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The Impact of Financial Reform

Written by David Starr, Head of Institutional Management and
William Gardner, Senior Client Portfolio Manager

The Dodd-Frank bill, recently passed by Congress, can be considered the most far-reaching financial legislation in over 80 years. It will have a lasting impact on critical elements of the financial environment, including Federal Reserve oversight and transparency, rating agency protocol and behavior, credit risk retention, and derivatives treatment. Whether the legislation will actually serve to protect consumers or mitigate the risk of another financial crisis, however, remains unclear at best.

Of significance to the defined contribution and 529 plan marketplaces, the treatment of stable value wrap contracts—defined in earlier versions of the legislation as “swaps”—will be taken up by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) over a 15-month study period. The SEC and CFTC have been charged with consulting the Department of Labor, Treasury, and state regulators to address the following:

1. Should stable value wrap contracts be included within the definition of swaps? If the contracts are not defined as swaps, regulatory treatment of the contracts will remain unchanged.

2. If stable value wrap contracts are included within the definition of swaps, should they be exempt from treatment as such? The legislation requires the CFTC and SEC to issue regulations regarding the determination that they make on this issue. If it is determined that stable value wrap contracts are exempt, regulatory treatment of the contracts should remain unchanged.

3. If stable value wrap contracts are determined to fall within the definition of swaps and are not determined to be exempt from regulation, the CFTC and SEC must develop and implement a regulatory framework that will address disclosure, capital, and reserve requirements, among other issues.

Under the Dodd-Frank bill, stable value wrap contracts will continue to operate under the existing regulatory framework during the study period. It is also important to note that the bill protects the status of all contracts in existence prior to the determination date, stating that these contracts will not be considered swaps nor will they be subject to the requirements of the bill, regardless of the outcome of the study. This “grandfathering” of existing contracts is a key element in providing certainty to plan sponsors regarding stable value wrap contracts.

While most stable value market practitioners viewed the original legislation’s treatment of stable value contracts as a clear case of “unintended consequences,” legislators on the conference committee did not exempt these contracts from such treatment. Accordingly, the stable value market, already constrained by an imbalance of wrap supply and demand, will be exposed to this 15-month period of further uncertainty as the regulatory bodies reach a determination.

Allowing a joint regulatory study was widely viewed as a positive outcome by stable value market participants. The additional time allows for a more reasoned approach with regulators to appropriately address and resolve outstanding issues in a manner that protects the asset class for plan sponsors and participants. Given the positive contribution stable value funds have made toward retirement security for millions of participants in the last 35 years, a more thorough analysis is warranted.

Dwight remains committed to providing capital preservation investment strategies in the form plan sponsors require and within the regulatory framework that is ultimately put in place. To that end, we are taking several actions to ensure that we continue to meet the capital preservation objectives of our clients:

• Rethinking Stable Value Strategy: We have engaged issuers and plan sponsors on a variety of asset strategies and contract terms that will bring greater uniformity to wrap contracts and address issuer concerns regarding investment guidelines, managing notional exposure, and providing greater liquidity to stable value portfolios. By doing so, we intend to provide plan sponsors with greater flexibility and clarity in using stable value while maintaining a risk/reward benefit critical to the retirement security of participants.

• Enhancing Liability Modeling: We have taken significant steps to improve the measurement of plan liabilities to help plan sponsors and issuers understand the associated risks and take the necessary steps to mitigate exposures. Our Enhanced Liability Model (ELM), designed to provide a transparent duration and allocation methodology for both plan sponsors and wrap providers, guides the overall duration, level of liquidity, and underlying asset mix that is appropriate for each client’s portfolio.

• Developing Capital Preservation Alternatives: Dwight has developed a variety of customizable cash, stable value, and short-term bond strategies. Given the confluence of market and regulatory constraints, it is likely that some plans will begin to offer capital preservation alternatives that allow for small net asset value fluctuations in addition to the stable net asset value strategies that are currently available.

Though the form of offerings in the capital preservation market has been evolving in response to market and regulatory pressures, it remains clear that participants require viable investment options that can serve as a foundation for building savings plans. We look forward to continuing our work with plan sponsors, consultants, and other market participants in offering leading investment strategies to meet those needs.