Ten years ago, the insolvency of Mutual Benefit Life Insurance Co. and First Executive Corp. shook up the stolid stable-value industry and, some say, permanently changed defined contribution plan design and the way participants invest their account balances.
It wasn't like the stock market crash of 1987, which made investors painfully aware that markets can go down in a hurry, but the solvency crises in the insurance business reshaped the perception of investing in stable value.
Some say the April 1991 failure of Mutual Benefit and August 1991 failure of Executive Life changed the way defined contribution participants manage their money, resulting in a massive shift to equities and other diversified options from guaranteed investment contracts. While that is still an open question, the insolvencies led to a wider array of investment options in defined contribution plans and a near decade-long slide in the percentage of assets allocated to guaranteed investment contracts (or stable value, as it is now called). In fact, total defined contribution assets invested in stable value have remained relatively constant; they're now around $250 billion, the same as in 1992, according to the Stable Value Investment Association, Washington.
The anniversary of the fall of two players in the GIC market isn't being celebrated by those in the stable-value industry. But some observers point to the firms' collapse as a turning point, hastening the industry's migration from traditional insurance company contracts into synthetic contracts, which predominate today. But the main beneficiary of the massive shift out of GICs starting in 1992 has been equity funds, a move that has continued until this year.
Stable-value assets account for about 20% of defined contribution assets, according to Hewitt Associates LLC, Lincolnshire, Ill. It was not uncommon, however, to find GICs representing 70% to 80% of account balances in many plans before the fall of Mutual Benefit and Executive Life. Since then, the percentage allocated to GICs has declined steadily from 41% at the end of 1991 to 30% in 1995 and 20% in 1999, according to Hewitt. According to the Profit Sharing/401(k) Council of America, Chicago, assets invested in GIC funds among all plan sizes fell from 21.3% in 1992 to 7.5% in 1999.
At the same time, surveys show a corresponding increase in equity exposure. Excluding company stock, defined contribution assets allocated to equities increased to more than 29% in 1999 from 10.7% in 1992, according to the Profit Sharing/401(k) Council. According to the Spectrem Group, Hartford, Conn., the allocation to diversified equity funds in 401(k) plans jumped every year from 1990. Starting at 10% in 1990, participants upped their allocation to diversified equity funds to 14% in 1992; 16% in 1993; 25% in 1995; 40% in 1997 and 44% in 1999.
A combination of factors took their toll on the two insurance carriers. A general decline in asset quality, undercapitalization, deterioration in the junk bond market, bond defaults and problem mortgage loan portfolios led the two insurance companies down the road to insolvency.
Of course, the failure of Mutual Benefit and Executive Life wasn't the only factor in the repositioning of defined contribution portfolios. The year 1991 also marked the start of one of the longest economic expansions in history and, not coincidentally, the bull market in equities. At the same time, the mutual fund industry beefed up its efforts to provide participants with better "information and education." Translation: participants should move a sizable chunk of their 401(k) assets into equities. A common theme was that if participants were overweighted in the GIC option, they would not have sufficient assets to retire comfortably.
The mutual fund industry's strategy worked. Participants poured money into equity options, the mutual fund industry thrived and participated in one of the biggest equity runups in history.
At the same time the stable-value industry was slumping. The insolvencies created a credibility gap among investors. A constant barrage of bad news about the insurance industry flooded the market. Problems with Executive Life and Mutual Benefit Life led to lawsuits and frozen benefit payments by pension funds that invested with either of the troubled companies. Although the problems were confined to only a few insurers, most were hit with questions about declining asset and credit quality stemming from problem real estate loans, bond defaults and junk bonds.
"It was a frightening period," said Kim McCarrel, portfolio manager at INVESCO, Portland, Ore., and formerly a principal at GIC manager PRIMCO Capital Management Inc., Louisville, Ky., which was acquired by INVESCO.
The insurance company failures raised concerns about the solvency and creditworthiness of an entire industry. One of the major lasting effects on the stable-value industry has been not only increased diversification by plan participants, but also diversification in stable-value investment portfolios.
Prior to 1991, GIC portfolios were made up mostly of traditional insurance company "guaranteed" contracts, or GICs. Today, wrapped fixed-income portfolios, or synthetic GICs, comprise about 53% of stable-value portfolios.
Move to external
Until the insurance crisis, and the resulting concerns over credit quality of GIC issuers, many plan sponsors managed GIC portfolios internally. Ms. McCarrel said concerns brought on by the insurance industry insolvencies accelerated the transition by plan sponsors to externally managed stable value portfolios and "ripped away the veil of book-value accounting."
The failures of Mutual Benefit Life and Executive Life "were the best thing that ever happened to synthetic GICs," said Ms. McCarrel. "Synthetic GICs were seen as complicated and less straightforward than (traditional) GICs. When Mutual Benefit failed, people got religion in a hurry."
Until the insolvencies, most defined contribution plan participants were invested heavily in GICs and showed no signs of changing. "Many times, they were 60-70-90% invested in GICs," said Charlie Bevis, analyst at Financial Services Co., Boston. Mr. Bevis believes the insurance company crisis of 1991 caused the lasting changes in the defined contribution market.
"It shook the faith of a lot of people and encouraged them to consider other alternatives than stable value," he said.
"Mutual Benefit and Executive Life shook people up. You had a lot of people with 100% in those things (GICs) and they thought they might lose it all. Many of them were from the Depression era and thought (GICs) were safe; it wasn't supposed to happen."
But it did happen. Plan sponsors and participants weren't the only ones caught off guard. Both companies carried AAA credit ratings by major rating agencies right up until the time of their failures. There was even talk of national regulation of insurance companies. Since then, the agencies have tightened up their rating procedures, particularly for insurance companies.
"Mutual Benefit and Executive Life caused plan sponsors to become a little more selective about the entities with which they invested," said Larry Mylnechuk, principal at Residential Capital Management, Bellevue, Wash., and former head of the GIC/Stable Value Association. "Mostly what I saw was that it caused them to look at ratings and financial data more carefully, particularly for insurance companies. It caused a whole higher level of due diligence by plan sponsors. Along with that, the rating agencies became much more proactive and installed tougher standards and tightened up their scrutiny of the insurance industry."
`First asset test'
Like many others, Mr. Mylnechuk said the insurance insolvencies were "frightening for the (stable-value) market. It was scary; it was the first asset test for stable value. People had talked about the likelihood of a default and rehabilitation of insurance companies, but it was all supposition - until then. Now it was real."
Ms. McCarrel called the companies' collapse a "momentous" event that "made the rating agencies much more acutely aware of the risk in insurance companies, which they had underestimated until then." But in the end, the impact on defined contribution plans is coincidental to the start of the bull market in equities, she said.
"The changes in defined contribution plans had more to do with what happened in equities than what happened to Mutual Benefit and Executive Life. The two events occurred about the same time."
Connecting massive changes in the defined contribution market with the collapse of two insurance companies in 1991 would be "quite a leap," said Bill Templeton, consultant with Towers Perrin, Atlanta.
"I don't think the money in equities today came from GICs," said Mr. Templeton. In fact, stable-value asset totals would be "many multiples higher" now had it not been for the remarkable runup in stocks during the last 10 years.
Mr. Templeton agreed with others that the insurance industry crisis of 1991 lead to greater use of synthetic contracts, or wrapped bond portfolios, and separate account stable-value management, while lightening up on the use of traditional insurance company contracts
But, he said, all that is "yesterday's problem." The problem for today's new and improved stable-value industry will be interest rate risk associated with the current crop of synthetic contracts, which make up more than half of stable-value investments, he said.
Today's synthetic contract is usually a diversified bond fund, either passively or, more likely, actively managed with a book-value wrapper purchased from an insurance company or bank. The wrapper gives the contract its means of preserving principal and providing a positive return. Unlike in traditional GICs - in which the underlying assets were owned by the insurance company, which caused the problems at Mutual Benefit and Executive Life - the underlying bonds in a synthetic contract are owned by the plan.
"Most synthetics and separate accounts are participating," said Mr. Templeton, and if the plan suffers heavy withdrawals in a rising interest rate environment, the crediting rate on the synthetic contracts will suffer losses. (With a participating wrap, gains or losses experienced on withdrawals are shifted onto plan participants. In a non-participating wrapper, the wrap writer makes up the difference between market and book value when withdrawals occur.)
Assuming there were substantial withdrawals from a fund heavily weighted with participating contracts and interest rates spike upward, some contracts "could unwind because of it," said Mr. Templeton. "With these securities, there is no finite (time) horizon, and there could be a pattern of events which could make it more manifest."
But despite the difficulties of 10 years ago, the stable-value industry has recovered from the uncertainties of 1991 and has moved on. (Another fallout from the insurance solvency crises is that the word "guaranteed" has been banished from the lexicon.)
The industry has broadened its appeal to 457 and 401(a) plans and is pushing for more exposure in the international market.
What happened in 1991 was an "anomaly," said Gina Mitchell, president of the Stable Value Investment Association - an anomaly that unduly plagued stable-value funds. "Company failures are not unique to stable value, but because it was retirement income invested in GICs, it resonated with people."