Stable Value Course

Learning Outcomes

Executive Summary: This section provides an understanding of the operational processes and nuances of stable value funds. Learners will understand the intricate steps involved in calculating the crediting rate and assessing the impact of market value, book value, and duration on the rate calculations. Learners will also explore the challenges of data management and reconciliations between managers and wrap issuers. This section also covers the importance and methodology behind determining the market-to-book ratio, the implications of the duration adjustment formula (DAF), and the contractual elements, such as put provisions, that safeguard stable value funds.

Learners will:

1. Understand the process and stakeholders involved in calculating the crediting rate, including the role of the stable value manager and wrap issuer, as well as the timing and inputs used for these calculations.
2. Identify the operational challenges and nuances in crediting rate calculations, such as delays in receiving clean data, discrepancies in calculations, and the necessity of manual communication to resolve issues.
3. Define the market-to-book ratio and its relevance to stable value funds, along with the process and frequency of its calculation and the challenge it presents when incorporating data from external managers.

Crediting Rate

The crediting rate at which book value grows is a mechanism that amortizes market-driven price fluctuations into a smooth rate of return. Knowing the crediting rate for stable value funds is important for the following reasons.

Investment returns: The crediting rate is a key determinant of the investment return an investor can expect from a stable value fund. It tells them how much interest their investment will earn over a period, which is crucial for retirement planning and for setting financial goals.

Comparing Options: When deciding where to invest, an investor may want to compare the potential returns of various options. Knowing the crediting rate helps them evaluate the attractiveness of stable value funds relative to other fixed-income investments or savings vehicles.

Stability and Predictability: Stable value funds are designed to provide stable and predictable returns. The crediting rate often does not fluctuate as dramatically as market interest rates, which helps investors understand the level of stability to expect in their returns.

Portfolio Diversification: The crediting rate can influence a decision on how much to allocate to a stable value fund within an overall investment portfolio, especially when considering diversification strategies to balance risk and return.

Long-term Planning: For long-term savings, such as retirement accounts, the crediting rate impacts the growth of contributions over time. A compounding crediting rate can significantly affect the final account balance over the course of many years.

Pricing Mechanics: Understanding the crediting rate is also useful for grasping how stable value funds are priced. The rate often incorporates factors like the underlying performance of the bond portfolio, the costs and fees of managing the fund, and any insurance elements like wrappers that guarantee the principal.

Risk Assessment: Stable value funds have low risk compared to many other investments, but they are not risk-free. The crediting rate can reflect the level of safety of the underlying assets and the soundness of the insurance guarantees.

Inflation Comparison: Comparing the crediting rate to inflation rates is crucial to determining whether an investment is growing in real terms (i.e., after adjusting for inflation) or merely preserving capital.

Summary: Knowing the crediting rate of a stable value fund helps an investor understand the potential growth of their investment and make informed decisions about where to place their money to align with their financial objectives and risk tolerance.

Crediting Rate Calculation

Crediting Rate = (1 + Yield) x (Market Value / Book Value)^(1 / (Duration * DAF)) - Fees - 1

• Market Value: The open-market price of the portfolio's securities
• Book Value: The participants' total guaranteed funds at period-start, including principal and interest
• Duration: A measure of bond portfolio sensitivity to changes in interest rates
• DAF (Duration Adjustment Formula): If the market-to-book ratio falls below a certain threshold, the DAF can apply to the rate calculated. This is part of the unique agreement between the wrapper and manager (this adjustment is not commonly utilized).
• Yield: The current average yield on the bond portfolio's securities
• Fees: The investment management and financial wrap charges

To explore crediting rate mechanics interactively, try the Synthetic GIC Training Tool.

Exercise: Using the Crediting Rate Calculation

To provide an example of how to use the crediting rate calculation, let's assume the necessary data as follows.

• Market value (MV) of the portfolio: $100 million
• Book value (BV) at period-start: $98 million
• Duration of the underlying assets: 3 years
• Duration adjustment formula (DAF) is not required
• Yield: 2.5%
• Management and wrap fees (Fees): 0.5%

Step 1: Use the provided crediting rate formula and insert the values:

Crediting Rate = (1 + 0.025) x ($100 million / $98 million)^(1/3) - 0.005 - 1

Step 2: Simplify and solve the equation:

Crediting Rate = (1.025) x (1.02040816327)^(0.3333) - 0.005 - 1
Crediting Rate = 0.0269 or 2.69%

Step 3: Apply. This resulting crediting rate would be applied to the book value for the specified period, and it represents the annualized rate of return that the stable value fund is expected to credit to investors' accounts, after accounting for fees.

Market to Book Ratio

The market-to-book ratio represents the premium or discount at which the portfolio's securities trade relative to the book value amount that is guaranteed to investors.

The relationship between the book value and the market value of the underlying bond portfolio determines whether the crediting rate will be more or less than the yield of the bond portfolio.

Relative to the bond portfolio's yield, a market value "deficit" (market value below book value) decreases the yield credited to participants, and a market value "surplus" (market value above book value) increases the yield. If market value and book value are equal, the net crediting rate will be set equal to the yield of the underlying bond portfolio, less the contract fee.

Keeping all other variables constant, an increase in the market-to-book ratio will improve the crediting rate, while a decrease in the ratio will result in a lower crediting rate. This holds true whether market value is greater than or less than book value.

Exercise: Interest Rate Change Scenario

Step 1: Understand your Bond Portfolio Composition

• A stable value manager holds a three-year duration bond portfolio with a market value (MV) of $100 million and book value (BV) of $98 million. This portfolio consists of fixed-income securities with a total yield of 2.5% annually, which will cause the initial wrap contract crediting rate to be 3.19%, assuming no fees for simplicity.

Step 2: Understand the Market Conditions when interest rates rise and market value falls

• Market interest rates increase due to economic conditions, so the yield of the bond portfolio increases to 3.5%, while the market value (MV) of this bond portfolio decreases to about $97 million. This situation reflects market value below book value, indicating a market value deficit.

Step 3: Adjust the Crediting Rate

• The wrap contract adjusts the crediting rate based on the market value of the bond portfolio. Given the market value of $97 million is less than the book value of $98 million, the net crediting rate should be lower than the yield of the underlying bond portfolio.
• The wrap contract reduces the crediting rate from the bond portfolio yield of 3.5% to 3.15% for participants because of the market value deficit.
• The yield increase and market value decrease caused only a small impact on the crediting rate provided to investors, from 3.19% initially to 3.15% now.

Step 4: Understand the market conditions for the next period when interest rates fall and market value rises

• Now suppose market conditions stabilize and interest rates begin to fall, so the yield of the bond portfolio decreases to 3.0%, while causing the market value of the bond portfolio to increase to $98.5 million (market value above book value).

Step 5: Adjust the Crediting Rate Again

• The wrap contract increases the crediting rate from the bond portfolio yield of 3.0% to 3.17% for participants because of the market value increase.
• The yield decrease and market value increase caused only a small impact on the crediting rate, from 3.15% the previous period to 3.17% now.

Summary: The contract crediting rate adjusts for changes in yield and market-to-book ratio, with the crediting rate higher or lower than the bond portfolio yield based on the market-to-book ratio. However, these modeled yield and market value changes cause only a gradual change in the crediting rates provided to investors from period to period.

Annualized Yield to Maturity (YTM)

The yield of the underlying bond portfolio is the portfolio's expected rate of return at a point in time, assuming bonds are held to maturity and cash flows are reinvested at the same rate. This is the expected earnings potential of the assets wrapped by the investment contract. Holding all other variables constant, an increase in the yield of the underlying portfolio will increase the crediting rate. Conversely, a lower yield will decrease the crediting rate.

For example, a bond purchased for $950 with a face value of $1,000 (which will be paid to the investor at maturity in 5 years), with a 5% coupon rate (or $50 paid annually), has an annualized yield to maturity that can be calculated as follows:

Yield to Maturity Calculation

YTM = [Coupon Interest + (Face Value - Purchase Price) / Years to Maturity] / [(Face Value + Purchase Price) / 2]

Exercise: Using the Yield to Maturity Calculation

To provide an example of how to use the yield to maturity calculation, let's assume the necessary data as follows.

YTM = [$50 + ($1,000 - $950) / 5] / [($1,000 + $950) / 2]
YTM = ($50 + $10) / $975
YTM = $60 / $975
YTM = 0.06154 or 6.154%

This means the investor would earn an annualized return of 6.154% on this bond investment if they held it until maturity, assuming all payments are made as scheduled.

Duration

Duration is a measure of interest rate risk, but in the crediting rate formula, the duration variable determines how quickly the difference between market value and book value will be amortized. The shorter the duration of the underlying bond portfolio, the more quickly the difference will be amortized. Stable value funds typically have durations of approximately three years.

For example, assuming a stable value fund has an underlying bond portfolio with a duration of three years, and there is a market value to book value discrepancy due to interest rate changes. If interest rates rise, causing the market value of the bond portfolio to decrease relative to the book value, the fund's duration dictates how quickly this discrepancy affects the crediting rate provided to investors. A shorter duration would require the fund to adjust its crediting rate downward more quickly to account for the reduced market value, while a longer duration would allow for a more gradual adjustment.

Effects of Duration for Stable Value:

Duration is used to determine the number of years to amortize the market-to-book ratio. If the market value is less than the book value, a shorter duration will drive down the crediting rate because the difference between market value and book value needs to be amortized more quickly. A longer duration will increase the crediting rate because the fund has more time to amortize the difference between market value and book value. If the market value is greater than the book value, a shorter duration will increase the crediting rate and a longer duration will decrease the crediting rate.

Cash Flows

Cash flows can also materially impact the crediting rate. Cash flow may come from participants' contributions to or withdrawals from the stable value fund, and participant fund transfers into/out of the stable value fund, or from employer matching or profit sharing-type contributions. The cash flows are accounted for at 100% market-to-book to maintain the participant's book value.

Therefore, cash deposits to an investment contract whose market value is less than its book value, improve the market-to-book ratio. Withdrawals that must be made from an investment contract whose market-to-book ratio is below 100%, lower the ratio. The opposite of each is true when a contract's market value exceeds its book value.

The interest rate environment in which cash flows occur can also affect the crediting rate. If current reinvestment rates are lower than the current portfolio yield, substantial cash inflows will negatively impact the yield, and thus the crediting rate. However, if reinvestment rates are higher than the portfolio yield, cash inflows will improve the yield and crediting rate more quickly than if the portfolio relied upon the reinvestment of its internal cash flows alone. A stable value manager can usually control the duration impact of any significant cash flows. Therefore, cash flows typically affect the crediting rate through the market-to-book ratio and the portfolio yield as described earlier.

Cashflow	Market-to-Book Ratio	Immediate Typical Impact on Crediting Rate
Positive	Market-to-book > 100	Negative
Positive	Market-to-book < 100	Positive
Negative	Market-to-book > 100	Positive
Negative	Market-to-book < 100	Negative

Individual Participants Daily Yield

In stable value funds that invest primarily in security backed investment contracts, the overall blended yield of a stable value fund—the daily yield earned by participants—is primarily determined by the crediting rate mechanism. Participants in a stable value fund earn the average credited rates of interest on all the stable value contracts held in the fund. The daily yield is a weighted average based on the investment value of the individual investments; it also reflects the interest earned on cash held for liquidity purposes as well as the crediting rates of any other insurance products owned in the fund, such as traditional GICs. Management and administrative fees reduce the yield. Like the crediting rate of a security backed investment contract, the yield on a stable value fund generally follows the direction of interest rates with a time lag.

Stable Value Product Creation

GIC: In a traditional GIC, an insurance company guarantees the principal of the stable value fund with its general account assets. The general account assets are subject to insurance regulatory oversight and the GIC contract counts toward their risk-based capital ratios as a liability.

Separate Account GIC: In a separate account GIC, an insurance company guarantees the principal of the stable value fund using a portfolio of assets that are segregated from the insurance company's general accounts. This is referred to as a "separate" account.

Synthetic GIC or book value wrap contract: In a synthetic GIC or book value wrap contract, the stable value fund manager, which could be an insurance company, asset manager, or financial institution, enters into investment contracts with other financial institutions. These are typically insurance companies or banks. These contracts insure, or wrap, a fixed-income portfolio of securities.

• Pooled Fund or Collective Fund: In a pooled fund, the plans are not of sufficient size to warrant their own stable value fund. In this instance, the stable value fund manager pools funds from numerous unrelated plans into a single collective fund.
• Individual Fund: In an individual fund, the plan has a sufficient investment portfolio size (for instance, greater than $50 million depending on the stable value manager) to create a stable value fund that is specifically for its organization.

Calculating the Crediting Rate

Stakeholders: The stable value manager runs the calculations. The wrap issuer runs and confirms the calculations, then approves. Participants receive the confirmed rate. The rate is then reported to third parties like the fund administrator or the recordkeeper.

Process:

• Rates are typically reset quarterly. If 1/1/24 is the 'Effective date', that is when the new rate is applied.
• Use crediting rate calculation inputs (market value, book value, duration, yield, fees) from the reference date 11/30/23 (prior month-end).
• If the fund uses an external manager, all involved need to collect and apply their data into the calculation.
• Both the manager and wrap issuer independently calculate the rate and need to agree on the new rate. This is the approval step.
• Typically, new rates are calculated and approved 6-12 business days after the reference date as it takes time to clean data, aggregate, and agree. The new rate is applied on the Effective date. In our example, as of 1/1/24 the investors will receive the new crediting rate.
• Both the manager and the wrap issuer need to maintain an audit trail of approved rates. This should include who approved, the date, and any comments if there are discrepancies.

Nuances / challenges:

• Delays in clean data may delay the approval step and all subsequent steps. This often is caused by a delay in the response from external managers.
• Differences in rate calculated between wrap issuer and manager may be caused by data discrepancies and different formula applied.
• A lot of manual communication is necessary to resolve discrepancies. This communication is usually by email. If there are hundreds of contracts, there could be lots of back and forth between the manager and the wrap issuer potentially causing a delay in final approval.
• DAF (duration adjustment formula): If the market value or book value drop below certain thresholds an adjustment to the crediting rate calculation is applied. Though, sometimes, the manager and wrap issuers agree to not apply the DAF, even if market-to-book drops within DAF parameters. The DAF is not a standard term and has rarely been applied.

Agreeing on the Crediting Rate

Stakeholders: This process occurs between the stable value manager and the wrap issuer. This agreed upon rate applies to each contract, and then to plan participants investing in the stable value fund.

Process: Refer to the Calculating the Crediting Rate section for details on this process. The steps are the same. Once the crediting rate has been calculated, the wrap issuer reviews, and approves the rate if it matches their internal calculation. If it does not match or is outside of threshold, the wrap issuer and manager work to address the differences. This process is often conducted via email or by phone. Once agreed upon, the wrap issuer approves the rate, and the rate is applied to calculate the contract book value on a daily basis. The crediting rate is usually reset quarterly but can happen less or more frequently.

Nuances / Challenges: Refer to the Calculating Crediting Rate section for details on nuances. As this process follows the same steps, the challenges and nuances are the same. In addition, the goal is a platform that is transparent so managers and wrap issuers can easily identify the root causes of the differences. Ideally, managers and wrap issuers utilize the same data to run the calculations. This could eliminate differences in data and increase efficiency.

Determining the Market to Book Ratio

Stakeholders: This process occurs between the stable value manager and the wrap issuer. The plan participants are then informed of any changes.

Process: This is a simple custom calculation:

Market Value of Stable Value Fund / Book Value of Stable Value Fund

This is done at the account/aggregate level, NOT individual fixed-income securities. This process is usually necessarily performed monthly. Some managers do perform this process intra-month. Market-to-book is a standard, key reporting metric for stable value funds.

Nuances / Challenges:

External managers/subadvisors – In most scenarios, the fund manager needs to intake outside managers' market value information via overrides, as they typically clean up their IBOR (Investment Book of Record) at month end (~5 days after ME). Custody feeds are not considered accurate enough.

In situations where the market-to-book ratio falls below a certain threshold, a DAF (duration adjustment formula) may be applied to the crediting rate calculation. This DAF is utilized to accelerate the speed at which the market-to-book ratio gets closer to 100%.

Because wrap issuers pay out at book value, they want to ensure that the market-to-book ratio is close to or above 100 – given the rate hikes starting in 2022, some stable value market-to-book ratios are currently below 100. In the highly unlikely scenario that market value is below book value and all participants request benefit payments simultaneously, the underlying bonds would be sold for cash to cover the benefit payments. If all the bonds are sold and additional benefit payments are required, the insurance company or bank contract issuer would then make a payment into the fund to cover the remaining benefit payments. This scenario has never occurred and there are contractual steps and negotiations that would take place to avoid this type of meltdown situation.

Contract Trading

Executing Put Provisions

A put provision in stable value protects the collective fund manager and wrap issuers from sudden outflows. One example would be a twelve-month put provision. If a plan sponsor wants to leave a stable value collective fund, they cannot withdraw all funds immediately. There would be a twelve-month notice period before they can withdraw the funds. In certain situations, when market value is above book value and with wrap issuer permission, the manager may pay out the plan(s) in the put queue prior to completion of the required put period. Certain managers, however, have internal rules which require that all plans remain in the put queue and exit the pool in orderly fashion despite market conditions and market-to-book gains.

In addition, a put provision may refer to language that many investment managers of stable value commingled funds request in their stable value investment contracts, allowing them to remove invested assets at book value for purposes of funding plan-initiated withdrawals within the put period.

Data Requirements

This is the information that should be collected to enter the stable value fund information in the fund accounting system.

Crediting Rate Calculation Requirements:

• Market Value is needed to accurately determine the value of the bond fund's assets and ensure stability in the fund's performance.
• Book Value helps determine the value of the fund's contracts and assets.
• Duration helps assess the sensitivity of the bond fund's assets to changes in interest rates. It helps determine the fund's stability and ability to generate consistent returns.
• Duration Adjustment Formula is used to change the duration of a bond portfolio during the crediting rate calculation based on certain factors. It is commonly used with stable value funds to account for changes in interest rates and other market conditions. The specific formula may vary depending on the methodology used. This adjustment helps investors and fund managers monitor and manage the interest rate risk associated with stable value funds.
• Annualized Yield helps measure the performance of these funds over time and provides investors with an indication of the return they can expect.
• Management Fees impact the overall market value and performance of the fund.

Duration: Effective Duration or Modified Duration

Effective duration, or modified duration, is a measure used in stable value to estimate the potential price sensitivity of the stable value investment to changes in interest rates. It helps assess the impact of interest rate fluctuations on the market value of the stable value investment.

In stable value, the effective duration takes into account the specific features and characteristics of the investment, such as the types of fixed-income securities in the portfolio and any options or derivatives employed.

When interest rates change, the value of fixed-income securities in the stable value fund can fluctuate. The effective duration provides an estimate of how much the stable value investment's price is expected to change for a given change in interest rates.

For example, let's say a stable value fund has an effective duration of three years. If interest rates increase by 1%, the stable value investment's price is estimated to decline by approximately 3%. Conversely, if interest rates decrease by 1%, the stable value investment's price is estimated to increase by approximately 3%.

Effective duration helps stable value managers and investors understand the potential risk and price impact of interest rate changes on the stable value investment. It assists in making informed investment decisions, managing risk, and maintaining the stability of the stable value fund's value over time.

Yield to Maturity, Yield to Worst, Current Yield

Yield to maturity (YTM), yield to worst (YTW), and current yield are all measures used in stable value to assess the potential returns or income generated by the investment. Here's a breakdown of how each works:

• Yield to Maturity (YTM): YTM is a measure of the total return expected from a fixed-income security, assuming the investor holds it until maturity. It takes into account the bond's price, coupon payments, and time remaining until maturity. YTM reflects the annualized rate of return the investor would earn if all cash flows (coupon payments and the final principal repayment) are received as scheduled. In stable value, YTM can be used to estimate the potential return of the portfolio of fixed-income securities backing the stable value investment.
• Yield to Worst (YTW): YTW is a measure of the lowest potential yield that an investor could receive from a bond or investment under certain circumstances. It considers the worst-case scenario in terms of the bond's potential redemption or call features. For stable value, YTW is used to assess the minimum potential yield that the stable value investment may generate. This is particularly relevant if there are callable bonds in the portfolio, as the issuer may choose to redeem the bonds early, leading to a lower yield for investors.
• Current Yield: Current yield represents the annual income or interest generated by an investment relative to its current market price. It is calculated by dividing the annual interest or income (coupon payments) by the current market price of the investment. In the context of stable value, current yield can be used to assess the income or return generated by the stable value fund's portfolio of fixed-income securities relative to its current value.

These measures help investors and managers evaluate the potential returns and income generated by stable value investments. They consider factors such as coupon payments, potential redemption scenarios, and market prices to provide insights into the expected performance of the investment.

Exit Provisions in Stable Value Contracts

Exit provisions allow stable value contracts to offer the advantages of intermediate-duration bond portfolios while maintaining the liquidity and stability of capital preservation investments.

These contracts provide daily liquidity for participant withdrawals, but the underlying assets are generally invested in fixed-income securities with average durations of three to four years for individually managed funds, pooled funds, and insurance company separate account products, and five to seven years for general account products.

When interest rates rise or spreads widen, the value of fixed-income securities may decline, potentially causing the market value of the stable value product's assets to fall below the book value. In such cases, the contract issuer is prepared to cover the difference for eligible withdrawals. To be clear, any payment of such a market-to-book deficit by the issuer would only occur once the underlying portfolio has been completely liquidated.

Issuers require exit provisions to mitigate risks from large, unpredictable withdrawals. Without these provisions, they might impose stricter limits on the underlying assets, resulting in lower returns for participants or be unwilling to issue the contracts at all. Exit provisions enable issuers to manage withdrawal risks while still providing the unique benefits of principal protection and attractive returns associated with stable value products.

Stable Value Product Type	Average Duration	Exit Provisions
Individually Managed Funds	3.3	Generally, immediate termination at market value (by request of the owner only) following required contractual notification, or must be managed to wind down the account if terminating at book value. Issuer or owner may request the contract be terminated via extended termination (or immunization) process where wind down periods may initially be set equal to the duration of the underlying assets but may extend until the market-to-book ratio equals 100% (par), subject to limitations (e.g., up to 10 years).
Pooled Funds (CITs)	3.0	Generally, will provide for termination at book value with 12-month notice (i.e., "twelve-month put"); for some products, notice periods can be longer and termination provisions may be subject to the discretion of the trustee. Termination prior to the expiration of the twelve-month put may be subject to a market value adjustment when market value is less than book value.
Insurance Separate Accounts	4.0	Varies from 3 to 10 years; may also require structured payout over multiple years.
Insurance General Accounts	3-5	Varies from 3 months to 10 years; may also require structured payout over multiple years. Traditional GICs (a type of general account product) have contractually set maturity dates but exit provisions (e.g., market value adjustments) may apply should the plan sponsor wish to terminate the contract early.

Source: SVIA

Plan sponsors accept specific restrictions on their ability to terminate the product or initiate events (known as market value events) that could trigger large withdrawals. Even in the event of a market value event such as a mass layoff, any benefit payments must be initiated at the participant level and not by the plan sponsor. These restrictions are in place to ensure participants enjoy the unique benefits of stable value products, such as principal protection, appealing expected returns, and daily liquidity. Therefore, it is crucial for plan sponsors and their advisors to thoroughly understand the exit provisions of a stable value product and any limitations on withdrawals initiated by the plan sponsor before making an investment.

Competing Funds

Stable value contract issuers require the plan sponsors to not include a competing fund (another principal preservation fund such as a money market fund) or if they include it, to administer a 90-day equity wash for requested transfers from the stable value fund to the competing fund.