Stable Value Market Value Gain

[MoJo]

A client has stated rate stable value fund in it's plan, which is in the form of an insurance company issued contract. Currently, the contract has a market value gain (i.e. the market value of the underlying pool of assets exceeds the book value allocated to the participant accounts). The contract is terminable at market value currently. Client wants to terminate the contract (capturing the market value gain) and transfer the funds (including the market value gain) to a new provider, who can guarantee a higher stated rate. Stable Value Advisors say this happens all the time. Outside counsel says the termination of the insurance contract may trigger an "allocatable event" which would require that the market value gain be allocated to the participant accounts currently as an investment gain, and can't be used to support a higher guaranteed rate in the future, on the theory that if it were a market value loss realized, with no replacement fund, the participants' would suffer an investment loss - hence, they should likewise receive any gain. Of course, allocating the MV gain would render the strategy of a provider shift to capture a higher going forward crediting rate impossible. The client would like the higher rate going forward.

On one level, that may sound appropriate, except when you consider that 1) the current insurance company (that issued the contract) is in fact using that gain (amortized over time) to support the rate it is guaranteeing (which is above current market) (which raises the question of whether the fiduciaries should terminate the contract just to capture that gain for allocation purposes only); and 2) the gain was accrued over time, and much of it was accrued previously (i.e. the current investors in the fund may not be the ones who were investors in the fund when the gain was accrued) - hence if an "allocatabel event" occurs, one who invests on the day before the proceeds were realized would benefit equally with one who had been invested in the fund for a period of time.

I have been unable to find any authority to indicate whether the MV gain is an allocatable item to the participants (who were "guaranteed nothing but preservation of principle plus a state interest rate), or can be used to support a rate going forward, with a different issuer. That is, is the act of terminating the contract with a replacement ready to take the assets immediately a realization of the MV gain such that it should be allocated to the participants currently, rather than amortized (and credited to them) as a higher crediting rate going forward? The closest analogy I have found deals with demutualization proceeds. The DOL has apparently indicated that demutualization proceeds may be used to provide future benefits (i.e. higher crediting rates going forward, as opposed to being allocatable to current investors in the fund(s)).

[E as in ERISA]

Is there something I'm missing? Are you saying that participants accounts show only the cost and have never been updated in prior years to reflect the market value? Plan assets are reported at current value not historical cost. E.g., if the plan buys a mutual fund for $9 a share and it increases to $18, then the shares are reflected at $18 in the participant accounting. The same is true for insurance arrangements. It's a little more complicated. There are several different values reported for an insurance contract and I can't remember which one you use. But I think that its one that estimates what you would receive if you cancel the contract in the current year.

[MoJo]

In the case of a stated rate stable value fund, the value of the contract (think GIC) reportable to the participants is the book value (cost plus accrued earnings at the stated rate). The underlying assets, which are not assets of the trust (by virtue of the insurance contract over the top of it (think synthetic GIC), but are rather assets in the insurance companies general (or separate) accounts form the basis of the amount of cash the trust will receive in the event of contract termination. That is, participants are guaranteed book value as long as the contract is in force (as a general obligation of the insurance company), but receive only market value of the underlying assets in the event of contract termination (i.e. the value of the underlying assets without the insurance wrap).

[mbozek]

I thought that under Rev. Rule 80-155 the plan assets must be valued each year and that all assets in a DC plan must be allocated to participants accounts except for suspense accounts under the exclusive benefit rule. See reg 1.401(a)-2. This is required because a DC plan under IRC 414(i) must provide for the allocation of income, expenses, gains and losses to the participant's accounts. This leads to the queston of how has the unrealized gain been allocated to the accounts of participant's who received a distributions? Have you reviewed the plan document to see how gains/losses are allocated?

[MoJo]

I don't think I'm being clear. The asset of the plan is a GIC contract which does not change in value (except to the extent that interest is credited at the stated rate). As long as the contract is in force, there are no gains to allocate. If this were NOT the case, then the concept of a stable value fund (either a GIC, a pool of GICs (collective trust) or a synthetic GIC would never work - as there would never be a "stable" value. Clearly, that is not the case....

Think of it this way: Upon termination, there is a contractual "penalty" - a termination charge or a surrender charge, if you will, which will alter the value of the contract - but only at the time of the termination. That "penalty" is formula driven, and the formula is based on the "market value" of a separate account managed by the insurance company issuing the contract. This pool of assets is NOT an asset of the plan's trust (only the contract is, which does not change in value, hence no current allocation issues exist). Because of the way the termination charge formula is written, it is possible that the penalty will produce a "negative charge", or a gain. So, NO gain exists until the contract is terminated, but the gain on termination is calculable in advance, and we know that if terminated today, the formula would produce a gain. I understand that a life insurance policy is generally carried at cash surrender value, which fluctuates, but I think that is not analogous to a stable value fund.

Bottom line - there is NO current problem with not having allocated the gain as it accrued, because none ever accrued, or could be accrued, per the terms of the contract, until the termination occurs.

So, now, the question still arrises as to whether there in fact is a gain which is allocatable to specific accounts of participants at the time of the termination of the contract, considering that there is a substitute fund, into which the gross proceeds would reinvested, at "book value" with the gain being amortized as an above market current stated interest rate?

This is the scenario that occurs all the time when one GIC contract is substituted for another. The subadvisor on the fund (one of the two largest stable value managers in this country) has indicated that they do it hundreds of times, and no one has ever raised the issue of the market value gain being currently allocatable to participants accounts - indicating rather that the "new" or substitute investment (another GIC contract in many cases) is simply purchased at a premium to book value, and the enhanced yield justifies the premium (which is, in effect, the market value gain that exists at the prior contract's termination). That is, a bond purchased with a 6% yield will cost more than a bond purchased at a 5% yield. So, in effect, the gain is "allocated."

[mbozek]

For those of us who are quantitatively challenged are you saying that upon termination, a SV contract with a bk val of $1m and interest rate of 5% will be exchanged for a SV contract with the same bk val and an interest rate of 6% or that a SV contract with $1m bk val and 5% rate will be exchanged for a SV contract with Bk val of $1.2m and interest rate of 5% which will produce a 6% return (1.2m x .05 =60,000/$1m= 6%). If the latter is the answer then I think the participants's account balances should be adjusted for the higher value of their accounts under IRC 414(i) that requires allocation of gains in a DC plan every year (RR 80-155). I am assuming that an the end of the term the contract will have a val of about 1.2 m. If the former is the answer then your client has a prudent investment question as to whether it should reinvest in the contract instead of pocketing the gain (200K) and reallocating the gain among the particiipants' accounts and reinvesting the prinicipal ($1m) at market rate to prevent a loss to participants in the contract for interest rate risk or other market risk in the future. Also there is a prudence question as to whether the plan should use this termination at a gain as a way to avoid paying charges to the participant's accounts at a later termination. I also think your client needs to rely on counsel and not on a sub advisor who cannot give legal advice.

[E as in ERISA]

Now that you're calling it a GIC, I now partially understand what you mean. I understand the economics of the first contract (where you only get guaranteed rates until maturity). But I don't understand what is happening on the substitution. Or at least I don't understand why does the reporting to participants should affect the economics of the transaction? You don't have to actually distribute any gains to the participants in cash.

I have some info that might describe the basics, but its not at my fingertips.

I think that GAAP (Generally Accepted Accounting Principles or something like that) specifically describes how the asset and income are reported on the plan's financial statements. And then I think that would determine what gets reported to participants. So if the plan is audited, you might also want to check with the plan's CPA to confirm how it will be treated.

[MoJo]

mbozek: This transaction is the former (i.e., a contract with a book value of $1 million at 5% is being exchanged for another "contract" with a book value of $1 million at 6%). The reason this can be done is the replacement deal is a synthetic GIC run through a separate account, which isn't encumbered by the prior insurance company's expenses and experience. The market value of the underlying assets in both the prior and the post fund will also be equal (say, $1.2 million). The current GIC contract is open-ended (i.e. has no true maturity date), but most contracts I've seen pay book value at termination (and not market value adjusted values).

I agree there is a fiduciary issue of whether the trustees should cancel the existing contract and capture the gain for the benefit of the participants, but they have reasoned (rightly or wrongly) that it is in the best interest of the participants, and therefore prudent, to maintain a fund which has a guaranteed rate (reset annually) at above market rates rather than suffer a lower rate going forward on a higher balance. In essence, as well, that market value gain in the existing contract is being captured (over time) as it has caused the interest rate to be above market (i.e. the gain is "amortized" over the average duration of the underlying portfolio to achieve that above market rate. Conversely, if there were a market value loss, the loss would be amortized producing a below market crediting rate for the next year or two (or until the underlying portfolio generates gains...)). While thie current contract is a "GIC" of sorts issued by an insurance company, it behaves very much like a synthetic. If interest rates change, there is a risk that the gain will evaporate, and next year's crediting rate will suffer, but the trustees are unconcerned by that currently.

Replacing the GIC with the synthetic offers a better underlying investment strategy with lower expenses which the trustees believe will produce better returns on the fund (better than the GIC, anyway) going forward - provided the current market value gain can be "captured" and utilized to support that rate (i.e. NOT allocated currently to participants). Structurally, the replacement deal is IDENTICAL to the current contract, as both use market value gains (or losses) to increase (or decrease) furture credinting rates. Economically, the synthetic (arguably) offers a better investment option by reducing expenses, and benefitting from a different underlying investment strategy.

The trouble with the client relying on counsel (which, of course is generally a good thing) is that their theory here is the antithesis of the entire stable value industry's current practices - and it isn't a "schlock" sub-advisor (you'd recognize the name if you do anything in the stable value field), and they have had their GC, and their outside counsel review this (trying to "disprove a negative" as it were), and I'm an attorney as well (but not representing the plan/trust/trustees) and have talked to other counsel all of of whom, recognize that the industry would typically not consider this a concern, but can't find authority to "disprove that negative," or conversely, to indicate these transactions are truly inappropriate (and shutting down the ability of one to capture assets to fund a synthetic GIC strategy).

Katherine: The goal here is to NOT recognize the gain as allocable to participant accounts, as it does destroy the economics of the deal, and in the trustees mind, the value of the fund to the participants (the trustees do not want to have rates going forward adjusted to market - they want to maintain above market crediting, and would like to capture even greater above market crediting by going to the synthetic strategy).

A few more facts: This is, of course, a Taft-Hartley plan, and hence, much ado is paid to the perceptions of the participants (members). The trustees will NOT allow the current crediting rate to be reduced - even though by "cashing in the contract and reinvesting the proceeds at current market rates" theoretically has no net economic impact on the membership. But *you* explain to a trademen that yesterday he was getting 5% on a 1x account balance, and tomorrow he or she is going to get 3.5% on a 1.5x account balance. You wouldn't get past the 3.5% before you'd be in trouble....

So, the issue is justification of essentially what happens many times each year in a "GIC to synthetic" transaction of maintaining book value on the participant records, and utilizing a gain to maintain a rate going forward.

Interesting problem, to say the least. And who says ERISA isn't an exciting field to be in?????

[rcline46]

I think y'all gettin' too fancy here. Lets look at facts.

1. A GIC is liquidated. I think that requires any g/l to be allocated.

I don't see any difference between liquidating a GIC or a bond. The fact that a GIC is constant income and nowadays a bond must be at market has no relevance. Anybody remember amortizing bonds??

2. I don't care if it is a 'swap' because it is NOT a swap.

3. If the GIC attorneys are so self assured no gain needs be posted, the most assuredly they have a DOL opinion letter, right?

Oh, no opinion letter? Then they are NOT so sure!!!

Have your Taft-Hartly plan get its own opinion letter, what's the big deal? If afraid of answer, then don't do it.

Life is so simple.

[MoJo]

Probably an oversimplification., rcline46. The one thing I like about an ERISA practice is that nothing is black and white. The GOAL of ALL, including the trustees and their attorneys is to make this happen.... And in fact, it happens all the time, but "proof" seems to be elusive of the correctness of either position.

Getting an opinion is an option, BUT, the issue I think is more of an IRS one, and not a DOL one, and I don't think this is a plr-able situation. Besides, timing is critical, or the economics of the deal change with the value of the underlying portfolio.

It's been suggested that the contract be transfered, in kind, into a separate account, and"wrapped" with another book value wrapper, and then liquidated (underneath the wrapper, which then becomes the new synthetic. And ideas?

[mbozek]

These issues are much too complex for a discussion on this site and can only be analzyed by counsel after a review of all the issues. My own view after reading all the posts is that there is a real risk to the fids under ERISA. Chasing yield at the risk to principal is not a prudent investment strategy. It is questionable to use investment gains to support current yield if the value of the principal investment held for participants can decline. There is a real risk of devaluation of fixed interest investments in the next year or two because interest rates are supposed to rise which could result in a lawsuit against the fids for not taking the profits and investing in a lower yielding investment. The legal fees would be staggering even if the fids prevail (Unisys litigation went through 4 court decisions before the decision to invest in Executive life GICs was determined to be prudent). I also think that the complexity of disclosure of a sale and capture of the gains to participants is not a valid basis for converting to the synthetic GIC. I disagree that the goal is to "make this happen" instead of making a prudent investment decision for the participants. The make it happen mentality in financial engineering resulted in ENRON and Executive life disasters. There are several law firms and Investment banks with financial risk because counsel signed off on dubious deals because ENRON executives wanted "to make it happen".

[Demosthenes]

Sorry MoJo,

When you reduce this to the simplest terms, I need to agree with rcline46. Back in the day, I worked at an insurance company with a large number of clients in all types of GIC arrangements, evergreens, windows, bullets, you name it. This was a pretty common occurrence

If you terminate the current GIC, that is an event that triggers an allocation of gains/losses.

Look at in the reverse, if the current market value resulted in a loss, you wouldn't be trying to bury loss that in the next GIC would you?

[MoJo]

mbozek - you're cautions are well taken, which is why the concerns exist with respect to this matter; however, in reality, these transactions occur virtually daily without a second thought (synthetics are generally a better buy when rates are low, and are expected to trend upwards, as they more closely track rates. Traditional GICs are better when rates are high, and are expected to trend lower, as they don't track as closely and will maintain the higher yield longer). The fiduciary angle is being well covered, and the appropriate process and documentation has been developed (and there are other reasons for doing this deal other than locking in the higher yield/market value gain, i.e. single issuer paper is becoming riskier and riskier (Cigna is one step away from junk status, for one, other's have had issues as well). The point of this thread, (apart from this specific set of facts) is, as well, to ascertain whether something which truly is standard operating procedure in the inducstry with respect to changes in stable value funds is appropriate. If it isn't, lots of people have problems. If it is, then there ought to be a way to logically demonstrate that appropriateness.

Demonsthenes: Well, I would disgree that a gain is always recognized (or even that a loss is always recognized). I've seen many, many circumstances where an insurance company will take another's contract in (cashing it in at a loss) and replacing it with a contract that maintains the prior book value. I believe they refer to it as a "market value equalizer," and they amortize the market value loss over an extended period of time (through lower crediting rates) with their own back-end load, or termination arrangement, to recapture any unamortized loss in case the contract is prematurely terminated. Now granted, I have some reservations about such a strategy for many reasons, but it in fact happens, and it is in fact is identical to this situation, except the numbers have minus signs in front of them.

[mbozek]

Too often what appears to be rational means of managing risk in financial products on paper breaks down in the reality of an unforgiving market (long term capital and Bankers trust come to mind). Both BT and LTC were victims of their overindulgence in financial products based upon faulty assumptions in future interest rate changes that were contradicted by the market. But at least its not my money.

[MoJo]

True, mbozek, but with interest rates at present historical lows (my money market is now paying .58%), wiith considerably more potential for increases than decrease (you can't go below zero!) and with insurance companiies now averaging a B or below credit quality, the conservative approach appears to be diversifcation in the highest credit quality product available (the synthetic has over 100 issuers, more than half in govies and agencies, an average credit quality of AA+, no more than 1.5% in any one issuer, no issue below A rating, and average duration (factoring out current cash flow in), of about 2.2 years - you can't get more conservative than that). The examples you cite were in a high(er) interest rate environment where the direction of rates were anybodies guess. I wish it were my money - I can't get close to the 5%+ this fund is paying....

[Guest jfp]

MoJo:

I believe I have what is the exact same issue you were wrestling with a couple of months ago. Would you mind telling me/the Board what happened?

[Kirk Maldonado]

I think that there are fiduciary issue implicated here, so that seeking DOL guidance would be appropriate. However, there are also plan qualification issues here.

I generally agree with the analysis stated by rcline46.

[four01kman]

It would seem the only way to accomplish your goal is not to have termination of the existing contract. Once that occurs, I see no way to avoid the allocation of the gain. On the other hand, if there is a way to have a "transfer for value" of some sort without any gain recognition to your new arrangement, that might be a possibility.

Existing Insurance Company A transfers the GIC (with its underlying assets) to New Company B in exchange for "x"(maybe $1 as valuable consideration) and the release of all liabilities. New Company B then issues, revises, amends (pick one) the contract to accomplish your goal.

Maybe you need to find the right (and I mean, an appropriate) attorney.

[MoJo]

No doubt there are fiduciary implications here - but the trustees have evaluated the situation and are prepared to make that decision - i.e. that want to go from a single issuer credit to a diversified pool - but without any allocation of the market value gain or change in the current stated rate. The issue is more on the qualification side. Nothing much has happened yet - except the research continues (and the industry continues to do these kind of transactions almost daily - albeit with no firm resolution of the issue). I still find it interesting that in the negative market value situation, that some providers (mostly insurance companies) will provide a "market value equalizer" on the transfer of the business to them which takes the market value, grosses it up to book value, and amortizes the difference over the duration of the underlying portfolio. What we've proposed is the same thing, except that instead of a negative market value adjustment, we have a positive one....

I guess those providers are just doing so without clear authority....

[MoJo]

Four01Kman: We've suggested a similar approach (assuming the contract in-kind within a separate account - placing an additional insurance wrap over the account so that for plan recordkeeping purposes, the wrap "book value" is used, then terminating the contract and reinvesting the proceeds appropriately). By using the added wrap over the top, the "value" to the plan won't change as a result of a change in the underlying investment, in the same way that the value of a synthetic GIC doesn't change when the portfolio manager trades (either at a gain or a loss) the underlying fixed income portfolio. Now, "prove it...."

For the record, I am an attorney, and have been shopping this arround my contacts in the profession, as well as through others to a fair number of other attorneys. Most concur that it is an interesting issue, and that the practice of the industry has been inconsistent (i.e. see my previous post about market value equalizers v. allocating market value losses to participants when no substitute stable value fund is offered (or when one doesn't want to do a market value equalizer) v. what I've been told is a common practice in the stable value business to do exactly what we've proposed).

[MWeddell]

Mojo,

Good to chat with you again.

My views are similar to yours, I believe:

- It is common for surrender charges and negative market value adjustments to not be assessed all at once but instead for the new provider to temporarily absorb that cost and recover it through higher ongoing fees for the next few (typically 5) years. This is such an analogous situation with no DOL enformcement initiative against the practice, that I'd be comfortable defending it in the reverse, where there's a positive market value adjustment.

- The guidance on dealing with demutualization proceeds is instructive. While they must be treated as a plan asset, how they should be allocated to participants is unclear and more than one reasonable method is possible. Demutualization proceeds are attributable to the longstanding relationship with the insurer, not attributable merely to those in the GIC contract on the date of demutualization, and hence may be spread among participants in a variety of ways. The same should apply to your situation.

- I have one client who is spreading the benefit of a positive market value adjustment over the next 3 years, after looking into the situation.

- Whatever the decision, it should be made by the plan fiduciaries in conjunction with legal counsel. Just the process of deliberating about the alternatives should make it more defensible if it's ever challenged.