Guaranteed-return investment soffer relative safety to pension funds, depending on the financial situation of the seller.
In the mid-1970s, pension funds were seriously considering an alternative to the stock and bond markets: the guaranteed investment contract.
The GIC, a variation on the insurance industry's annuity contracts, promised a guaranteed interest rate on the investment for a number of years, and return of principle at the end of the period. In this it was like a bond. But the GIC essentially was a private bond issued by the insurance company to the investor, backed by the general account assets of the insurance company.
The GIC had no market value and thus suffered no market value fluctuations when general interest rates changed. It never showed a loss of value and, in fact, always showed a gain equal to the guaranteed rate. This made it a popular investment for thrift or savings plans, as plan sponsors did not like their employees to experience negative returns on the thrift plan assets.
Of course, the guarantee of interest was only as strong as the insurance company underwriting it. This was something plan sponsors and individuals lost sight of through the years, a development that 15 years down the road would impose a cost.
Some sponsors began considering GICs not only for their thrift plans, but also for their defined benefit plans.
In September 1974, Leo M. Walsh Jr., vice president of pensions at Equitable Life Assurance Society of the U.S., reported to Pensions & Investments that the insurance company had sold $50 million of GICs to defined benefit plans and $100 million to thrift plans.
But in the first half of 1975, as the extent of the market debacle of 1974 became clear, at least half of the pension business picked up by six of the major insurance companies was for GICs. Equitable was reporting $1 billion in new pension business for the year, about 45% of it in GICs; Metropolitan Life reported gaining 85 new clients and $143 million in assets, of which $59 million was for GICs; Travelers Corp. reported $250 million of new pension business in the first six months of 1975, $140 million of it for GICs; and John Hancock Mutual Life Insurance Co. reported $250 million in new pension business, with at least $150 million for GICs.
The "guarantee" worked its magic on the new 401(k) plan in the '80s, as employees were given widespread investment discretion for the first time. And insurance companies initially gained most of the 401(k) plan assets. The GIC would remain the most popular investment option among 401(k) plan participants for many years.
In 1987, however, banks began offering their own version of the GICs that had been so successful for insurance companies.
The bank investment contracts, or BICs, were guaranteed up to $100,000 per participant by the Federal Deposit Insurance Corp. But the insurance companies attacked the FDIC guarantee, arguing it gave banks an unfair advantage and exposed the government to huge risks in the event of default.
By September 1989 banks had gained 10% of the guaranteed contract market. However, the more than 20% annual growth in demand for such investments over the next two years, driven by the continued double-digit growth of 401(k) plans, provided more than enough demand to satisfy both banks and insurance companies.
Eventually, BICs became managed bond portfolios around which the bank wrapped an insurance policy bought from an insurance company. Later still, synthetic GICs were developed by fixed-income managers using futures to provide the guarantees.
The growth of the guaranteed market led to concerns about how sponsors select the best contracts and build the best portfolios for their funds.
A group of GIC managers emerged to help 401(k) plan sponsors select contracts and construct efficient, diversified portfolios. They included such major institutions as Bankers Trust, Fidelity Investments, T. Rowe Price Associates and Vanguard Group.
For another group of firms, however, GIC portfolio management was the primary business. Among the pioneers in this area was Peter W. Bowles, who started managing GIC portfolios for Citytrust in Bridgeport, Conn., in 1977.
Ten years later, Mr. Bowles established Fiduciary Capital Management to specialize in GIC portfolios, in the belief that a carefully selected, diversified portfolio of GICs made as much sense as a carefully selected, diversified portfolio of stocks or bonds in that it could minimize risk without reducing expected return.
Within a few years, Mr. Bowles had been joined by firms such as PRIMCO Capital Management, Certus Asset Advisors and Morley Capital Management. The firms used the full range of what became known as stable-value investments -- GICs, BICs and synthetic GICs.
The collapse of Drexel Burnham Lambert, the investment banking firm that had virtually created and supported the junk bond market, at first caused barely a ripple in the GIC market. The average portfolio backing GICs had only small holdings of junk bonds.
But one insurance company, Executive Life, had a substantial amount of its $3 billion in GICs backed by junk bonds. In addition, Executive Life had sold annuities to companies terminating their defined benefit plans. These annuities guaranteed future benefit payments to employees and retirees.
Within a year of the junk bond market's collapse, Executive Life was in deep financial trouble as the value of its junk bond holdings collapsed. Insurance regulators had to step in to prevent the collapse of the company; they froze annuity payments and GIC contracts.
Pension plan sponsors, including Honeywell Inc., Unisys Corp. and the State of Alaska, followed suit, freezing payouts from their employee benefit funds that held Executive Life GICs or annuities.
Honeywell acknowledged that $72 million of its savings plan was in Executive Life GICs. The company announced it would make payouts to employees from the GIC account only as payments were received from Executive Life. Unisys reported $134 million in Executive Life GICs. The Alaska fund had $132 million in Executive Life GICs.
The first lawsuit against Executive Life was filed by retirees of Pacific Lumber Corp., which had been acquired by Maxxam Inc. in 1989. Maxxam partly financed the acquisition by selling junk bonds to Executive Life. It then terminated the Pacific Lumber pension fund, recaptured surplus assets and bought annuities for the retirees from Executive Life. Now, the retirees' benefit payments were frozen.
Only months after the Executive Life collapse more suits were filed, this time by employees of Honeywell and Unisys, seeking to recover losses on GIC contracts.
In the Unisys suit, employees charged Unisys breached its fiduciary duty by failing to recognize how much of its assets Executive Life had in junk bonds, and therefore how vulnerable it was to economic forces.
The inclusion of the Executive Life GICs as an option was therefore imprudent, the employees charged. However, Executive Life had been rated highly by the insurance industry's primary rating agencies, and had been cleared by Unisys' pension consultant, and the company was thus exonerated by a federal district court in 1997.
MUTUAL BENEFIT SUFFERS
But Executive Life was not the only insurance company brought down by the junk bonds and GIC crisis. Five months after Executive Life failed, Mutual Benefit Life Insurance Co., an old-line insurer, was seized by New Jersey insurance officials after client withdrawals threatened its viability. The Executive Life crisis apparently prompted thousands of participants in 403(b) plans to begin withdrawing their assets from GICs and annuities. These withdrawals were made easier at Mutual Benefit than at most insurance companies because Mutual Benefit had lower withdrawal penalties, and because many of the clients were longtime clients. (Withdrawal penalties usually decline with the length of the relationship.) Mutual Benefit also was vulnerable because its policies were backed by relatively undiversified and illiquid real estate and mortgage portfolios, and it was relatively thinly capitalized.
At least 25 large corporations, including AT&T, Allied-Signal, Bell Atlantic, General Mills and Grumman, had multimillion-dollar GICs with Mutual Benefit. However, the New Jersey Department of Insurance developed a plan to stabilize Mutual Benefit and for the orderly payment of withdrawals. Eventually, Mutual Benefit's GIC customers received all of their principal back.
Ironically the pioneer of GICs, Equitable Life, announced in December 1991 that it was leaving the GIC business. The company had lost $1 billion on high-rate contracts issued years earlier when interest rates plunged in the mid-'80s. Since then, it gradually had reduced its GIC business to about $500 million a year from a high of $2 billion a year.
Equitable finally decided its capital could be allocated to higher-return businesses.
Following the Executive Life and Mutual Benefit collapses, a number of companies reported they were de-emphasizing GICs in their 401(k) plans and stepping up efforts to educate employees about the investment markets, about long-term returns of various assets, and the relationship between risk and return.
But in 1994, GICs still accounted for more than 25% of the asset mix of the average 401(k) plan participant when more bad news hit.
Confederation Life Insurance Co., a major Canadian insurer that had substantial operations in the United States, and which was a major factor in the GIC and pension annuity market, was seized by Canadian regulators when its financial condition became critical. Many GIC and annuity holders were faced with the probability they would receive less than 100% of their investment back.