After the shock of the losses at Executive Life Insurance Co. and Mutual Benefit Life Insurance Co., guaranteed investment contracts have only in the past couple of years begun to regain their credibility with defined contribution investors. But now some issuers of GICs risk jeopardizing that newly rehabilitated standing.
A few issuers have begun adding derivatives to GICs. These so-called structured GICs use derivatives to boost yields and diversify portfolios in what usually is considered a conservative investment.
That's potentially a problem. Participants in 401(k) and other defined contribution plans invest in GICs to minimize risk. Using derivatives to enhance GIC returns could put a different perspective on risk assumption by participants. Vendors, consultants and sponsors need to keep in mind participants bear the investment risk in defined contribution plans.
A structured GIC, according to a Pensions & Investments news story, offers investors a premium in return over conventional GICs in turn for accepting the possibility of receiving return of principal before maturity. That is, the investor accepts pre-payment and reinvestment risk in return for the return premium.
Already $2 billion to $4 billion in the contracts have been issued by various companies.
The danger is many GIC investors, already inclined to minimize risk, undoubtedly won't have the experience or knowledge to make an educated evaluation of the additional risks associated with structured GICs.
In addition, structured GICs might be too new for their potential risks to have been thoroughly examined. If there is any doubt about the need for a greater understanding of structured GICs, one need only look at the mortgage-backed securities market. Many professional investors suffered huge losses when interest rates suddenly turned more volatile.
If there are hidden flaws in the new instruments, they risk harming not only issuers of structured GICs, but also the entire GIC industry. In addition, they could harm the move to defined contribution plans, if participants suffer huge losses taking investment risk they don't understand and really didn't want.
Derivatives and GICs aside, many defined contribution participants should take on more risk in order to obtain a higher expected returned and thus better their ability to meet their retirement income objectives.
According to P&I's 1994 annual survey of pension funds, 24.3% of corporate defined contribution money was in guaranteed-type contracts. That's down from 31.8% in the previous year's survey.
But participants shouldn't be denied an opportunity to invest in GICs, structured or otherwise. Rather, vendors selling structured GICs, and sponsors offering them, first must stress-test these new vehicles to ensure there are no flaws hidden in the derivatives, like the flaws that hurt investors in mortgage-based derivatives. Then vendor and sponsor must spell out explicitly for participants in understandable language the terms of the contracts and risks - pre-payment risk, reinvestment risk and market risk.
Participants expect, even after the losses of the late 1980s, safe, sure investment in a GIC. They expect more than just a guarantee; they expect the investments backing GICs to be invested conservatively. Wrapping a guarantee around a package of complex derivatives could be like giving participants a trick when they come calling for a treat.