GICs: market value or book value, which is fair? (guaranteed investment contracts)by Morley, Harold H.
GICs are insured group annuity contracts issued by about 100 U.S. and Canadian life insurance companies. They provide for guaranteed principal, payment of interest at negotiated rates, and fixed maturities. There is a wide variety of contract types and terms -- no two GICs are identical.
GICs and bank investment contracts (BICs) are especially popular with defined contribution (DC) plan sponsors and participants. The reasons: GICs, and portfolios of GICs, offer a relatively high yield, stability of return, and safety of principal. In addition, contract terms and portfolio steuctures are designed to meet the specific needs of each plan, which include providing liquidity to meet participant benefit payments at book value.
GICs have become as visible as other investments like stocks and bonds. There has been spectacular, steady growth in GICs in the last decade--the value of outstanding contracts is now about $200 billion. More recently, there has been a proliferation of new GIC products, such as BICs and look-alikes, with a variety of features and potential applications in both defined benefit (DB) and DC plans. The total amount of new GIC business done in 1982 was about $8 billion. Today, the annual figure is somewhere between $35 and $40 billion.
Today there are serious concerns among government officials and investors about the stability of the financial services industry, including insurance companies. Several major life insurance carriers -- such as Executive Life and Equitable -- have taken a drubbing in their business activities and in the press. Exposure to problem mortgages and junk bonds continue to plague others. Nevertheless, Morley Capital continues to rate its broad universe of about 45 GIC issuers as "excellent" in terms of credit quality.
FASB EXAMINES GIC VALUATION
SFAS 35, "Accounting and Reporting by Defined Benefit Pension Plans," states that, "plan investments (excluding contracts with insurance enterprises) are to be presented at fair value." The FASB is currently reconsidering the exception to fair value given to GIC investments in defined benefit (DB) plans, and has tentatively concluded that the exception should be eliminated. It is also considering the valuation principles to be applied to insurance contracts in DC plans; the sentiment coming from the FASB seems to be that GICs and similar investments should be carried at fair value for DC plans also.
The GIC industry has no fundamental problem with valuation of GICS at fair value. It does, however, strongly believe that there are situations in which fair value of GICs in both DC and DB plans, but especially in DC plans, is contract or book value.
As an important preliminary step in establishing viable guidelines for determining when fair value might be equal to contract or book value in the case of GICs and similar investments, the FASB staff has asked for help from the GIC industry. A questionnaire was issued by the FASB regarding valuation of GICs and similar products. The GIC Association's Contract Valuation Committee researched the issues and subsequently submitted its response to FASB as the official GIC Association position. Morley Capital submitted its onw response, as did other members of the Association. The criteria for valuing GICs described in this article are derived primarily from the GIC Association response. However, the position regarding the valuation of GIC portfolios is that of Morley Capital Management.
GICS ARE BUY-AND-HOLD
It is clear from the research and analysis performed that there is more to this issue than valuing GIC funds in the same way as trading- oriented bond funds. The argument that fair value is equivalent to the price at which someone will trade an asset in the open market assumes that all assets are purchased to be auctioned off at some point. The history of the GIC industry stands in direct opposition to this trading- oriented model. GICs are buy-and-hold investments that satisfy, in a planned and orderly manner, the long-term investment needs of plan participants. Not surprisingly, a majority of DC plan participants prefer these book-valued investments over U.S. Treasury securities. In fact, studies show that over 60% of all DC plans offer GIC funds as their secure fixed-income funds, while less than 20% offer government funds.
What Are the Differences?
There are two significant differences between a stable-valued GIC fund and a market-valued bond fund, and both relate to the concept of a willing buyer and seller.
First, at the participant level, with a GIC contract the agreement between the participant and the plan is that deposits and withdrawals will be transacted at book value and that the participant's return is based on the income actually earned during the holding period. GIC investors are deliberately seeking to avoid market-price risk. On the other hand, in trading-oriented bond funds, the participant is explicitly seeking market gains through trading activities, and is willing to accept losses that may occur. The agreement with the participant is that deposits and withdrawals will be at market value. Clearly, the participants in each plan, and the plans themselves, have different parameters as willing buyers and willing sellers of a bond fund from the parameters in a GIC contract.
The second major difference is in the methods that GIC funds use to achieve liquidity at the fund level, as contrasted with the market method used by bond funds.
Each GIC is individually negotiated between the purchaser and the issuer to provide for liquidity that protects the plan participant from the fluctuations ordinarily experienced in the market. The insurer issuing a GIC acts as an intermediary agreeing to absorb market-price risk and to provide participants with full book value when they withdraw from the fund. Furthermore, many plans "self insure" their GIC investments through portfolio management techniques; these techniques assure that there will always be enough liquidity to meet participant benefit needs.
In the bond fund, on the other hand, an intermediary is not used to absorb marketprice fluctuations. The participants agree to a value based on discounted present values of all future cash flows. Liquidity is achieved in the open market at the expense of the certainty that all participants will get out at full book value. There is no doubt that a number of Wall Street brokerage firms would love to see the $200 billion GIC industry change to daily trading, but market values for GICs do not appear to meet the long-term retirement needs of most plan participants.
Market Value Doesn't Work
In light of these differences, if the FASB applies market-value accounting measures to all investments alike, it is inadvertently dictating investment policy and practices that would contravene the understanding currently in place between participants, fiduciaries and GIC issuers. But, more importantly, in the GIC industry, market value is only hypothetical.
From an accounting, legal and investment standpoint, market value is inappropriate for these investments because they are essentially agreements between two parties that allow the investor to cash out at book value or less than book value, but never in excess of book. If the contract rate is higher than current market rates, the "appreciation" remains with the issuer. Moreover, getting out of a GIC generally requires that the purchaser bear the expense to renegotiate the contract or have it reassigned through the issuer.
Recently, as interest rates have dropped, a number of issuers and other industry experts have cast serious legal doubts on the ability of investors to sell GIC cash flows to third parties. This is one reason why there has never been a serious secondary market in GICs.
MARKET VALUE VERSUS
Generally, in investment options where the investor chooses to participate in a market-valued asset, fair value is market value. When the investor wishes to participate in an asset that eliminates or reduces market fluctuations, fair value may be book value. Moreover, book value is normally equivalent to fair value if the contracts, or portfolio of contracts, are benefit responsive for participant-initiated transactions.
The American Council of Life Insurance (ACLI) argues, "there is no practical way to determine the fair market value of a GIC contract. Contract, or book, value is a far more accurate and relevant measure of the value of GIC contracts sold to DC plans for both plan participants and plan sponsors."
There are a number of established criteria backing the ACLI's argument for treating GICs as book-valued investments.
1. The contracts are:
* Part of an ongoing plan;
* Not traded; and
* Nontransferable and nonassignable without the explicit written consent of the issuer.
2. The contract issuer's financial condition is judged to be adequate to repay future interest and principal commitments.
3. There is no active secondary market by which to establish a market value for individually negotiated insurance contracts.
4. The contracts, or portfolio of contracts, provide sufficient liquidity at contract value for all participant-initiated transactions allowed under the plan. If a plan restricts participant transfers and withdrawals so that participant-initiated withdrawals may not occur except over an extended period, this extended liquidation period may be considered in determining fair value.
5. Contracts are purchased with the intent of holding until maturity in order to capture the yield premium available over more liquid instruments of similar quality.
6. Contracts can be cloned, i.e., transferred from one plan to another in total and in part.
These facts present a problem for the FASB to provide a standard measure of fair value for investments in both DB and Dc plans. Quite simply, GICs and similar investments do not look like stocks and bonds and are, therefore, hard to place in the same category. The FASB staff recognizes that an exception is required but may not know what criteria to use to support when fair value equals book.
The first guideline is contained in SFAS 35, paragraph 5; it states that the primary objective of a DB pension plan's financial statements is, "to provide financial information that is useful in assessing the plan's present and future ability to pay benefits when due. A plan's financial statements should provide information about: a) plan resources and how the stewardship responsibility for those resources has been discharged; b) the accumulated plan benefits of participants; c) the results of transactions and events that affect the information regarding those resources and benefits; and d) other factors necessary for users to understand the information provided."
However, the focus of a DC plan's financial statements is somewhat different from that of a DB plan. In DB plans, the focus is to reflect the ability to pay the aggregate benefits promised. In DC plans, the focus is to report the aggregate of participant account balances that the plan fiduciary, in good faith, believes fairly reflects the amount the participant could have realized on that date if the participant's account had been transferred to another investment option or paid as a benefit in accordance with the plan. It is because of this distinction, that the case for book value as a representation of fair value is especially persuasive for DC plans.
The second guideline is contained in the Employee Retirement and Income Security Act of 1974 (ERISA). In ERISA, Congress mandated that fiduciaries assume responsibility for clarifying the objecties, investment policies, and valuation methodologies for pension plans. Therefore, it is the obligation of the plan fiduciary to make a good faith determination of fair value for the assets which it manages. At present, SEC guidelines state that no single standard for determining fair value in good faith can be laid down, because fair value depends upon the circumstances of each individual case.
CRITERIA FOR VALUING AT
There are two additiional criteria that must be met before book value or contract value is equivalent to fair value: The issuer must demonstrate credit worthiness with no question as to solvency and the plan holding the GICs must be structured to be benefit responsive to participant-initiated transactions.
Solvency of the Issuer
It is Morley Capital's position that for a GIC fund to be valued at book, issuers must be able to make payments on all outstanding contracts. An auditor can assess an issuer's credit-worthiness in a number of ways:
* Review of third-party credit-rating status of each issuer to assure all have investment-grade ratings and paying abilities.
* Review of credit analysis provided by the plan fiduciary on issuers not rated at or below investment-grade rating by other rating agencies.
* Statement from the plan administrator that no issues are in default or in the process of default.
* Confirmation statement from the issuer on contract values and that contracts are not in default or in the process of default.
IF issuers are deemed not to be credit-worthy or an issue is in default, the task is to determine the adjustment from book value and ultimately to ascertain liquidation value. Until the decision is made on liquidation value, the fair value is equal to principla plus accrued interest up to: 1) the date of default; or 2) the date the determination is made that the issuer's paying ability is uncertain.
Benefit responsiveness needs definition at both the contract and portfolio levels.
At the contract level, benefit responsiveness is clearly a key factor for determining fair value as contract value. The benefit-responsive provisions of a contract should permit all participant-initiated transactions to be made at book value. Limitations to benefit responsiveness for plan terminations or other unusual and extraordinary events should not preclude book-value accounting, because these types of events are normally not anticipated in accounting practice, because they are not relevant to a going concern.
The primary question when plan assets are invested in a portfolio of GICs or BICs, which may or may not include benefit-responsive provisiions, is whether the portfolio as a whole can accommodate all participant-initiated transactions at book value. If the plan fiduciary determines that sufficient liquidity exists for all employee-initiated transactions allowed by the plan, book value is appropriate.
There are other significant restrictions on a contract for it to be considered benefits responsive. It cannot be stripped, sold or traded and payments must be made on a pro-rata, LIFO, or other basis with other contracts. Benefit responsiveness can be exercised for permitted plan benefits only.
These negotiated restrictions and obligations are integral to the terms of a contract and can only be exercised by the individual participant in the plan. Therefore, they cannot be priced separtely.
Furthermore, the benefit-responsive provisiions often tend to be exercised on a non-economic or non-interest-sensitive basis. For example, if a participant terminates employment or retires, it matters little whee interest rates are at the moment. Therefore, traditional option valuation models, such as Black/Scholes, have little meaning when applied to this issue.
Valuing GICs and BICs
For both benefit-responsive and non-benefit-responsive GICs and BICs, the plan fiduciary must make a good faith determination of fair value.
In lumping GICs and BICs together for the purpose of valuation, some explanation is necessary. The primary difference between the two is that domestic BICs are currently insured by the FDIC up to $100,000 per participant in qualified plans. In nearly every state, GICs are considered to be insurance or annuity contracts. GICs contain provisions for the purchase of individual annuities.
Book-valued portfolios, made up primarily of GICs, are a necessary and viable alternative to market-valued portfolios for the majority of plan participants.
With book-valued portfolios, the investment medium used is clearly different and distinct from stocks and trading-oriented bond portfolios, venture capital and other similar investments. Book-valued funds generally share the following characteristics:
* The investment objective of the portfolio is to maximize yield consistent with a high degree of safety and liquidity, and to avoid potential market and trading losses.
* Participants and plan sponsors view the funds as a long-term foundation investment.
* The portfolio structure is relatively short term in nature, with an average maturity generally less than three years. This creates a rapid internal cash flow that keeps a fund's invested rate close to current market rates.
* Assets in the portfolio are held to maturity and not traded.
* Participants make deposits into the funds at contract value.
* During the holding period, participants receive the income actually generated by the portfolio; they do not share in discounted future values.
* Participants receive withdrawals for plan benefits at book value.
* Portfolios are currently primarily invested in GICs, BICs, and money market instruments.
Auditors need criteria that allow them to determine when book value is the approprite accounting method for GICs and GIC portfolios. In setting guidelines, the following questions need to be answered:
1. Are portfolios being managed in a way that is consistent with the participant's expectations?
2. Are plan fiduciaries exercising prudent stewardship?
3. Can plan fiduciaries honor the liquidity provisions of the plan under reasonable circumstances?
ARE YOU CONVINCED THERE
IS A DIFFERENCE?
Stable, book-valued GIC funds and other similar investments differ greatly from market-valued investments.
GICs are designed to meet the needs of plan participants who want a long-term retirement investment. The agreement between the participant and the plan is that transactions will be made at book value, thus avoiding market-price risk. This is made possible by the issuer, which agrees to absorb market risk and to provide plan participants with full book value when they withdraw from the fund. On the other hand, investors in a trading-oriented bond fund are seeking market appreciation and are, therefore, willing to accept the potential losses associated with market timing. As FASB considers guidelines for investments in DB and DC plans, it must take into consideration the different roles played by book-valued and market-valued investments in these plans.
The criteria described herein are enough to allow plan fiduciaries and accountants to apply book-value accounting measures to GICs and similar investments.
Harold H. "Hal" Morley is President of Morley Capital Management, Inc. Mr. Morley is Chairman of the Contract Valuation Committee of the CIC Association, Lake Oswego, Oregon.
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