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GIC strategies for the '90s.

Participants in defined contribution plans, when offered a choice of investment products, typically have chosen the book value GIC investment option. Depending on what study you look at, GIC investment options account for anywhere from 60 to 80 percent of total plan assets.

No wonder. These funds have a number of attributes plan participants want.

* Stable Returns: GIC funds are not subject to the volatility associated with most other investment products, so a well-managed portfolio of GIC investments generates returns that gradually rise as interest rates go up and gradually decline as interest rates fall. Plan participants can understand the relationship between the earnings rate credited to their accounts and the current level of interest rates.

* Book Value Withdrawals: Participants can get distribution of their assets at book value regardless of the investment environment. With employment so insecure during the past few years, older and younger participants alike have chosen this option because they know exactly what they'll get from the plan should they leave.

* Competitive Return: Throughout the years, the investment returns associated

with GIC options have been attractive, and, in fact, many defined contribution plan sponsors still support blended rates above 8.5 percent, a very good rate in the current environment.

Safety of Principal: Until recently, participants assumed that investment in a GIC meant that their principal was safe and the rate of return guaranteed. They have not understood that the guarantees are only as good as the insurance companies that issue them. While most plan sponsors have made a point of delivering this message to participants during the past two years, there has not been a major exodus from this investment option.

Even when Executive Life and Mutual Benefit were taken over by the State Insurance Department, only a small number of participants moved into other products.

We should point out that even though GICs have been popular and generally successful investment options for participants, we recognize that participants who invest heavily in them are not necessarily doing the right thing. Perhaps education will encourage participants to accept more risk and invest more heavily in equities to obtain higher returns. The majority of participants so far have voted with their feet and have directed most of their money into conservative options, such as GIC and money market funds.


With the credit risks now apparent in traditional GIC products, some plan sponsors have decided to stop using GICs and their attendant book value accounting. But, while this solution may be appropriate, a plan sponsor needs to make certain that any replacement has the attributes participants want most--those attributes we've already discussed.

During the past few years, a new product structure has evolved that offers participants these attributes and, at the same time, satisfies the plan sponsor's need for diversification of investment credit risk. The most recent of these products is the synthetic GIC offered by insurance companies, banks, and investment management organizations. We estimate that as much as 50 percent of both new money and maturities have been placed within synthetic GIC products since mid-1991, and they are likely to become even more popular in the future.


The best way to define a synthetic GIC is to compare it with a traditional GIC product, as in the chart below.

The left side of the chart depicts a traditional insurance company GIC, in which assets are handed over to the insurer for investment within its general asset portfolio. In the traditional structure, the credit risk associated with the GIC is directly related to the ability of the insurance company to pay the obligation when it comes due. If the insurer were to default on its obligations, the amount and timing of the receipt of funds, needless to say, would be important to the plan sponsor.

The synthetic GIC structure, depicted on the right side of the chart, involves either (a) the purchase and ownership of an asset or portfolio of assets consisting of all or a substantial portion of the invested funds plus a book value wraparound guarantee from a bank or insurance company, or (b) the investment in an insurance company's separate account product that entails a book value wraparound guarantee. The separate account products offered by insurance companies define investment criteria (for example, all investments might be limited to government, government agency, and AAA credit quality). As further protection, contract documents must spell out that the account is separate and apart from the general asset portfolio of the insurer.

With either of these products, the plan normally accepts the credit risk associated with the portfolio investments. (Note that the plans offered by some carriers do not accept the credit risk.) And, if the issuer of the wraparound guarantee became impaired, the trust would either take delivery of the securities if it owned the portfolio investments (option a above) or have a claim against the fair market value of the insurer's separate account (option b). With either structure, the trust would have a secondary claim against the issuer of the wraparound guarantee in an amount representing the difference between the market value of the assets and the book value of the synthetic investment.


The following are brief summaries of the various approaches that plan sponsors are currently taking.

* Traditional GIC/BIC Product: While there have been a number of downgrades in insurance companies during the past year or so, a handful of top-rated issuers are still sufficiently creditworthy--with minimal exposure to problematic investments and appropriate levels of capitalization--so that plan sponsors do not need to change the structure of investments within the plan's fixed-income funds.

In our experience, less than half of the funds previously directed to the traditional GIC/BIC is being invested in this product today. And only those carriers with the very highest ratings and creditworthy characteristics are benefiting from the flight to quality.

Using fixed-income funds from the top-noted carriers has some clear disadvantages. First, the fixed-income fund is like a bond fund invested in illiquid securities with no industry diversification. Second, the small handful of carriers still viewed as having largely bulletproof creditworthiness are clearly aware of their position and quote accordingly. We have heard of situations in which sponsors have chosen one of a handful of top AAA carriers even when their quoted returns were as much as 75 points below AA-rated carriers. So plan sponsors that pursue this strategy over the long term will achieve increasingly modest yields compared with three- to five-year treasuries.

* Bond Portfolio with No Wraparound Contract: At the other end of the spectrum, some plan sponsors have elected to do away with the practice of book value accounting, generally as a result of a decision to direct funds into marketable bond portfolios.

While this alternative has the advantages of enhanced flexibility and industry diversification, it also has some disadvantages. Most importantly, as an increasingly large percentage of the fixed-income fund is marked to market, returns become increasingly volatile. There will be times when returns will severely lag behind interest rates, as happened in the late 1970s and early 1980s, or, even worse, go down as interest rates go up. Needless to say, plan participants became very dissatisfied with the plan when this happened.

Also, when a sponsor changes from a book value program to a market value program, the book value GIC issuers may not have to pay their share of benefit payments at book value. This could create big financial problems if an increase in interest rates causes withdrawals and transfers to accelerate. So, while this alternative is appealing because it introduces true industry diversification and flexibility, it may cause participant dissatisfaction in the future.

* GIC-like Synthetic with Direct Asset Ownership: A common alternative for plan sponsors today is to invest in synthetic GIC arrangements that operate very much like the traditional product, but also provide diversification from the credit risk of the financial services industry. Under this alternative, the plan has direct ownership of specific underlying securities (usually Fannie Mae or Freddie Mac) and a book value wraparound contract that nullifies fluctuation in the market value of these securities. The operational characteristics of the synthetic GIC--interest rate guarantee, assumption of pre-payment and extension risk, reinvestment risk and nonparticipating benefit payment risk--are identical to the traditional GIC/BIC product.

The primary advantage of this alternative is that it provides the least risk of disrupting the operation of the fund, while at the same time it addresses credit risk. The primary disadvantage of this alternative is that the underlying strategy is still a relatively simplistic buy-and-hold approach similar to the traditional GIC/BIC. The relatively modest returns the GIC market has seen in the past three or four years-top three-year quotes have ranged between 0 to as much as 75 basis points over comparable treasuries--are also applicable here.

* Insurance Company Separate Account Synthetics: Many of the major carriers in the traditional GIC market have recently developed a version of the synthetic GIC. The most common forms involve separate account arrangements--in which the carrier rather than the plan sponsor owns the assets in an account legally segregated from the carrier's other assets and liabilities--and a wraparound that preserves the book value accounting.

In some versions, the portfolio is actively managed, which is an advantage over the traditional GIC/BIC product or the more GIC-like synthetic we just described.

A possible disadvantage of this alternative is that the carrier owns the assets, even though the assets are protected in a separate account, which makes it less attractive than when the sponsor owns the securities. How insulated these accounts will be from the carrier's credit risk has not been tested in court.

Another possible disadvantage is that, because the benefits provided by these products are generally fully participating, capital losses and gains arising from benefit payments and transfers are simply reflected in the future rates of return. So the capital backing the book value operation of the fund is simply the future rate of return credited to participants. Once again, a protracted increase in interest rates accompanied by a heavier than normal level of benefits and transfers could cause big problems.

Recently, versions of separate account GIC alternatives have emerged which, to one degree or another, provide operational characteristics similar to those of the traditional GIC/BIC product and the GIC-like synthetic. With these products, benefit payments are handled on a non-participating basis so that the carrier's capital, rather than the future rates of return credited to participants, is at risk in the event of heavy withdrawals in a high interest rate environment. Other traditional GIC/BIC characteristics, such as guaranteed rates of return and automatic maturity dates, are beginning to appear as part of the wraparound contract features within the separate account synthetic GIC products.


Increasingly, the investment management function is becoming separate from the book value wraparound contract. New structures have just come into the marketplace in which independent investment management organizations provide their expertise in managing the portfolio, and a separate organization, typically a bank or insurance company, provides the wraparound contract.

There is real promise that these new alternatives can achieve not only greater diversification and better protection against credit risk, but also better rates of return than the traditional product. And they can do this while retaining the operational characteristics of traditional GICs that participants find so attractive.

For example, a well-managed portfolio consisting primarily of government and government agency securities will provide returns superior to the traditional product alternatives even with the wraparound expense. In fact, some immunized portfolios--those that offer a high probability of meeting a targeted return--with three- to five-year maturities net returns ranging from 25 to 50 basis points above comparable three- to five-year traditional GICs, even after the wraparound expense is reflected.

The main risk in a synthetic GIC is the possibility of material discrepancies between the market value of the assets and the book value of the participants' accounts. Portfolio structures that minimize the likelihood of any such material discrepancies arising are obviously advantageous. For example, portfolios that include Fannie Maes and Freddie Macs collared with put and call options are appropriate as underlying strategies for synthetic GIC/BIC arrangements, because they can be structured to have minimum returns such as 0 percent or the 90-day treasury return during any given three-month period.

The track record of such portfolios is exciting because, in addition to improving diversification and credit-risk protection, historical returns compare favorably with those available from the traditional product. Specifically, the historical returns on a 0 percent minimum return arrangement exceeded competitive GIC rates by 100 to 200 basis points (depending on whether the comparison was between three-year GICs or five-year GICs). Portfolios with a more modest total return goal and higher minimum return floor, such as the 90-day treasury, have also done surprisingly well, coming within 25 to 50 basis points or so of matching the returns available from competitive three-year GICs. (Indeed, such a portfolio structure with a 90-day treasury quarterly "floor" might be more consistent with participant expectations than traditional GIC/BIC approaches, because the rate of return participants see is, by definition, always consistent with current rates.)


So Executive Life and Mutual Benefit, along with the well-publicized portfolio problems of many of the major carriers, have led to some dramatic changes in the GIC/BIC market. At one extreme, plan sponsors continue to purchase from the few top-quality issuers of traditional products; at the other end, you will find plan sponsors that switch from book value to market value accounting and run the risk of potentially significant dissatisfaction among participants. We find that the most interesting opportunities lie between these extremes. The better synthetic arrangements not only capture most, if not all, of the attractive characteristics that participants have enjoyed in GIC funds in the past, but they also have the advantages of industry diversification, enhanced protection against credit risk, and, in some cases, surprisingly competitive or even superior total returns.

Mr. Hughes is a senior consultant and Mr. Templeton is director of insurance consulting within the Asset Consulting Practice of Towers Perrin.
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Title Annotation:Benefits; guaranteed investment contracts
Author:Templeton, William D.
Publication:Financial Executive
Date:May 1, 1992
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