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Stable Value and GICs
a chapter for the Pension Investment Handbook
II. Types of Investment Contracts
Q6 What is a GIC? Return to top
A GIC is 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. There are 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 effective rate.
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 underwrites the market value risk on this popular withdrawal feature (see Q15).
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.
Q7 What is a synthetic GIC? Return to top
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. The synthetic is an alternative to a traditional GIC in a stable value fund that unbundles the GIC’s investment and insurance components. The plan investing in a traditional GIC owns a group annuity contract, and the insurance company owns and retains custody of the assets backing the contract. With a synthetic, the plan has custody of the asset and negotiates for the wrap contract providing the book value insurance protection separately.
Figure 3
The synthetic asset may be almost any type of fixed income 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. 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 15). The contracts come in many different legal forms: group annuity contracts (issued by insurance companies only), interest rate swap agreements, asset purchase agreements, investment management agreements, etc..
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. Synthetics offered the investor the opportunity to diversify away from what had become a very large single-industry concentration in their GIC funds. This need for diversification became a driving force in the stable value market following the financial difficulties of Executive Life and Mutual Benefit in 1991 and 1992 respectively. From a very low volume of sales in 1990, synthetic GICs rose to 35 percent of stable value sales in 1996. (See Figure 4.)
With a typical synthetic GIC, the plan trustee has a contract with the asset manager and another with the wrap provider. Investment policy guidelines such as the duration of the assets and their credit quality are agreed to by all parties at purchase, 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 be a single company or corporate affiliates.
Q8 How does a synthetic wrap work? Return to top
The synthetic wrap contract maintains a book value asset or fund balance for the underlying asset and reports the yield credited on that book balance. Any market value gains or losses are amortized over a multi-year period, usually the time to maturity or the duration of the asset being wrapped, and the crediting rate 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, since 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 Q20).
Q9 What types of risk protection do synthetic GICs offer? Return to top
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.
Q10 Who are the largest providers of synthetic GIC wraps? Return to top
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 Q15). It is not surprising therefore that the largest volume of synthetic wraps to date have been issued by large, high quality domestic and foreign banks and life insurance companies.
Q11 What are the relative advantages of synthetics and traditional GICs? Return to top
Synthetics 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 still leave the wrap in place. The fact that the trust has direct ownership of the wrapped asset is also appealing, since this reduces the risk of regulatory hassles and valuation difficulties should there be an insolvency by the wrap issuer.
Traditional GICs, on the other hand, are generally simpler to negotiate and purchase and typically offer more forms of risk protection than most synthetics. There is a single contract with the insurance company, rather than separate contracts with the custodian, wrap provider and the asset manager as in most synthetics. 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 for deposits of $2 million or less.
Q12 What is a separate account GIC? Return to top
A separate account GIC is a guaranteed group annuity contract issued by a life insurance company that is backed by assets invested in a separate account, a portfolio 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, however. 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 Q19).
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 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. The crediting rate may not be negative to maintain the guarantee of principal. 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.
Figure 4
Source: Stable Value Association and LIMRA
Q13 What is a BIC? Return to top
A 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 is classified on the bank’s balance sheet as a deposit. Like a traditional GIC, the 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 Q19). 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 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.
Q14 What is a muni-GIC? Return to top
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 reliance on the good credit of the insurance company issuer. In other circumstances they 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.
