rate reset.  The crediting rate may never be negative, because this would violate the guarantee of principal.  Wraps are typically fully participating for credit and call experience on the underlying asset(s) and may also participate in gains and losses on assets sold to fund participant withdrawals or transfers (see Q 21).   

Q 9  What types of risk protection do synthetic GICs offer?

            As with traditional GICs, the degree of risk protection available in synthetics covers a wide range, from full guarantee of principal and interest to maturity to a guarantee of principal with full participation in the experience on the underlying assets and plan cash flows and an interest rate guaranteed only until the next rate reset.  However, most synthetic GICs outstanding are participating products where the stable value fund is assuming all credit and interest rate risk on the underlying assets, with market value gains and losses reflected on an amortized basis in the credited rate as long as the credited rate does not drop below zero.

 Q 10  Who are the largest providers of synthetic GIC wraps?

            The market requirements for a successful synthetic wrap issuer are similar to those for a traditional GIC issuer:  excellent financial quality (typically an AA rating or better); risk capital or another mechanism to absorb the risk of market value fluctuations on benefits maintained at book; and the financial expertise to immunize or protect the firm from the market value risks guaranteed in the contract (see Q 16).  It is not surprising therefore that large, high quality domestic and foreign banks and life insurance companies are the predominant wrap issuers.

 Q 11  What are the advantages of synthetic GICs compared with those of traditional GICs?

            Synthetic GICs offer the investor more flexibility and the potential for lower wrap and asset management fees, especially if a single buy-and-hold asset or an index fund is wrapped.  Many investors like the ability to select the asset manager and the wrap provider separately, so that they can replace the asset manager if performance is unsatisfactory and leave the wrap in place.  The fact that the trust has direct ownership of the wrapped asset is also appealing, because that reduces the risk of regulatory hassles and valuation difficulties should the wrap issuer have financial difficulties.
            Traditional GICs, on the other hand, are generally simpler to negotiate and purchase and typically offer more forms of risk protection than most synthetic GICs.  The  traditional GIC requires only a single contract with the insurance company, rather than separate contracts with the custodian, wrap provider and the asset manager as in most synthetic GICs.  Traditional GICs typically offer protection against all credit, call or extension, and interest rate reinvestment risks on the underlying assets plus protection against contribution and withdrawal risk.  Most synthetic GICs are structured so that the fund participates in many, if not all, of these risks. Traditional GICs are also more readily available in smaller sizes (i.e., deposits of $2 million or less) than synthetic GICs.

Q 12  What is a universal wrap?

            Some stable value managers have created a universal wrap structure for a segment of their stable value fund.  This segment is designed to be the last to be tapped for any withdrawal payments from the fund (see Q 21) and usually consists of actively-managed fixed income portfolios which are wrapped with a single wrap contract entered into on a pari passu or equal risk-sharing basis by three or more wrap providers.   The presence of a single wrap contract simplifies administration for the fund manager.  However, the difficulty of getting the wrap issuers to agree on similar contract wording and risk assessment has somewhat limited the use of this structure.

 Q 13  What is a separate account GIC?

            A separate account GIC is a guaranteed group annuity contract issued by a life insurance company that is backed by an actively-managed portfolio invested in a separate account, a fund owned by the life company but invested outside the insurance company’s general investment account.  The contract guarantees are additionally supported by the surplus and assets of the general account.  The separate account may be one created specifically for the investor or a commingled account in which the investor purchases a share.
            Guaranteed separate account products are sold to both defined contribution and defined benefit plans and may be issued as either book or market value products for the plan.  The term “separate account GIC”, however, typically describes a book value product sold to stable value funds that provides a guarantee of principal and accumulated interest and benefit-responsiveness, maintaining participant withdrawals at book value (see Q  20).
            The separate account GIC investor receives title to the annuity contract, not direct title to the assets in the separate account. To provide stable value investors a degree of diversification from their insurance company credit concentration, most separate account GICs are contractually “walled off” or insulated from general account liabilities in the case of any financial impairment of the insurer.  The degree of legal protection for this insulation varies from state to state.  Many states have enacted laws stipulating separate account insulation where the contract so specifies;  in many other states the insurance department has issued letters ensuring the protection of insulated separate account assets.  The states where major separate account GIC issuers are domiciled generally have either statutes or opinion letters granting insulation status, but this is something that the investor should check prior to purchase.
            Most separate account GICs are participating products, in which the crediting rate (see Q  8) is adjusted to reflect market value gains and losses on the assets in the separate account and on participant withdrawals.  The adjustment is made on an amortized basis, usually over the period to maturity or over the duration of the portfolio where the contract has no stated maturity.  This amortization process keeps the credited rate relatively stable.  To maintain the guarantee of principal, the crediting rate may not be negative. Yields are credited on an annual effective rate basis.
            Some describe separate account GICs as “asset-backed” contracts rather than “insurer-backed” like traditional GICs, since stable value funds are expected ultimately to assume all the credit and interest experience on the assets in the portfolio.

 Q 14  What is a bank investment contract?

            A bank investment contract (BIC) is a GIC-like investment contract purchased by a defined contribution plan from a commercial bank.    Technically a BIC is a bank deposit agreement, and it is therefore classified on the bank’s balance sheet as a deposit.    Like a traditional GIC, a BIC provides an issuer guarantee of principal and accumulated interest and typically offers a guaranteed rate of interest over the life of the contract.  BICs issued to stable value funds are benefit-responsive contracts that maintain participant transfers made subject to plan rules at book value (see Q 20).  Because BICs are bank deposits, they typically have priority over other types of bank liabilities in the case of insolvency. 
            BICs were extremely popular in stable value funds in the late 1980s because Federal Deposit Insurance Corporation (FDIC) rules permitted each participant’s implicit share of the contract to be insured up to $100,000.  Thus, under the rules,  a $5 million BIC might receive full FDIC insurance.  This provision was amended as a part of FDIC reform measures, however, and bank deposits which permit withdrawals without any interest rate or market value penalty prior to maturity no longer receive FDIC insurance when issued to most types of defined contribution plans, nor do the banks pay FDIC premiums on those deposits. 
            Currently most banks who provide investments for the stable value market issue wraps for synthetic instruments rather than issuing BICs. 

 Q 15  What is a muni-GIC?

            A muni-GIC is a investment agreement sold by an insurance company to a municipality which provides for a guaranteed rate of interest over the life of the contract.  Unlike traditional GICs, the muni-GIC is not an annuity contract.
            These investment agreements are often used by municipalities to collateralize borrowings by relying on the good credit of the insurance company issuer.  They also may be utilized to increase the yield on funds being held awaiting completion of construction projects.  In the first instance, the issuer is providing a form of credit enhancement.  In the second, it is providing a longer-term investment with a higher yield than the municipality could obtain through other short to medium-term investment channels.

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Stable Value Contracts from the Issuer’s Perspective

Q 16   What risks do stable value contracts pose for the issuer?

            A GIC or synthetic wrap issuer assumes risk whenever it makes a guarantee of interest or principal on an investment contract.  These risks fall into two categories:  asset risk and liability risk.
            There are three primary forms of asset risk, as follows:

1.  Default risk.  The risk that the assets that are backing the contract will default on interest or principal payments.
2. Call or extension risk.  The risk that an asset’s principal will be paid more quickly than expected when market rates fall or more slowly than expected when rates rise, so that the income generated by the asset and its market value are inadequate to support the guarantee.
3.  Reinvestment risk.  The risk that income on the assets backing the contract will be invested at a rate lower than the rate guaranteed by the contract.

There are two basic forms of liability risk as follows:

1.      Contribution risk.  The risk that the amount of deposits at the guaranteed rate of interest during the window period of a contract will differ from expectations.  Changes in deposit activity may be induced by large movements in interest rates.  If market interest rates rise, the guaranteed rate will seem less attractive to participants, who may reduce their contributions, forcing the issuer to sell fixed-income assets at a loss.  If market rates drop substantially, contributions may rise, forcing the issuer to buy additional, lower-rate assets to back the contract.

2.      Withdrawal risk.  The risk that participant withdrawals from the contract will exceed expectations when interest rates rise above the rate guaranteed on the contract, forcing the issuer to sell assets at a loss.

 Q 17  How do stable value issuers protect themselves against stable value risks?

            Insurance companies and banks participating in the stable value market use a combination of risk underwriting and sophisticated asset/liability matching techniques to protect themselves from losses on the risks assumed.  When a contract is issued, a risk charge is assessed based on the underwriter’s estimate of the likely contribution and withdrawal rates.  The issuing company determines the likely pattern of inflows and outflows on the contract and estimates its effective duration Assets are acquired to match the duration and/or expected cash flows of  the contracts.  Issuers have elaborate computer systems to monitor and project the duration, convexity, and cash flows of their asset and liability portfolios.  Most do the process on a stochastic basis that varies the cash flows under different interest rate scenarios.  Generally issuers don’t match a single contract with a single asset but work with a portfolio of assets that is internally dedicated to their stable value contracts.  The portfolio approach provides diversification and better flexibility to handle liquidity needs.  However, the issuer’s full asset and capital base are available to support its guarantees.

            The right to withdraw from the contract at book is an option issued by the financial institution providing benefit-responsiveness to the participant.  Estimating the exercise efficiency of this option - the likelihood of withdrawal at various levels of interest rates - is a highly subjective exercise.  Most issuers use a combination of option techniques and probabilistic scenario testing.  The underwriting process is also designed to limit this risk by screening out plans containing excessive arbitrage risks, such as those that allow unrestricted investment transfers to a competing fund (see Q 22).  Good contract design is also important in reducing risk.

            Rating agencies and others evaluating the risk of stable value issuers routinely analyze the risks assumed in the contracts and the matching techniques used to protect against those risks as a part of the rating agencies’ credit review process (see Q 29).

 Q 18 How are stable value contracts priced?

            Stable value contracts include both asset fees for asset management and custody and wrap fees for administrative expense, risk charges, and profit to support the capital to support the risk.  In a traditional GIC, the investor is quoted a guaranteed rate that is net of all the insurance company’s expense, risk and profit charges.  In a synthetic structure, the investor negotiates fees with both the asset manager and the wrap provider which are then deducted from the earnings on the synthetic portfolio.  Wrap fees usually range from 6 to 25 basis points depending on the size of the deal and the risks covered;  standard fixed income asset management fees apply.

            Traditional GIC issuers generally price their products based on the yield available for investments of the appropriate duration for the contract being quoted.  Deductions are made for the estimated credit and call risk in the asset, and the yield is then converted to the annual effective basis credited in stable value contracts.   Investment and administrative expenses are deducted as well as a plan-specific risk charge for the liability risks assumed.  The life company also deducts a profit charge for a return on capital, a charge that increases with the amount of risks assumed.  Total GIC risk charges and fees are generally in the 55 to 90 basis point range depending on the size of the contract, the risks assumed and the types of assets utilized by the issuer.

            The plan can choose whether to self-insure against risks in its stable value assets and liabilities by buying participating contracts or whether to purchase insurance for those risks by having the issuer assume them.   The issuer can diversify many of its risks, thus reducing the charge below the effective cost to the plan.  By self-insuring, however, the plan avoids paying for the issuer’s capital costs and profit taxes.

 Q 19  What is underwriting for a stable value contract?

            Stable value issuers evaluate the interest rate risks posed by each plan that requests a contract bid.   This evaluation process is called underwriting the contract or bid.  The firms analyze the bid specifications provided by the prospective purchaser (see Q 22) to determine how likely participants are to change their deposit and withdrawal patterns in response to interest rate changes by looking at the financial sophistication of the participants, the other investment options in the plan, past investment behavior, the plan’s allowed transfer frequency, t