The shift by plan sponsors from traditional insurance company guaranteed investment contracts toward more esoteric synthetic GICs and structured contracts has led to calls for more financial disclosure.
With plan sponsors seeking additional diversification and improved yields, synthetic contracts captured nearly 25% of new placements in 1993. Industry sources estimate that will increase to 35% of new placements in the next five years.
As the number of synthetic contract providers continues to expand and the types of contracts grow more complex, one plan sponsor has called for uniform disclosure standards for synthetics, "so people will know what they are buying."
Paul Lipson, associate treasurer of the Federal Reserve Employee Benefits System, Washington, has fashioned a 15-point disclosure standard that he uses in contract bidding and he hopes will be the prototype for an industrywide disclosure standard for synthetics or other GIC alternatives.
Mr. Lipson said disclosure standards will help plan sponsors better understand how synthetics are constructed and how they might perform, or, at least help them have a deeper level of information concerning the new breed of GIC.
Most of the suggested disclosure standards are fairly routine and include such items as the name of the manager, guarantor and trustee; who has title to the underlying assets; the precise term of the investment and under what circumstances are principal and interest paid to the plan; what penalties, if any, are associated with delays in funding or withdrawals before maturity; and an investment policy statement describing eligible investments, the objective of the account and how performance will be assessed and a fee schedule.
More problematical provisions include:
A detailed description of the crediting rate reset methodology, including the formula. The crediting rate on a synthetic contract is periodically reset (monthly, quarterly, semi-annually) to reflect the current yield of the underlying portfolio, the portfolio performance since the last reset, and participant withdrawals and/or benefit payments.
An interest rate stress test, using at least two rising and two falling interest rate scenarios, with the corresponding changes in asset values and crediting rates.
The manager's or guarantor's written assessment of the stress test and the appropriateness of the investment for the plan.
Mr. Lipson said he hopes the standards will be adopted throughout the industry either through the GIC Association, the industry trade group, "or some other industry body."
Larry Mylnechuk, association executive director, acknowledged the need for a higher level of due diligence on synthetic contracts and said, "currently there aren't a lot of analytical tools available to analyze" the contracts in detail. He said the association will review Mr. Lipson's suggested standards, adding the issue "is on our agenda for the future."
Mr. Lipson said he has been using the disclosure requirements in hiring managers for the Fed's $1.2 billion stable value GIC fund, of which about $240 million is in synthetic contracts.
He said marketing materials from the various synthetic vendors "vary in quality" and "many assume a high degree of sponsor familiarity with financial markets and instruments" but that some sponsors in "haste to diversify ... have purchased alternative investments they did not fully understand and could not effectively monitor."
"I have identified 15 pieces of information, the minimum essentials, that I require for a proposal to be considered here. They are pretty straightforward, but you frequently don't find all of them in proposals," said Mr. Lipson.
He said some of the requirements have elicited "some gripes" from some asset managers, but most have complied.
He said the minimum disclosure requirements "recognize there are risks that people may not fully understand and it is in everyone's best interests to get this information out on the table," he said.
Some synthetics, he said, "may be at variance with the objectives of plan participants" since some synthetic contracts are total return oriented while defined contribution plan participants are more income oriented with a bias toward capital preservation.
Uniform disclosure requirements would assist plan sponsors in conducting "proper due diligence" on the contracts.
Most GIC consultants and managers as well as money managers who offer synthetic contracts claim most of the information requested by Mr. Lipson already is provided during the bidding process.
But, some managers say they do not agree with the requirement for them to provide a written assessment of the interest rate stress test and the appropriateness of the investment for the particular plan.
"It is a reasonable question to ask," said one GIC consultant/manager who asked not to be identified. "But it is not clear to us that it should be up to the contract provider to assess the appropriateness of the contract for the specific plan. That seems like a job for the plan sponsor. The manager should understand how the contract fits and be in communication with the plan, but the sponsor should assess the appropriateness of the investment."
A money manager who offers synthetic contracts agreed most of the data already is provided and that assessing the appropriateness of the investment for a fund should be the responsibility of the plan sponsor.
"It's really the plan sponsor who has to do that assessment. The money manager provides as much information as possible, but it is unreasonable (for the sponsor) to say to the money manager, 'you decide if it is appropriate'," he said.
C. Jason Psome, managing director-stable value at Sanford C. Bernstein & Co., New York, a leading provider of synthetic contracts, said his firm "not only is a proponent of the disclosure requirements, but we already have started offering the data. Clearly we think this is appropriate and important, and have taken steps to do it. We have no problem with it."
Ned Schmidt, president of Schmidt Management Co., a GIC research firm in Deland, Fla., said a higher level of disclosure is needed, but he doesn't expect the standards to be adopted across the board by the industry.
"These products are being sold to investors, many investors don't understand all the caveats or how they react under different market and interest rate conditions. These are not unreasonable disclosure requirements, but the industry probably won't accept it," Mr. Schmidt said.