But wrap capacity still needed remains north of $50 billion

The stable value industry, especially the industry for wraps, is finally calming down after significant changes in recent years following the financial crisis. Stable value funds performed relatively well during the crisis and for the most part continue to provide both returns and protection of principal as they've always been expected to. But because of excessive risk taking by some stable value fund managers in the years leading up to the crisis, wrap providers have been reshaping the industry, mostly by imposing higher fees and tightening investment guidelines.

Stable value is a major component of the retirement industry. These funds are available in most U.S. defined contribution plans, 457 governmental plans and 401(k) plans. The 25 members of the Stable Value Investment Association managed $437 billion in wrapped assets as of September 2010, and total stable value funds hold nearly $561 billion in 401(k) assets.

Stable value funds provide the safety and low volatility of money market funds with the higher returns of intermediate bond funds, thanks to a crediting rate that allows funds to smooth returns over time regardless of fluctuations in the value of their underlying portfolios. Stable value funds are also protected from interest rate volatility through wraps, which are contracts from banks and insurance companies. These wraps guarantee a book value to plan participants wanting to withdraw their money from a fund, even if market value is below book value. There are some exceptions to that book-value guarantee in cases including layoffs and bankruptcies.

The fees that wrap providers charge have been increasing since the financial crisis of 2008, which culminated with the bankruptcy filing of Lehman Brothers. While they were in the single digits in the years leading up to the financial crisis, they have now stabilized in the mid-teens to the mid-twenties in terms of basis points. There are some exceptions, though, with unsubstantiated rumors of a wrap provider outside of the 15 to 25 basis point range. Eric Hasenauer, managing director and head of sales for Aviva Investors North America Inc., which has roughly $1 billion under management, noted that 15 basis points is at the low end, while most wrap fees are between 19 and 25 basis points. The increase in fees for wrapping assets in stable value funds is the result of wrap providers being less willing to take risk as well as of demand for wraps outpacing supply. "For the foreseeable future, they'll remain in that range," he said. "Risk has been priced in."

"Fees have pretty much been accepted by the stable value managers," concurred James King, senior vice president and head of stable value markets at Prudential Retirement. "We are at an equilibrium with most market participants at this point." Among its general accounts, separate accounts and guaranteed investment contracts, Prudential manages more than $60 billion of stable value assets.

For Ron Heath, managing director of sales and marketing at Morley Financial Services Inc., which has $14 billion of assets under management, the fact that the industry has seen an increase in activity at the 15 to 25 basis point fee level likely means it has found a level where wrap providers are earning a sufficient return on capital to make the business attractive to them.

Higher fees attracting new entrants

Aviva Life and Annuity Co. and Mutual of Omaha started offering new wraps last year. Prudential Retirement and Principal Life Insurance Co. also recently jumped back into the game. "It's an attractive market for wrap providers," Mr. Heath said. Additional firms are also said to be looking to enter the market for wraps, with Goldman Sachs being one of them.

"We're seeing some more new entrants come in, especially in the last six months," Mr. Hasenauer said. "Reasons prompting new entrants include higher fees, the recovery of market-to-book ratios in stable value and investment guidelines being more closely watched over." The main providers of wraps currently are large insurance companies like Prudential, Principal Life Insurance Co., MetLife and New York Life. Principal Life is an affiliate of Morley Financial Services.

"We believe the market for stable value wrap contracts has stabilized and is in the early stages of turning the corner," said Karl Tourville, managing partner at Galliard Capital Management, which has more than $67 billion in assets under management for 220 institutional clients. "We're expecting additional wrap capacity in the marketplace this year as the combination of higher fees and reduced risk attracts new entrants. The market, however, is evolving. Banks, which have been significant providers of wraps for almost two decades, are expected to shrink their book of business modestly while life insurance companies, who were the dominant players in stable value during the 1970s and 1980s, are increasing their market presence." The shift back to insurance companies as main wrap providers over banks is because banks have been forced to shrink their balance sheets and their business as a result of the financial crisis and increased regulations.

Although new entrants and existing wrap providers offer a substantial chunk of wrap services, the financial crisis also prompted existing wrap providers to exit the market. These include UBS, Rabobank and American International Group. For some of them, like AIG, exiting the wrap business was a direct consequence of the financial crisis, while others, like Rabobank, exited because stable value wasn't a core competency for them and no longer fit into their business models. "We're seeing an exit of some wrap providers," Mr. King said. "But it's a controlled and orderly exit, not a run through the door."

These three firms alone still account for about $46 billion, or 11%, of the wrap market today, according to a December Pensions & Investments article. And some wrap providers have upped their capacity.

Mutual of Omaha initially provided $5 billion and later increased it to close to $10 billion. The annuity company Aviva has said that it can provide at least $10 billion in wrap capacity. Prudential, which started offering wraps again in recent years, had in-force wraps of $17.8 billion as of Dec. 21, 2010. ING's U.S. Retirement Services division has been growing and said in November that it expanded its capacity to provide new wrap coverage to meet increased market demands. It also reported that it posted stable value asset sales of $3.6 billion throughout the first three quarters of 2010 and wraps more than $25 billion in stable value assets.

But despite new entrants in the wrap business and due to UBS, Rabobank and AIG exiting, there continues to be a shortage of wrap offerings. "Wrap capacity has been coming back and is increasing, but there's still a need for wrap capacity," Mr. Heath said. The exact wrap capacity still needed in the market is unclear, but some estimates put it between $50 billion and $70 billion. wrap contracts in combination with investment management services. As a result, wrap-only offerings are becoming less common. "The wrap-only business is certainly scarce," said Mr. Hasenauer of Aviva. Mutual of Omaha, for example, is one of the few wrap-only providers remaining in the market. "It's in small pockets. It's now being offered in the form of a package with investment services."

There are advantages and drawbacks to having a bundled product.

On the positive side, a bundled product with both wraps and investment management services allows the wrap provider to offer flexible investment guidelines. For example, Aviva's annuity arm, Aviva Life and Annuity Co., which provides wraps, has more flexible investment guidelines with Aviva Investors, which is the investment manager, than with outside managers. "One of the advantages of having a bundled product is that there's the ability to offer flexible investment guidelines, since there is an assumed level of trust and comfort between the wrap issuer and investment manager," Mr. Hasenauer said. Terms are also more negotiable and fees more competitive. On the other hand, some companies are forced to relinquish control over the investment management. "To give that up and the revenue associated with it could be an issue," he said.

New York Life, which entered the market in summer 2009, is organized in a similar fashion to Aviva. New York Life Insurance Co. offers wraps, while New York Life Investment provides investment management services. Neither Aviva nor New York Life offers wraponly products.

Higher fees pushing some managers out

Higher wrap fees have also had the consequence of forcing some stable value fund managers to exit the market. "The fee pressure is certainly considerable," said Mr. Hasenauer. "It flows through to a plan and there are some ramifications as far as return objectives." For example, State Street Global Advisors said in June 2010 that it would close down its stable value asset management business by the end of 2010. As of March 31, 2010, SSgA had $8.4 billion of client money in the firm's stable value strategy. Its decision to exit the business reflected a broad range of uncertainties in the market, it said, including persistent challenges stable value providers have faced recently in obtaining new wrap insurance capacity, according to a June article in P&I.

SSgA was one of the few, if not the only, stable value manager that had to inject capital into its funds during the market turmoil. The company decided instead to pick a money market fund as a cash option in its defined contribution offering.

"There have been a number of stable value providers that have terminated their funds as a consequence of a number of factors including higher fees," Mr. King said. In another example, Merrill Lynch closed its $10 billion fund. "Book values were covered and they had the ability to terminate the funds," he added, referring to both instances.

Meanwhile, stable value is still attracting plan sponsors. Los Angeles County Deferred Compensation and Thrift Plan and its Savings Plan said in December they would issue a request for proposals for a stable value consultant for its $5.5 billion 457 plan and $1.5 billion 401(k) plan. The search came as the contract of its existing consultant, Mercer, expired at the end of 2010. As of Oct. 31, the deferred compensation plan had $2.6 billion in its stable value fund, while the savings plan had $654 million in its stable value fund.

What remains to be seen is whether the wrap industry, as well as potential new wrap providers, will continue to take advantage of the opportunity in the marketplace and finally fill the gap in needed capacity once and for all.