(November 29, 2011) — Plan sponsors are subject to new risks within stable-value strategies, consulting giant Towers Watson says. 

“While stable value investment strategies have performed relatively well during the past few years compared to money market strategies, we believe the changed environment means investors should revisit these with a view to understanding all the risks now associated with this investment strategy,” said Peter Schmit, research manager in Towers Watson’s investment business and co-author of the paper. “Regardless of upcoming regulatory decisions, we believe there has been a structural shift in competitive advantage away from plan sponsors and stable-value managers over to insurance providers and the investment strategy now faces distinct market risks and regulatory headwinds.”

In a statement, Schmit added: “We have been discussing stable value with our clients for a number of years, specifically with an emphasis on the education and oversight of the complex structured product…As a plan sponsor fiduciary, it is important to understand the wrap issuer market and the developments within the wrap market, as well as the risks associated with stable value. Ultimately, those who are armed with the best information will make the wiser investment choices as they relate to this issue.”

The whitepaper — titled “Assessing Stable-Value Strategies: What Plan Sponsors Should Consider” — noted that Dodd-Frank is a wide-ranging law that could impact stable-value because it will define whether or not stable-value wrap contracts should be included within the definition of a swap security. “This is a concern throughout the stable-value market since Dodd-Frank could be very harmful to the future of the stable-value industry. Reform could include capital and margin requirements for banks’ swap transactions as well as new clearing and reporting requirements,” the report explained. “If stable- value contracts were to fall under this definition, the additional requirements may deter certain wrap providers from issuing new wrap capacity, which would put even greater pressure on a market that is trying to cope with an already-limited supply of insurance wrap capacity.” 

The consulting firm warned plan sponsors that they should be aware of the type of events that may cause a violation of the wrap agreement. Such risks include counterparty, term, credit and liquidity (at the plan level) and are exaggerated by:

1) Complexity

2) Lack of standardization

3) Less-than-ideal transparency

4) Changing markets prompted by uncertainty over Dodd-Frank, swap legislation, diminishing capacity and evolution of the wrap market 

5) The reality of higher wrap fees and lower yields

Last year, sources told aiCIO that the San Diego Country Employees Retirement Association (SDCERA) was leveraging its fixed-income portfolio to create ‘risk parity’, continuing a trend among pension funds. At the time, the SDCERA board planned on increasing its stable value portfolio to 35% from 21%, cutting the value of its growth-oriented portfolio to 40% from 55%. While its stable value portfolio included US Treasuries and emerging fixed-income, its growth-oriented portfolio consisted of global and emerging market equities and high-yield bonds. Lee Partridge, the pension’s outsourced CIO at Integrity Capital, recommended the changes.

Read Towers Watson’s whitepaper on the future of stable-value strategies here.