Federal Reserve DC plan launches stable value alternative

The Federal Reserve Employee Benefits System is using an innovative form of bond laddering in its $5.5 billion defined contribution plan to replace the GIC-laden stable value option that had been its most popular with participants.

The change was necessary “to introduce new fixed-income options that offered certainty of returns but did not have the concentration of risks from investing in guaranteed investment contracts,” William Clark, chief investment officer of the Newark, N.J.-based Federal Reserve Office of Employee Benefits, said in an interview.

Investments in the stable value fund had been 100% in GICs until the fourth quarter of 2008, when plan officials began investing new participant contributions and maturing GICS into a prime money market fund they incorporated into the stable value option, known as the Interest Income Fund.

Mr. Clark said plan executives were concerned that there were GICs from only seven insurance companies in the Interest Income Fund, and only three of them were offering new contracts. “A secondary concern was that the plan restrictions imposed by the GIC issuers limited the plan's flexibility to introduce new investment options and change various plan provisions,” he said.

Plan officials began phasing out the internally managed stable value option in July. That option had been offered since 1970.

In its place, plan officials launched a series of three bond funds — the Select Maturity Bond Family — with maturity dates of June 30, 2014; June 30, 2016; and June 30, 2018. “This allows the participants to invest in the equivalent of a CD (certificate of deposit) ladder or a bond ladder,” said Mr. Clark, adding that most participants choosing this option have invested in all three maturities.

The new bond-fund family is managed by BlackRock Inc., New York, which also manages a bond index fund and a Treasury inflation-protected securities index fund for the Federal Reserve's plan. (The plan also offers a passive Government Securities Fund, managed by State Street Global Advisors.)

Each of the new BlackRock funds will invest in U.S. Treasuries, other U.S. government agencies, foreign governments, corporate debt and securitized-debt-backed by a loan, lease or mortgage.

The allocation to the five sources varies with the length of maturity of the funds within the bond family. “There are strict credit and diversification requirements in order to limit the potential for — and exposure to — defaults in the underlying portfolio,” Mr. Clark said.

Early results indicate participants have accepted the change, he added.

When the bond family option was launched, the Interest Income Fund accounted for 52.3% of plan assets. Now, that's down to 38%, and the bond family fund accounts for 15% of assets, indicating to Mr. Clark that the “vast majority” of money leaving the Interest Income Fund went into the new bond family funds.

The Interest Income Fund is being phased out in stages. In six-month intervals, a portion of participants' balances will be reallocated; the default option is one-third each into the three Select Maturity bond funds.

DC plan officials began talking with representatives from BlackRock in mid-2010 about developing a new fixed-income option. “We approached BlackRock because they were the only investment manager at the time that offered products that had some of the elements of what we wanted to achieve,” Mr. Clark said.

The result was a structure “that behaved much like CDs with full liquidity prior to maturity,” Obie McKenzie, a New York-based managing director in BlackRock's global client group, said in an e-mailed response to questions.

The Federal Reserve is BlackRock's first defined contribution client for the bond-family offerings, Mr. McKenzie said. He added company officials are in “active discussions” with executives at other DC plans.

In seeking a new fixed-income option, Mr. Clark said plan executives set several goals: flexibility, such as no transfer restrictions; high-credit quality and diversification; and certainty of returns if held to maturity.

The bond fund family option is being valued on a daily basis, whereas the Interest Income Fund is valued monthly. The bond fund family allows daily withdrawals and deposits; the Interest Income Fund allows these transactions monthly.

A new bond fund will be added to the Select Maturity Bond family to replace a maturing fund every two years. For example, a fund maturing in 2020 will be added to the investment lineup in 2013.

The Select Maturity Bond fund family isn't the only change to the Federal Reserve's DC Plan.

• The number of target-risk funds was cut to three from five “to reduce complexity to participants,” Mr. Clark said. These options are constructed using the DC plan's core options. Ayco Co., a subsidiary of Goldman Sachs Group, determines the asset allocation percentages for each fund once a year, Mr. Clark said.


• A passively managed emerging markets collective investment trust, managed by Northern Trust Corp., was added. Plan officials chose the emerging markets option following an asset allocation study that showed such an option would produce “a significant enhancement in potential risk-adjusted returns for diversified portfolios at various levels of risk,” Mr. Clark said. Northern doesn't manage any other options for the Federal Reserve plan.


• An active domestic large-capitalization equity separate account was merged into a passively managed equity blend fund managed by Vanguard Group. The large-cap option, which was co-managed by BlackRock and Davis Select Advisors, was terminated for “performance reasons,” Mr. Clark said.