August 02, 2012
in Morningstar’s Investment Management division released a paper that explores
the true risk of guaranteed investment products and how they should be modeled. ---
Guaranteed investment products, including stable value
funds, guaranteed investment contracts (GICs), and synthetic GICs, are offered
in many defined contribution plans in the U.S. According to “Estimating Credit
Risk and Illiquidity Risk in Guaranteed Investment Products,” they appear to
have low risk, but since the returns are based on rules and formulas rather
than marked to market it can be hard to tell.
As an example, the paper notes that the coupon payments
associated with Lehman Brothers-issued structured products had no volatility
until Lehman’s bankruptcy in 2008.
Traditional methods for comparing products and constructing
optimal portfolios—in other words, looking at return and risk (standard
deviation)—underestimate the risk of guaranteed products and lead to
over-allocation. The researchers estimate that the true standard deviation for
guaranteed products should generally be about one to five percentage points
higher depending on the product structure, liquidity terms, and financial
strength of the insurance company issuer. These higher standard deviations make
the risk profile of many guaranteed products more similar to domestic bonds
The paper can be downloaded here.