Reducing Volatility in DC Plan Lineups

April 8, 2014 (PLANSPONSOR.com) – It sounds like the ever-elusive free lunch—an investment strategy that reduces the potential for major losses while still pursuing the market’s strongest opportunities for growth.

But that’s exactly what an increasing number of investors are demanding in the wake of the 2008 financial crisis, says Bradford Campbell, counsel with Drinker Biddle & Reath LLP and former head of the Department of Labor’s Employee Benefits Security Administration (EBSA). It’s an especially pressing demand in the retirement planning context, Campbell tells PLANSPONSOR, where investors feel the long-term outlook that dominates decisionmaking about defined contribution (DC) plan investment menus doesn’t sufficiently address shorter-term volatility concerns.

Campbell partnered recently with investment services provider F-Squared Investments to author a whitepaper on the subject of addressing volatility in DC plan fund lineups. One important theme addressed in the paper is the particular set of challenges facing plan participants as they close in on their projected retirement date. At this point the participant has less time to recover from dramatic downturn events, Campbell explains, but as average lifespans lengthen and the cost of medical care and other necessities increases, there is also a pressing need for continued equity exposure to help ensure workers’ assets last through retirement.

These opposing considerations can leave a participant floundering for the right investment choices, Campbell says, especially as he nears retirement age. Further compounding the confusion is the fact that many of the target-date fund (TDF) products that automatically reduce an investor’s equity exposure as he nears retirement also suffered major losses in 2008, calling into question whether the general idea of favoring bonds and fixed income in later years offers sufficient downside protection to those who need it most.

“The traditional way of thinking about retirement investing is that it’s long-term investing, and you look to your horizon and if things go up or down in the middle, well that’s why you’re taking the long view,” Campbell says. “But as we saw in 2008, we can have some unexpected and significant shakeups that have some really harmful effects on the participants that are nearing retirement and those who have less time to recover.”

Campbell says F-Squared and other investment providers are keenly aware of this dynamic and are starting to bring a diverse stream of downside-protection products to market that seek to address both the need for long-term growth and the ability to protect assets from major losses.

“There are different ways to pursue this, and it’s important for plan fiduciaries to really consider products that take this approach to see if they are a good fit per their plan’s demographics,” Campbell says. “What’s thematically similar about them is the notion of finding a way to address shorter-term volatility.”

One popular type of product involves giving active fund managers the ability to convert much or all of a portfolio into cash when indications arise that markets are going to turn sour, Campbell says. This strategy may not protect portfolios from all loses, but it should help active managers stop portfolios from losing one-third or more of their value during major downturns—as occurred for many in 2008.

Campbell says, for plan fiduciaries, it’s important to remember the duties imposed by the Employee Retirement Income Security Act (ERISA) when thinking about these matters. He says there is a common perception that ERISA is a conservative statute that looks skeptically on new products and strategies that exist in the wider investment marketplace but have not been popularized for workplace retirement investors, but this is not necessarily true.

“That’s one of the things the whitepaper is intended to emphasize, the ERISA statute does not demand that you always do what you’ve done before,” Campbell says. “It’s a statute that says you have to go through a prudent process for the circumstances you now find yourself in. So in that sense it’s a law that requires ongoing monitoring and deciding whether new issues, products and circumstances require you to make a change. So in fact you won’t always be protected under ERISA if you keep doing the same thing.”

The upshot for plan fiduciaries and the downside-protection conversation, Campbell says, is that it’s not hard to imagine a future where it could be considered imprudent not to offer participants better downside protection, should these products prove to be effective and powerful tools. In other words, plan fiduciaries have a duty to monitor new types of products and, in appropriate circumstances, to bring those new products and services into their own plan.

So in the same way that TDFs and other relatively new investment strategies are quickly becoming normalized in the ERISA retirement plan context, Campbell says, so too could downside-protection products become an essential part of the DC plan investment lineup as market conditions change.

Campbell says, once a fiduciary decides it’s important to bring better downside protection to a fund lineup, it’s critical to closely examine what exactly is being offered. For instance, in the case of products that move aggressively into cash when downturns start or appear imminent, a fiduciary should be aware of what extreme asset allocations are possible in the strategy.

Campbell says this is especially true when downside-protection products are used as a plan’s Qualified Default Investment Alternative (QDIA), as there are rules limiting extreme allocations in QDIAs.

“Presumably the folks who are offering these products in the retirement planning context have done all this analysis on their end and can just provide it to the sponsors, especially if it’s labeled as a QDIA-compliant product,” Campbell says. “But remember, the fiduciaries also have a duty under ERISA to consider all this and come to their own conclusion as well.”

When assessing the risk tolerance levels of plan participants, Campbell adds that fiduciaries may also find that some participants have risk tolerances that are not static, but instead are adaptive based on the market environment. These participants may prioritize the protection of principal in weak markets, but could be willing to take on greater risk when markets are healthy, suggesting more dynamic products are necessary in the fund lineup.

Such participants may not find the benchmark-centric risk structure of traditional equity funds or intermediate bond funds to be an appropriate match for their particular risk tolerances as—by design—these investments do not seek to protect against significant market loss. For these investors, Campbell says fiduciaries should consider offering investment options that have a focus on downside risk management.

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