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Stable Value Excluded from QDIA Based on Faulty Assumptions

As part of the massive Pension Protection Act (PPA) of 2006, many positive developments have occurred, including auto-enrollment and other features to increase defined contribution plan assets and participation. However, the Department of Labor (DOL) – in its effort to define Qualified Default Investment Alternatives (QDIA) for plan participants – has proposed recommendations beyond – and contrary to – the intent of the PPA. They have excluded stable value from the list of QDIAs, based on what we believe is faulty analysis of capital preservation safe harbors like stable value.

As proposed, the DOL permits only three safe harbors – balanced funds, lifecycle funds, and managed accounts – all with equity components. The disruption of removing stable value and other capital preservation options has led a number of organizations representing stable value plans and participants to write letters to the Department. Many feel that any equity volatility can be detrimental to some plan participants.

The exclusion of stable value came as a surprise because it reverses prior DOL guidance on Individual Retirement Account (IRA) rollovers that use principal-protected funds – such as stable value funds – as safe harbor default investments.

The DOL explains in the proposed regulations that it believes that nearly risk-free, fixed income investments would “more likely … erode benefits” than “increase them (benefits).” The DOL position is based upon faulty assumptions and runs counter to the PPA’s call to provide a “capital preservation” safe harbor.

First, the assumptions regarding stable value performance offered in the DOL recommendation are not supported by the actual return patterns of stable value. The DOL’s conclusions are based on its assumption that equity-based products provide a return that is 6.7 percentage points higher than short-term, low-risk investments. This contradicts its own peer review of the data, which suggests a differential of around 2 percentage points.

The DOL stretches back to 1926 to get equity return assumptions of 10.40 percent, while the return data over the past 15 years (a timeframe more relevant with the advent of stable value and the creation and growth of 401(k) plans) from the S&P 500 Index suggests an assumption of 8.59 percent. And instead of comparing equity returns to stable value returns (which, according to the Hueler Stable Value Pooled Fund Index, have averaged 5.92 percent over the past 15 years), the DOL uses the 78-year average of Treasury bills at 3.70 percent. The DOL’s apples-to-oranges comparison yields a 6.70 percentage point differential, compared to a difference of 2.67 percentage points when comparing the S&P to the Hueler Index over the past 15 years.

Second, the DOL’s conclusions also seem to discount the needs and behaviors of risk-averse participants. One of the DOL’s peer reviewers pointed out that low-income workers also may be risk-averse, such that any additional expected income from lifecycle funds “may only come with an unacceptable amount of risk.” Stable value is a superior default option in many cases, particularly for those close to retirement age or who plan to spend only a short time at a given company and do not want to risk losing capital in the short term because of volatility in the equity markets.

The DOL acknowledges that the principal contributor to savings is increased contributions, not higher investment performance. Since default fund selections with equities still produce negative quarters – and, as a result, could actually lower participation for some risk-averse participants – one outcome of equity-only QDIAs is to negate any potential for out-performance to grow balances. In fact, over the 15-year time period referenced above in comparing stable value returns to equity returns, a typical 70 percent equity/30 percent fixed income balanced fund portfolio would have delivered 18 quarters with negative returns, compared to zero for stable value funds.

Third, stable value funds also have relatively low costs when compared to lifecycle, target-retirement-date, and balanced funds, particularly those that use a “fund of funds” structure. According to a 2004 study by IOMA, Inc., annual fees for stable value pooled funds average 42 basis points, compared to 74 basis points for lifestyle funds and 78 basis points for balanced funds.

Finally, though the DOL states that the proposal should not be construed to indicate that the use of other types of investment alternatives not covered by the regulation (such as stable value products) would be imprudent, the likely effect will be to shift plans away from stable value as default investments to give themselves a clearer safe harbor with a QDIA. This would push plans to offer higher-risk and higher-fee default options for their participants.

This proposal has already had real effects on plans. Wyatt Watson reports that in a survey of Insider plan sponsor subscribers, 94 percent currently have a default investment fund; 47 percent expect to leave the assets that are currently invested in the default investment fund in the same fund; 27 percent will consider changing their default investment fund; 13 percent have not decided what they will do; and 3 percent expect to transfer to one of the new proposed default investment funds. Clearly, the proposed guidance has encouraged a rethinking of capital preservation investments for default investments.

Groups representing plans like the Profit Sharing / 401(k) Council of America (PSCA), the U.S. Chamber of Commerce, the National Association of Manufacturers, the Employers Council on Flexible Compensation, and the ERISA Industry Committee have called for guaranteed products to be added as a fourth QDIA. Plan participant groups such as the American Federation of State, County and Municipal Employees, the AFL-CIO, the Cultural Institutions Retirement System, and the Pension Rights Center have supported adding a capital-preservation option. Industry groups such as SVIA, the American Benefits Council, and the American Council of Life Insurers have also written the DOL seeking to amend its proposals regarding the QDIAs. And companies such as Diversified Investment Advisors, Metropolitan Life Insurance Company, John Hancock Financial Services, Mass Mutual Financial Group, AEGON Institutional Markets, Prudential Financial, Transamerica Retirement Services, and Dwight Asset Management have appealed to the DOL to revise its proposals to include stable value.

There is no reason to exclude stable value funds from the safe harbor. It is consistent with the PPA and in the best interests of participants to add stable value as a fourth QDIA, which in turn will give the decision about the appropriateness of using stable value to plan sponsors. They are in the best position to make this judgment for their plans’ participants.

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