pension fund perspective: interest guarantees revisited

CFA Institute

Pension Fund Perspective: Interest Guarantees RevisitedAuthor(s): Patrick J. Regan, Madeline Einhorn Glick and Harrison Givens, Jr.Source: Financial Analysts Journal, Vol. 35, No. 1 (Jan. - Feb., 1979), pp. 8-9+48Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478202 .

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PENSION FUND m

Patrick J. Regan, BEA Associates, Inc., Editor

A Interest Guarantees Revisited, Harrison Givens, Jr. 4 Madeline Einhorn Glick Replies

Interest Guarantees Revisited by Harrison Givens, Jr.

The article by Madeline Einhorn Glick in the July/August 1978 Pension Fund Perspective column was an interesting effort to evaluate the interest guarantees of life insurance companies as if they were securities. The following observations are intended to put those guarantees back into their natural perspective.

The Nature of Interest Guarantees

The life insurance business offers many varieties of interest guarantee to qualified pension and profit-sharing plans. These guarantees are backed by the assets of the insurer's general account, as are life insurance policies, annuities and health insurance. All insurance guarantees are in the nature of a debtor-creditor relationship, and all promises have an equal claim upon the assets of the general account: The widow and orphan are alike with the pension plan.

Those unfamiliar with the insurance business may be overwhelmed by the variety of terms available. However, the amount that the usual plan client places under guarantee is large enough-ranging from one million to 100 million dollars or more-to justify considerable tailoring of terms. The amounts and timing of payments to the contract, the schedule of payments from the contract, whether interest will be paid out or reinvested, whether the rate guaranteed is fixed or subject to

participation in higher earnings-all these details are subject to variation. But there is no favoritism involved: State regulation bars discrimination in terms of either the offer or the alloca- tion of investment results. The interest rate and other investment guarantee specifics are equally available to all clients. Expense charges, following the general practice of group lines, are commonly graded by size, on a uni- form basis.

Investment Characteristics

It is natural that those whose daily concern is the management of publicly traded bond portfolios should attempt to evaluate an interest guarantee as if it were another such bond. But it isn't. The main type of interest guarantee discussed by Ms. Glick (1) applies only to a single sum (although others apply to future plan contributions as well), (2) offers a fixed rate (although others guarantee a minimum and allow participation in earnings above that minimum) and (3) covers a fixed term

(although some allow premature cash- outs, on various bases).

It would be best to put aside consideration of any limited right to cash in before maturity and accept the guarantee for what it basically is-a sure, immutable stream of specified bene- fits. Since the instrument is to be held to maturity, the fluctuations of long- term interest rates over the term of the guarantee have no significance: Even if a bond-yield type of calculation were used to develop a kind of market (or fair) value for the remaining stream of guaranteed payments, the result merely measures a gain or loss that is not only unrealized but unrealizable.

In the case illustrated by Ms. Glick's Chart I, therefore, the plan must decide whether it wants, exactly and specifically, a return of nine per cent for a specified period, with return of capital at the end. It will get no more, and no less, on the scheduled dates, and not earlier or later. The proper graphical representation for Chart I is thus a single vertical line at

Chart I

Normal Distribution Returns on of Returns GICs

Frequency Frequency of Returns of Returns

9% Expected Returns 9% Expected Returns

Harrison Givens, Jr. is Vice President and Actuary of the Equitable Life Assurance Society of the United States. Madeline Einhorn Glick is Vice President, Director and Manager of the fixed income portfolio of BEA Associates.

8 O FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1979



the nine per cent point, with no curve or shading to either side.

Safety

The safety of interest guarantee contracts is regulated by the state insurance departments, which hold per- formance of promises paramount to all other considerations. The statutory ac- counting required would look strange to anyone accustomed to the financial statements on publicly traded bonds. For example, general account assets are carried at book value, although they now earn about seven per cent on average; on the other hand, liabilities assume that future earnings will be at less than half this rate. Therefore, if "fair value" were calculated to reflect the current level of long-term interest rates, liabilities would be marked down far more than assets would, and the resulting measure of surplus would be much higher than statutory statements show. This is exasperating to someone evaluating a life insurance company as an investment, but highly comforting for someone considering the purchase of an insurance promise.

The fact that insurance companies are regulated by state insurance departments, rather than by the Securities and Exchange Commission, makes them different, rather than inferior. Who can name any policyholder who failed to collect on his insurance promise? Even the policyholders of the notorious Equity Life Funding were paid in full and on time: It was the stockholders who bore all the pain, despite federal securities laws. Indeed, how many stocks have proved worth- less, and how many debt securities have in fact defaulted, despite full prospectus disclosure? A plan trustee can view the purchase of an interest guarantee with the same confidence-no more and no less- with which he would view a life insurance policy from the same carrier.

Insurable Risk

Actuaries are astonished to hear that interest guarantees are not an insurable risk. An interest guarantee is an essen- tial component of every permanent life insurance policy and of every annuity contract, and has been so for over 200 years. The term of such guarantees is

concluded on page 48

Madeline Einhorn Glick Replies A major argument against the guaranteed investment contract rests upon the belief that market risk is uninsurable. While it may be claimed by the insurance industry that the interest and prin- cipal guarantee offered in today's GICs does not differ from that ''guarantee" inherent in all life policies and annuity contracts, there is actually a very significant difference. Payments at some future date on life policies or annuity contracts have been determined on the basis of forecastable risk, like mortality, in contrast to payments on a GIC which have been set according to assumptions of certain investment returns. However, since investment risk is a function of future securities market risk, which cannot be quantified or forecast, it seems there can be no true insurance guarantee under a GIC.

It is inappropriate to remove from consideration the cash-in provision of those contracts permitting termination prior to maturity. Plan requirements do not always remain the same, and if a need to cash in develops, a penalty is usually incurred, sometimes as much as 15 per cent of market value determined by the carrier, causing detri- ment to the value of plan assets. Therefore, the standard deviation of

return must be greater than zero. One good reason that no one has lost

money on insurance contracts is that prior to the initial issuance of GICs in the early 1 970s returns guaranteed were at the three to 31/2 per cent level, the lower range of interest rate returns. Now, in the period 1974 to date, guarantees of eight to over nine per cent are at the upper range of interest rate experience. The net rate of investment income of U.S. life companies shown in the 1978 Life Insur- ance Fact Book illustrates a range of 4.61 per cent in 1965 to 6.44 per cent in 1975, an average of 5.42 per cent over 11 years. At high interest rate levels competitiveness to increase promised investment yields drives up the probability of risk. It would be interesting to know how much of the business of the major carriers is com- prised of guaranteed contracts.

The primary issue relating to guaranteed contracts today is not the financial strength of first tier carriers. The issue is a question of prudence in purchasing such contracts when investment alternatives such as U.S. government guaranteed GNMA's offer total marketability, liquidity, and a yield of 9.60 per cent to a 10-year average life. U

Growth is a way of life at American Heritage Life, and has been for 22 years. Earnings continue to hit new

Q RO W T *highs, for example, and we have built our assets to over $170 million and H^ w q life insurance in force to more than

G R O W T , five and a half billion. ?NN f^ ITUTII1 But as we tell our managers, where

^& FV VIFI we are now is but a beginning ... ?Ifn II7TLI and that's an attitude our G J V L shareholders

GROWTH like.

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GR(-WTH companies in the business? GqVTH Call or write: W. Ashley Verlander,

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FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1979 O 9



a firm's total investment in these items with its sales volume gives a clear indication of the operational and financial leverage inherent in its business.

Table II illustrates the relation of these six items to sales for 10 firms during 1974-76. The table deliberately omits companies with prominent fixed cost components. If it had been included, UAL, Inc., for example, would have shown a fixed cost ratio of 34 per cent for 1975-76. The 1976 fixed costs for the firms in the sample range from 4.2 per cent of sales in the case of Josten's to 15.3 per cent in the case of Eastman Kodak. Obviously, forecasting Eastman Kodak's earnings will be far more difficult than forecasting Josten's.

During 1975, the aggregate fixed costs for Table II's 10 companies rose 9.2 per cent. Half the firms experienced an even more rapid gain in sales, however, lowering their fixed cost ratios. Given the recessionary conditions of that year, this outcome was far from expectable, and demonstrates vividly

that individual companies can experience important short-run changes in fixed cost ratios.

Although two years is obviously too short a period to draw any conclusions about trend, it is neverthe- less interesting to note that the three most levered firms-Eastman Kodak, McDonald's and 3M-in- creased their fixed cost to sales ratios during 1975, while the three least levered firms-Rubbermaid, Lenox and Josten's-all reduced their fixed cost ratios. Excepting McDonald's, the same pattern per- sisted in 1976. The disparity in fixed cost leverage among firms may be growing over time.

With all the current interest in risk analysis and measurement, including the prediction of future betas, it is surprising how little research has been directed toward the income statement aspect of financial risk. Monitoring, over time, the fixed cost items described in this article will at least enable the interested reader of financial statements to recognize the relative risk inherent in his forecasts. U

INTEREST GUARANTEES... concluded from page 9

for life-30, 40 or 50 years. The form of interest guarantee discussed by Ms. Glick is hardly a brand new discovery; it differs merely in spanning a shorter duration, in covering a group of participants, rather than a single life, and in demoting the associated mortality guarantee from its usual role of equal partner to the junior role of an annuity option for individual participants when the interest guarantee expires.

Level of Guaranteed Rate

It should come as no surprise that interest rate guarantees are usually at a level somewhat above that prevailing on publicly traded bonds. Companies offering interest guarantees make rela- tively little use of publicly traded bonds, preferring instead to put funds into direct placement bonds and commercial mortgages, because the latter characteristically have higher yields. Direct placement borrowers pay a higher rate to compensate the lender for the lack of marketability of the debt instrument and to gain continuing access to a sophisticated lender, indi- vidually tailored terms (including de- layed takedown) and privacy. Com-

mercial mortgage borrowers pay for access to the limited number of sophisticated lenders large enough to handle the required permanent financ- ing and to commit for it years in ad- vance.

Historically, the yield spread for a comparable quality of borrower is 50 to 75 basis points. When investment demand is good, the insurance company can attract substantial additional funds by offering a part of this spread and retaining the rest as compensation. In the recent past, the spread has been minimal, and publicly traded bonds have been a reasonable altemative to a guarantee.

A Matter of Choice

Interest guarantees are simple, sound and safe. They are rarely the best choice for all the assets of a plan, and not always even the best choice for some of the assets of a plan. The nearest alternative to an interest guarantee is to put funds into the carrier's general account without guarantee, but with receipt, instead, of the full earnings of the carrier. The carrier in effect asks the plan, shall I credit you with all that is earned, or shall I guarantee to credit less? The absolute assurance may well be worth the mod- est reduction in expected yield.

An interest guarantee is likely to be

the best choice for a Taft-Hartley plan, particularly when the guarantee applies to future plan contributions, because the assurance that the actuarial interest assumption will be met is of special significance to such a plan. It is also especially attractive to participants in profit-sharing and thrift plans, particularly of the "employee-choice" variety, where each employee chooses the investment vehicles for his own account.

Larger, more sophisticated plans may prefer to put funds into the broad diversification of the carrier's general account without a guarantee, or into one or more specialized vehicles (called separate accounts, when offered by life insurance companies) for investment in direct placements, or commercial mortgages, or publicly traded bonds, or short-term paper, or common stocks, or real estate, with various sub-choices of emphasis in investment policy.

The private pension system, with over $200 billion of assets, is large enough to make good use of all the choices made available by insurance companies, banks, investment advisers and other vehicles. Variety of choice is desirable and inevitable, and nothing constructive is accomplished by cas- tigating one instrument for not being the same as another. U

48 El FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1979



pension fund perspective: interest guarantees revisited

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