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The Future of Low Risk Options in Defined Contribution Plans
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The Future of Low Risk Options in Defined Contribution Plans

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The Future of Low Risk Options in Defined Contribution Plans The Future of Low Risk Options in Defined Contribution Plans Presentation Transcript

  • The Future of Low-Risk Options Within Defined Contribution Plans ©2003 – 2013 Multnomah Group, Inc. All Rights Reserved.
  • Scott Cameron, CFAScott is the Chief Investment Officer for the Multnomah Group and a FoundingPrincipal of the firm. In that role, Scott leads Multnomah Group’s InvestmentCommittee, is responsible for the development of the firm’s investmentresearch methodology, and conducts investment manager due diligence. Scottalso consults with plan sponsors on investment menu design, investmentmanager selection, fiduciary governance, and vendor fees/services.Prior to founding the Multnomah Group, Scott was an investment consultantwith a national retirement services firm.Scott is a member of the CFA Institute, the CFA Society of Portland, theInvestment Management Consultants Association, and the Portland Chapter ofthe Western Pension & Benefits Council. Scott holds a B.S in Managementfrom Purdue University.2 The Future of Low-Risk Options Within Defined Contribution Plans
  • Agenda• A History of Stable Value Funds• Challenges Facing Stable Value Providers• Changes in Money Market Fund Rules• Other Options for Low Risk Investments3 The Future of Low-Risk Options Within Defined Contribution Plans
  • Stable Value Facts• $540 billion invested in stable value assets• 127,000 defined contribution plans offer stable value vehicles• Aon Hewitt 401(k) Index™ 2011 had stable value assets at 23.12% of 401(k) plan assetsSource: SVIA 15th Annual Investment Policy Survey Covering Stable Value Assets as of year end 20104 The Future of Low-Risk Options Within Defined Contribution Plans
  • A History of Stable Value Funds1980s 1990s• Insurance company guaranteed • Executive Life Insurance Company investment contracts (GICs) most failed in 1991 popular • Failure of large GIC issuer caused• Backed by full faith and credit of insurance industry to transition to issuing insurance company separate account GICs• Assets invested in insurance • Similar to GIC but assets placed in company general account a separate accounts• Earn stated interest rate declared • Synthetic GICs began to develop as by insurance company well• Insurance company earned • Assets owned by a plan / trust “spread” – difference between the • Guarantee function provided by a return on general account assets “wrap contract’ provided by a bank and the crediting rate paid out to or insurance company contract holders5 The Future of Low-Risk Options Within Defined Contribution Plans
  • A History of Stable Value Funds (cont.)• 2000s 2008 – Present• Fixed income management evolved • Credit crisis froze credit markets within synthetic GICs and pushed bond spreads to • Use fixed income portfolios instead historically wide levels of single bonds • Widening spreads caused market • Allowed for the use of outside sub- value to book value (MV / BV) ratios advisors to fall into the low 90% range• Synthetic GICs become more • Underwater stable value funds prevalent than traditional GICs or increased likelihood that wrap separate account GICs providers would have to make good• Wrap contract pricing decreased to on their guarantees mid single digit basis points (6-8 • Some wrap insurers elect to get out bps) of the business, putting pressure on stable value managers6 The Future of Low-Risk Options Within Defined Contribution Plans
  • Synthetic GIC Stable Value Structure• Objective: Capital preservation coupled with steady, positive returns• Expected to provide a return premium to money market funds because of the ability to accept greater interest rate and credit risk• Synthetic GIC stable value funds consist of short / intermediate duration, high credit quality bond portfolio• Bond portfolio is “wrapped” with contracts from wrap issuers (banks or insurance companies) that enable participants to transact at book value• Wrap contracts do not protect against credit losses• Investment returns and gains / losses are smoothed using a formula to maintain stable book value• Structured as a separate or pooled account (collective investment trust)• Separate accounts are for large plan sponsors (single plan)• Pooled accounts consist of many (sometimes thousands) of smaller plan sponsors7 The Future of Low-Risk Options Within Defined Contribution Plans
  • Stable Value Funds Today• Wrap capacity is tight• Cost of wrap contracts increased to 20-25 bps• Wrap providers worried about mismatch in duration (12 month put vs. 3 year duration) Stable Value Wrap Issuers Providers• Wrap providers existing business • Rabobank • Bank of America • JP Morgan • AIG (maybe)• Stable value providers exiting business • Bank of America • State Street • Deutsche Bank • Schwab8 The Future of Low-Risk Options Within Defined Contribution Plans
  • Stable Value Funds in the Future• Consolidation of stable value providers • Higher costs / lower capacity will continue to squeeze providers• More expensive wrap insurance will bring new entrants into the market• Low interest rate environment • Improved MV / BV ratios • Stable value funds have only existed during a period of steady, declining interest rates • Increasing rate environment will put pressure on MV / BV ratios • May also cause higher levels of participant transactions as participants try to arbitrage return differentials • Money market funds react more quickly to yield changes (may outperform stable value for a period of time)• Back to the future • Use of more traditional GICs / separate account GICs with synthetic GICs portfolios • Bundling of wrap insurance with investment management • Increased usage of traditional GICs and separate account GICs by plan sponsors9 The Future of Low-Risk Options Within Defined Contribution Plans
  • Replacement Options Option Option Option Option 1 2 3 4 Money Money Money Replacement Market Market Market Stable Value Fund Short Term Short Term Ultra Short Government Bond Term Bond Bond Intermediate Bond Intermediate Intermediate Intermediate Bond Bond Bond10 The Future of Low-Risk Options Within Defined Contribution Plans
  • Investment Product CharacteristicsMoney Market• Targeted stable Net Asset Value (NAV)• Regulated by SEC Rule 2a-7 (Revised in Jan. 2010) • Mandates liquidity minimums • 10% liquid within 1 day • 30% liquid within 1 week • Maximum 5% in illiquid securities • Higher credit quality • Maximum 3% limit on Second Tier securities • Maximum 0.5% limit on single issuer Second Tier securities • Maximum maturity of 45 days for Second Tier securities • Shorter maturity limits • Maximum weighted average life of 120 days • Maximum weighted average maturity of 60 days • Requires periodic stress tests • Enhanced disclosures11 The Future of Low-Risk Options Within Defined Contribution Plans
  • Investment Products Characteristics (cont.)Ultra Short Term Bond“Ultrashort-bond portfolios invest primarilty in investment-grade U.S. fixed-income issues and have durations typically of less than one year. This categorycan include corporate or government ultrashort bond portfolios, but it excludesinternation, covertible, multisector, and high-yield bond portfolios. Because oftheir focus on bonds with very short durations, these portfolios offer minimuminterest-rate sensitivity and therefore low risk and total return potential.” –Morningstar• Category Average Statistics (Morningstar) • Average Effective Duration – 0.41 • Average Effective Maturity – 0.94 • Average Credit Quality - A12 The Future of Low-Risk Options Within Defined Contribution Plans
  • Investment Product Characteristics (cont.)Short Government Bond“Short-government portfolios have at least 90% of their bond holdings in bondsbacked by the U.S. government or by government-linked agencies. Thisbacking minimizes the credit risk of these portfolios, as the U.S. government isunlikely to default on its debt. These portfolios have durations typically between1.0 and 3.5 years, so they have relatively less sensitivity to interest rates, and,thus, low risk potential.” – Morningstar• Category Average Statistics (Morninstar)• Average Effective Duration – 1.88• Average Effective Maturity – 2.55• Average Credit Quality – AA13 The Future of Low-Risk Options Within Defined Contribution Plans
  • Investment Product Characteristics (cont.)Short Bond“Short-term bond portfolios invest primarily in corporate and other investment-grade U.S. fixed-income issues and typically have durations of 1.0 to 3.5 years.These portfolios are attractive to fairly conservative investors, because they areless sensitive to interest rates than portfolios with longer durations.” –Morningstar• Category Average Statistics (Morningstar) • Average Effective Duration – 2.17 • Average Effective Maturity – 2.79 • Average Credit Quality – A14 The Future of Low-Risk Options Within Defined Contribution Plans
  • Historical Performance15 The Future of Low-Risk Options Within Defined Contribution Plans
  • DisclosuresMultnomah Group, Inc. is an Oregon corporation and SEC registered investmentadviser.Investment performance and returns are based on historical information and are nota guarantee of future performance. Investing contains risk. Some asset classesinvolve significantly higher risk because of the nature of the investments and thelow liquidity/high volatility of the securities.Any information and materials contained herein or on our website are provided forgeneral informational purposes only and are not intended to be comprehensive forany particular subject. Multnomah Group utilizes information from third partysources believed to be reliable but not guaranteed, and as a result, information isprovided to you "as is." We do not represent, guarantee, or provide any warranties(either express or implied) regarding the completeness, accuracy, or currency ofinformation or its suitability for any particular purpose. Multnomah Group shall notbe liable to you or any third party resulting from any use or misuse of informationprovided.Receipt of information or materials provided herein or on our website does notcreate an adviser-client relationship between Multnomah Group and you.Multnomah Group does not provide tax or legal advice or opinions. You shouldconsult with your own tax or legal adviser for advice about your specific situation.16 The Future of Low-Risk Options Within Defined Contribution Plans