Ticking Fiduciary Time Bombs

September 1, 2007:  Does the fact that all Formulaic Asset Allocation (FAA) approaches, e.g., Lifecycle, Target Date and etc., lead typical Plan Participants to an impoverished retirement expose Plan Fiduciaries to non-defensible liability?

Our recently released white paper, The Paradox of Asset Allocation for Retirement Plan Participants: A Blessing or a Curse™, definitively proves that no Formulaic Asset Allocation (FAA) approach (Lifecycle, Target Date, Target Risk, Balanced Funds, Managed Accounts and Monte Carlo Simulation) can provide Plan Participants with nearly enough money for Retirement Income Security, and that, in fact, FAA, exposes them to the highest risks over Market Cycles.

As it is now a matter of public record that FAA is a failed approach that does not prudently serve the Plan Participant’s best interest, Plan fiduciaries will not be able to claim they “did not know.”  In our view, this reality when combined with the provisions of the Pension Protection Act of 2006—which provide that a “complaining participant” can challenge in a court of law the quality of advice the Plan Sponsor made available to the Plan—creates a ticking fiduciary liability “time bomb.”

We are not alone in this caution.  In the Plan Sponsor Council of America’s Executive Report, February 2007, DOL ISSUES GUIDANCE ADVICE-Field Assistance Bulletin 2007-01, Section 601, issued by the Department of Labor February 2, 2007, the Council notes that:

“The Bulletin provides only one example of when monitoring specific advice is required-only to the extent needed to address a complaint [by a Participant] about the quality of the advice (the Participant received).  It should be noted that ultimately it is a court that will decide whether the monitoring is appropriate and Plan fiduciaries may want to periodically sample the actual advice provided to participants.”

Sally Doubet King, Partner at McGuire Woods LLP, who is a leading legal advisor to plan sponsors on all aspects of ERISA fiduciary responsibility and related corporate governance issues as well as Employee Benefits, observes:

“Good fiduciary practice requires that plan fiduciaries assess all emerging issues that may impact their plans and participants; the recent 401(k) fee litigation is a very high-profile example.  The information presented in this study regarding problems with the formulaic asset allocation approach and the benefits offered through the Adaptive Asset Allocation™ approach define a new set of issues that plan fiduciaries must address.”

Our report also shows that only an Unrestricted (no asset class rules) Objective (does not try to forecast the future, i.e., has zero to do with market timing) Adaptive Asset Allocation™ (UO-AAA™) approach can—and with the least risk—provide Participants with realistic Retirement Income Security.

All FAA approaches cause maximum loss of Plan value in a Down Market due to the formulaic requirement to hold a fixed percentage (40% to 80+%) of the Plan’s value in equity funds that lose money for as long as the Down Market lasts. Further, FAA can not provide adequate recovery when the next Up Market occurs due to the formulaic requirement to hold a fixed percentage (20% to 60%) of the Plan’s value in fixed income funds that typically lose money for as long as the Up Market lasts.

By comparison, in a Down Market UO-AAA limits, then stops losses, by adapting and shifting from stock funds to fixed income funds/cash.  When the next Up Market occurs, UO-AAA maximizes gains by doing just the reverse—adapting and shifting from fixed income funds/cash to stock funds.

The inability of FAA to overcome the effects of a single down market that inevitably occurs during the life of a retirement Plan dooms Participants following an FAA approach to failure.

To quantitatively illustrate the enormous differences between these two approaches, the report shows that the average annual return (AAR) over the 10-year period 1/1/1997—1/15/2007 was 8.8% for the best performing FAA lifecycle fund versus 16.2% for all Plans supported by the UO-AAA strategy.  These returns reflect investments from the beginning of an Up-Down-Up Market Cycle.

Similar results are found from investments made at the beginning of a Down-Up Market Cycle (1/1/2000—1/15/2007):  4.0% AAR for the best performing FAA lifecycle fund versus 11.9% for all Plans supported by the UO-AAA strategy analyzed in the report. 

The study compares the AARs produced by the best performing FAA fund in numerous Plans with those of a UO-AAA strategy applied to the very same Plans.  As a typical example, the AAR results used by three 401(k) plans for the Down-Up period 1/1/2000 – 2/19/2007 were:

           Professional Services Firm:  Best Performing FAA = 4.0%, UO-AAA = 10.0%

          Global Pharmaceutical Firm:  Best Performing FAA = 4.0%, UO-AAA = 12.7%

                National Hospital Chain:    Best Performing FAA = 4.2%, UO-AAA = 13.2%

The average long-term AAR over Market cycles, i.e., at least one significant Up and one significant Down Market, is shown to be 6.4% for the best performing FAA funds vs. 14.1% for the UO-AAA strategy applied to the very same Plans.

Studies presented in the report determine that the minimum AAR required over the life of a Plan to provide the typical Participant with Retirement Income Security is between 10% and 12%—an AAR that no FAA approach can ever achieve (the actual AAR over Market Cycles for an FAA approach must fall between 5.5%, the long-term return on bonds, and 10.2%, the long-term return on equities).  Thus, even in the highly unlikely event that a Down Market never occurs over the life of the Plan, FAA can never produce the required 12% AAR.

Other analyses contained in the report show that increased Participant contributions cannot overcome the inherent fatal flaws of FAA.

Given these stark realities, we strongly suggest that to defend against potential fiduciary exposure, plan sponsors include—and be sure their Participants are aware of—a UO-AAA strategy that can be applied to their existing retirement Plan.