Stable Value Crediting Rates - Galliard

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STABLE VALUE ANALYST INSIGHTSSTABLE VALUE CREDITING RATESHow They Work, How They are CalculatedCREDITING RATES are a key component of stable value investing. We address how aLeela Scattum, Partnerstable value crediting rate works and the role that the crediting rate plays in determining theoverall blended yield of a stable value fund. Our focus is on the crediting rate for syntheticGICs (also known as security backed investment contracts), although much of what wecover also applies to participating separate account GICs as well. The discussion is lessrelevant to traditional GICs and non-participating separate account GICs, since these aretypically fxed or foating rate fxed maturity contracts and are not addressed.Client Portfolio ManagementHead of Stable Value ContractStrategy and IssuerPlacementW ha t i s a Cr e d i t i n g R a t e ? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2Ho w i s a Cr e d i t i n g R a t e C a l c u l a t e d ? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2The I m pa c t of C o m p o n e n t Va r i a b l e s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4The I m pa c t of C a sh F l o w s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6Fr o m a Cr e di t i n g R a t e t o t h e P a r t i c i p a n t ’s D a i l y Yi e l d . . . . . . . . . . . . . . . . . . . . . . . . . . 8Nick Gage, CFA, Senior DirectorClient Portfolio ManagementHead of Stable Value SeparateAccount StrategyThe Cr e di t i ng R a t e M e c h a n i sm :A Ke y Co m po n e n t f o r M a i n t a i n i n g S t a b l e Yi e l d s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10GALLIARD CAPITAL MANAGEMENT is a wholly owned, independently operated investment managementsubsidiary of Wells Fargo Bank, N.A. Founded in 1995, Galliard specializes in architecting fxed income and stablevalue investment solutions for institutions nationwide. A deeply rooted client-centric culture and an in-depth levelof expertise in every critical area of the investment solution are the key differentiating characteristics of the frm.Galliard manages more than 84.8 billion in assets for more than 240 institutional clients nationwide. r'GALLIARD\.,.;;,Capital Manag ement , Inc.ARCHITECTS OF INVESTMENT SOLUT I ONS800 LaSalle Avenue, Suite 1100Minneapolis, MN 55402-2054www.galliard.com 800-717-1617FOR INSTITUTIONAL INVESTOR USE ONLY.

The Stable Value Crediting RateINTRODUCTIONStable value funds are typically considered to be a “safe” investment option in manydefned contribution plans. They are designed to preserve principal and generate steadyrates of return, while allowing participants to make withdrawals at contract value(principal plus accrued income), regardless of market conditions.Over the long run, stable value funds have delivered returns that are similar to the returnsof intermediate-term bonds; yet the volatility of those returns has been equal to or less thanthat of money market funds. This favorable risk/return profle is one of the main reasonsthat stable value is such a popular choice among plan participants.A crediting rate is theaccrued income)Stable value funds typically have durations of about three years, which helps explain theirbond-like returns. But how do they maintain such low volatility? The answer lies withthe mechanics of contract value accounting provided through contracts issued by highquality fnancial institutions. Stable value funds are able to report smooth returns becauseinvestment contracts are beneft responsive and insulate participants from movements inbond prices and changes in market interest rates. This smoothing effect is achieved throughthe crediting rate. Financial institutions that issue investment contracts calculate the initialcrediting rate and then reset it periodically, typically on a quarterly basis.expressed as anWHAT IS A CREDITING RATE?interest rate earnedon the contractvalue (principal pluseffective annual yield.A crediting rate is the interest rate earned on the contract value (principal plus accruedincome) expressed as an effective annual yield. The crediting rate also acts as a stabilizingmechanism by amortizing investment gains and losses so that participants are protectedfrom short-term changes in market value. Principal preservation is furnished by acontractual minimum crediting rate of 0% and contractual provisions that require thecontract issuer to make payments at contract value in the event that the supporting fxedincome investments are depleted.HOW IS A CREDITING RATE CALCULATED?It is the underlying bond portfolio’s performance that ultimately determines the creditingrate of a participating separate account GIC and a security backed investment contract.Thus, the crediting rate formula is a function of the contract value of the investmentcontract, the market value of the underlying bond portfolio, and the yield and durationof the underlying bond portfolio. The crediting rate is designed to converge the differencein the investment contract’s value and the market value of its underlying collateral byamortizing those differences over time. This convergence is represented as a market valueto contract value ratio (MV/CV). It is set at a rate that is equivalent to the portfolio yield,2GALLIARDCapital Management

The Stable Value Crediting Rateadjusted for the difference between market value and contract value (positive or negative)over the amortization period less the fees that fnancial institutions charge for the contract.In the current environment, fees typically range from 0.15% to 0.25% of the investmentcontract’s value. The amortization period is typically defned by the duration of the bondportfolio.Compounding Crediting Rate Formula:The most commonly used crediting rate formula in the stable value industry isas follows:Gross crediting rate (MV/CV) (1/D)*(1 AYTM)-1; whereMV market valueCV contract valueD durationAYTM annualized yield to maturity (1 YTM) 2-12How the Crediting Rate Formula is Derived:The contract value (CV) when compounded at the crediting rate (CR) for theduration of the portfolio (D) equals the market value of the portfolio (MV) whencompounded at the portfolio’s annualized yield to maturity (AYTM) for the sameduration of the portfolio (D). This assumes there are no changes in market ratesor portfolio yield.CV*(1 CR) D MV*(1 AYTM) D[CV*(1 CR) D] (1/D) [MV*(1 AYTM) D] (1/D)CV (1/D)*(1 CR) MV (1/D)*(1 AYTM)1 CR (MV/CV) (1/D)*(1 AYTM)CR (MV/CV) (1/D)*(1 AYTM)-1In short, the contract value must accrue the crediting rate for “D” years toconverge to market value, assuming the market value portfolio continues to earnthe annualized yield to maturity for the same period.GALLIARDCapital Management3

The Stable Value Crediting RateTHE IMPACT OF COMPONENT VARIABLESThe crediting rate formula is somewhat complex and, as noted earlier, is primarily affectedby these component variables: the market value to contract value ratio, the yield of theunderlying bond portfolio, and the duration of the underlying bond portfolio. While it isnot necessary to master the crediting rate formula, it is important to understand how eachof these variables impact the crediting rate.Successfully managingthe crediting ratecomponent variablesis key to assuring thata stable value fundmakes good on itsname by providingMarket Value to Contract Value RatioThe relationship between the contract value and the market value of the underlying bondportfolio determines whether the crediting rate will be more or less than the yield of thebond portfolio. Relative to the bond portfolio’s yield, a market value “defcit” (MV CV)decreases the yield credited to participants, and a market value “surplus” (MV CV)increases the yield (see Figure 1). If market value and contract value are equal, the netcrediting rate will be set equal to the yield of the underlying bond portfolio, less thecontract fee.Keeping all other variables constant, an increase in the MV/CV ratio will improve thecrediting rate, while a decrease in the ratio will result in a lower crediting rate. This holdstrue whether market value is greater than or less than contract value.a consistent rate ofreturn.Annualized Yield to MaturityThe yield of the underlying bond portfolio is the portfolio’s expected rate of return at apoint in time, assuming bonds are held to maturity and cash fows are reinvested at thesame rate. This is the expected earnings potential of the assets wrapped by the securitybacked investment contract.Holding all other variables constant, an increase in the yield of the underlying portfolio willincrease the crediting rate. Conversely, a lower yield will decrease the crediting rate.DurationDuration is a measure of interest rate risk, but in the crediting rate formula, the durationvariable determines how quickly the difference between market value and contract valuewill be amortized. The shorter the duration of the underlying bond portfolio, the morequickly the difference will be amortized. As previously mentioned, stable value fundstypically have durations of approximately three years.4GALLIARDCapital Management

The Stable Value Crediting RateFIGURE 1 THE IMPACT OF THE MARKET VALUE TO CONTRACTVALUE RATIO ON THE CREDITING RATEIf Market Value is LESS than Contract Value.If Market Value is GREATER than Contract Value.Market Value 48,000,000Market Value 51,500,000Contract Value 50,000,000Contract Value 50,000,000MV/CV Ratio96.0%MV/CV Ratio103.0%Duration3.00 YrsDuration3.00 YrsYield to Maturity3.30%Yield to Maturity3.30%Annualized Yield to Maturity3.33%Annualized Yield to Maturity3.33%Gross Crediting Rate1.93%Gross Crediting Rate4.35%.the contract value crediting rate will be less than thebond portfolio’s yield, to allow the market value “deficit” tobe made up over time. 54,000,000 57,000,000 53,000,000 52,952,386 52,000,000 54,986,054 55,000,000 54,444,960MV 51,247,274 50,965,370 56,813,498 56,000,000 51,949,379 51,000,000 50,000,000.the contract value crediting rate will be greater than thebond portfolio’s yield, to allow the market value “surplus”to be recognized in the contract value over time.CV 50,000,000 54,000,000 53,213,521 53,000,000 49,597,068 52,175,167 52,000,000 49,000,000MVCV 51,500,000 48,000,000 51,000,000 48,000,000 50,000,000 47,000,000CurrentYear 1Year 2Contract Value Growth 50M(1 1.93%)3 50,000,000CurrentYear 1Year 2Year 3Contract Value Growth 52,952,386*Market Value Growth 48M(1 3.33%)3Year 3 50M(1 4.35%)3 56,813,498*Market Value Growth 52,952,386* 0 51.5M(1 3.33%)3 56,813,498* 0As shown in the above example, the crediting rate converges the differences in the investmentcontract’s value and the market value of its underlying collateral by amortizing those differences overthe duration of the portfolio.*using extended decimal places for AYTM and crediting rateGALLIARDCapital Management5

The Stable Value Crediting RateSince duration sets the amortization period, its impact is slightly more complicated thanthat of the other component variables. When market value is less than contract value, aloss is being amortized, and a longer duration amortizes the loss over a longer period oftime (assuming all other variables are held constant). An increase in duration thereforeresults in a higher crediting rate. When market value exceeds contract value and a gain isbeing amortized, a longer duration amortizes the gain over a longer period, decreasing thecrediting rate. The opposite is true when duration is shortened, as shown in Figure 2.FIGURE 2 IMPACT OF DURATION ON THE CREDITING RATESome contract issuersnow require a shorterChange in Portfolio DurationImpact on Crediting RateMV CVMV CVamortization periodLonger DurationIncreasesthe Crediting RateDecreasesthe Crediting Rateas a consequence ofShorter DurationDecreasesthe Crediting RateIncreasesthe Crediting Ratethe financial crisisand deterioration inthe market values ofsome underlying bondportfolios.Some contract issuers now require a shorter amortization period as a consequence of thefnancial crisis and deterioration in the market values of some underlying bond portfolios.Certain contract issuers require crediting rates to be reset based on a percentage ofportfolio duration (from 50%-99%) if the MV/CV ratio falls below a certain threshold.By shortening the amortization period for the loss, these contract issuers are requiring anadjustment to the crediting rate to more quickly narrow the gap between market value andcontract value.A Word About ManagementExamining these “all else equal” scenarios in Figure 1 helps illustrate the impact of changesin each of the crediting rate formulas’ component variables. Yet in reality, stable valuefunds face a dynamic and constantly shifting market environment. Because each variablecan have a dramatic effect on the crediting rate, it is important for a stable value managerto actively seek to limit the volatility of these factors in the underlying bond portfolio.Successfully managing the crediting rate inputs is key to assuring that a stable value fundmakes good on its name by providing a consistent rate of return.THE IMPACT OF CASH FLOWSCash fows can also materially impact the crediting rate. Cash deposits to an investmentcontract whose market value is less than its contract value improve the MV/CV ratio.6GALLIARDCapital Management

The Stable Value Crediting RateWithdrawals that must be made from an investment contract whose MV/CV ratio is below100% lowers the ratio. The opposite of each is true when a contract’s market value exceedsits contract value (see Figure 4).The interest rate environment in which cash fows occur can also affect the crediting rate(see Figure 3). If current reinvestment rates are lower than the current portfolio yield,substantial cash infows will negatively impact the yield, and thus the crediting rate.However, if reinvestment rates are higher than the portfolio yield cash infows will improvethe yield and crediting rate more quickly than if the portfolio relied upon the reinvestmentof its internal cash fows alone.Persistently lowFIGURE 3The Crediting Rate in a Falling Interest Rate EnvironmentIf reinvestment rates are lower when cash flows are reinvested,the crediting rate will decrease (with a lag).interest rates haveresulted in lower fixedincome yields withinInterest Rates (%)1.60%underlying bond1.40%1.20%1.00%Stable value creditingrates will decreasewith a lag0.80%0.60%0.40%Falling reinvestmentrates0.20%0.00%Year 1Year 2Year 3Year 4portfolios, puttingdownward pressure onstable value creditingrates.The Crediting Rate in a Rising Interest Rate EnvironmentIf reinvestment rates are higher when cash flows are reinvested,the crediting rate will increase (with a lag).3.00%Rising reinvestmentratesStable value creditingrates will increasewith a lagInterest Rates (%)2.50%2.00%1.50%1.00%0.50%0.00%Year 1Year 2Year 3Year 4GALLIARDCapital Management7

The Stable Value Crediting RateFIGURE 4 IMPACT OF CASHFLOWS ON THE CREDITING RATECashflowMarket to Contract Value RatioImmediate Typical Impact onCrediting RatePositiveMV/CV 100NegativePositiveMV/CV 100PositiveNegativeMV/CV 100PositiveNegativeMV/CV 100NegativeA stable value manager can usually control the duration impact of any signifcant cashfows. Therefore, cash fows typically affect the crediting rate through the MV/CV ratio andthe portfolio yield as described earlier.FROM THE CREDITING RATE TO THE PARTICIPANT’S DAILY YIELDIn stable value funds that invest primarily in security backed investment contracts, theoverall blended yield of a stable value fund—the daily yield earned by participants—isprimarily determined by the crediting rate mechanism. Participants in a stable value fundearn the average credited rates of interest on all of the stable value contracts held in thefund. The daily yield is a weighted average based on the investment value of the individualinvestments; it also refects the interest earned on cash held for liquidity purposes as well asthe crediting rates of any other insurance products owned in the fund, such as traditionalGICs. Management and administrative fees reduce the yield (see Figure 5). Like thecrediting rate of a security backed investment contract, the yield on a stable value fundgenerally follows the direction of interest rates with a lag.8GALLIARDCapital Management

The Stable Value Crediting RateFIGURE 5The Components of Daily YieldWeighted-AverageCrediting Rateof Individual(security backedinvestmentcontracts) Yield on CashEquivalents(and otherinsuranceproducts i.e.,traditionalGICS)–Management andAdministrative Fees Stable Value FundNet Daily Yield toParticipantsCalculating the Daily YieldWeighted AverageCrediting Rate*% of CreditingPortfolio RateContract 1 20%2%Contract 2 30%4%Contract 3 40%3% Yield on CashEquivalents(and other insuranceproducts i.e.,traditional GICS)% ofPortfolioCash/ 10%OtherYield.40%–Management andAdministrative Fees.50% Stable Value FundNet Daily Yield toParticipants2.34%* Assumes use of three security backed investment contractsThe Math Behind the Daily Yield Calculation20% x 2% 30% x 4% 40% x 3% 10% x .40% 2.84% Portfolio Gross– Yield0.50% Less Fees 2.34% Stable Value Fund Net Daily Yieldto ParticipantsExample: Applying the Daily Yield to a Participant’s AccountParticipant balance beginning of day 1 10,000.00Participant balance end of day 1 10,000 x (1 2.34%) (1/365) 10,000.63Assuming no change in crediting rate for 1 year,Balance at the end of year 1 10,234.00GALLIARDCapital Management9

The Stable Value Crediting RateTHE CREDITING RATE MECHANISM: A KEY COMPONENT FOR MAINTAININGSTABLE YIELDSInvestment contracts and the use of a crediting rate are critical components for maintainingconsistent, competitive yields in a stable value investment option. These contracts enablean investment manager to invest in a portfolio of short-to-intermediate term fxed incomesecurities, while insulating plan participants from volatility in the value of their investment.This ability to dampen volatility is a distinct feature of the stable value asset class, andallows stable value funds to provide plan participants protection against loss of principaland attractive risk-adjusted returns that have historically outpaced infation.10GALLIARDCapital Management

The Stable Value Crediting RateFOR MORE INFORMATIONCONTACT:For other Stable Value AnalystInsights publications, pleasecontact your Galliard relationshipmanager or email Galliard at thefollowing address:Galliard Client ServiceGalliardclientservice@Galliard.comYou can also visit the Galliardwebsite at www.Galliard.comGALLIARDCapital Management11

The Stable Value Crediting Rate-r,,.::,Galliard Capital Management, Inc.800 LaSalle Avenue, Suite 1100Minneapolis, MN 55402www.Galliard.com (800) 717-1617The information contained herein refects the views of Galliard Capital Management, Inc. and sources believed to be reliable byGalliard as of the date of publication. No representation or warranty is made concerning the accuracy of any data and there is noguarantee that any projection, opinion, or forecast herein will be realized. The views expressed may change at any time subsequentto the date of publication. This publication is for information purposes only; it is not investment advice nor a recommendation fora particular security strategy or investment product. Graphs and tables are for illustrative purposes only. Galliard’s advisory feesare disclosed in the frm’s ADV Part II, which is available upon request. Past performance is no guarantee of future results. FORINSTITUTIONAL INVESTORS ONLY. 2015 Galliard Capital Management, Inc.12GALLIARDCapital Management

contract’s value. The amortization period is typically defned by the duration of the bond portfolio. Compounding Crediting Rate Formula: The most commonly used crediting rate formula in the stable value industry is as follows: Gross crediting rate (MV/CV) (1/D)*(1 AYTM)-1; where MV market value CV contract value D duration

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