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Debate with Department of Labor Continues on Stable Value as a QDIA Safe Harbor

The Department of Labor (DOL) has delayed the release of final regulations on qualified default investment alternatives (QDIA) as the debate on whether to include stable value funds as a QDIA continues.

So far, we know that the proposed regulations took an odd approach by prescribing three types of investments that the Department considered a QDIA - balanced funds, target-date/lifecycle funds, and managed accounts. The approach was odd for two reasons. Until the proposed regulations, the Department had refrained from dictating a particular type of investment for retirement plans. Instead, it provided direction through guiding principles or characteristics of investments it felt appropriate for ERISA-governed plans. Finally, from a stable value perspective, the approach was also odd because it excluded stable value, which has long been considered a de-facto safe harbor by most investors.

Stacking the Deck
One might say that the deck is stacked against stable value, since many of the Department's assumptions regarding the safe harbor are problematic and, when it comes to stable value, just plain wrong. Stock returns are assumed to have a 6.7 percent premium even though DOL's own peer review calls for a more conservative equity premium, and stock gurus like Jeremy Siegel, author of Stocks for the Long Run, recognize the equity premium should be 2 to 3 percent. While the equity premium is overstated, stable value returns are underestimated, since they are assumed to be equal to cash. The Department's cash assumptions for stable value ignore the intermediate bond-like return that stable value delivers without the associated volatility of bonds and the fact that stable value portfolios consist of diversified bond portfolios with a wrap or financial assurance against interest rate fluctuations.

Further, the proposed regulations simplistically and incorrectly use age as an approximation for risk tolerance. The proposed regulations also ignore variability of rates of return and their impact on retirement wealth creation. Lastly, the proposed regulations are based on capital asset management and behavioral finance theories, which continue to develop and evolve. In Capital Ideas Evolving, financial historian Peter L. Bernstein highlights the gap between theory and practice of the Capital Asset Pricing Model (CAPM), which provides a foundation for the Department's safe harbor proposal. Berstein says,

Debate Likely Decided in the Fall
The final regulations were submitted to the Office of Management and Budget (OMB) for review in mid-July. The OMB has been asked to weigh-in on whether stable value funds should be included as a QDIA. Because of the ongoing debate, it looks like this issue and the release of the regulations will be decided sometime in the fall.

Fight Obscures Issues
Much of the fight obscures the issues. The purpose of auto-enrollment is to encourage savings. As the CRS Report for Congress, "Retirement Savings: How Much Will Workers Have When they Retire?" points out, there is only one true and proven path to retirement security, stating that "...starting to save while young and doing so consistently every year is perhaps the single most effective way to assure that one reaches retirement with adequate savings." If this is so, then why is there any controversy?

The answer is that it matters how you get to retirement with adequate savings. CRS also attests to this point in the conclusion of the report:

The Investment Company Institute (ICI), however, has argued that plan participants are better off invested in equities, and that equities will achieve higher returns over time. However, these assumptions downplay the trade-offs for that higher return, which is higher volatility and risk of loss. In determining an appropriate QDIA, it is important to consider not just the upside potential, but also the potential risks in trying to achieve that upside potential. While equities may perform better over extended time periods, many participants - even employees that go beyond the median five-year employment-may not continue to participate in the plan when the markets are volatile or they experience losses because they have a low risk tolerance and/or concern about significant swings in investment performance. Equities do not always perform better than other asset classes, as the markets earlier in this decade and even as recently as this August illustrated. SVIA believes that plan fiduciaries should be able to take that into account in selecting a QDIA and have stable value as a stand-alone QDIA. Further, the ICI asserts that ignoring variability or the downside is okay since "safe harbors are designed to protect participants and provide the greatest good for the greatest number." ICI supports this premise with its stochastic simulations comparing returns from a lifecycle fund to that of a stable value fund. The ICI simulations are fundamentally flawed. The simulations ignore and underestimate the impact of negative investment experience and the variability of returns, which CRS warns us not to do.

Based on analysis submitted to SVIA that attempts to replicate the ICI simulations, lifecycle funds produce better returns for someone who begins to save at age 30 in 82 percent of the simulations, which means that stable value provides better returns in 18 percent of the simulations. For the bottom decile, the 401(k) average default balance is $147,529 for a stable value fund, compared to $136,798 for a lifecycle fund. In a worst case scenario, the 401(k) default balance is $88,594 for stable value, compared to $37,600 for a lifecycle fund. Total real contributions in 2006 dollars were $130,980 for those who start making contributions at age 30. For the age 30 cohort, lifecycle funds reported 351 losses (savings and returns are less than real contributions), with an average shortfall of $19,375, compared to stable value funds reporting 71 losses, with an average shortfall of $6,599. A summary table of this analysis is provided below to further illustrate these points.²

Lifecycle Compared to Stable Value Funds Simulation3
	Contributions Start at Age 30			Contributions Start at Age 40			Contributions Start at Age 50
	Lifecycle	StableValue		Lifecycle	StableValue		Lifecycle	StableValue
Average Across 10,000 Paths	$365,713	$199,974		$203,278	$135,868		$100,348	$79,544
By Decile
Top	$813,534	$266,189		$393,717	$173,745		$165,485	$96,136
Middle	$318,414	$196,802		$186,463	$134,353		$95,988	$79,050
Bottom	$136,792	$147,529		$93,987	$105,576		$56,200	$65,268
Worst Case	$37,600	$88,594		$43,999	$83,332		$27,718	$52,108
Total Real Contributions	$130,980			$99,630			$65,280
No. Cases with Real Losses	351	71		589	145		1,063	404
Average Short Fall	$19,375	$6,599		$13,660	$3,951		$8,567	$2,729
% of cases SV	17.8%			22.2%			27.7%

For these reasons, SVIA strongly believes that volatility and variability must be considered in the safe harbor and that stable value should be included. Stable value minimizes variability and provides certainty as a safe harbor since it is the only investment option that focuses on capital preservation and provides consistent, positive returns. Further, when it comes to selecting a specific QDIA, plan sponsors are in the best position to determine if a QDIA safe harbor provides the greatest good for the greatest number for their specific defined contribution plan population. That is why SVIA believes that the Congressional mandate for a capital preservation vehicle and the broad support for stable value by commenters on the proposed regulations supports making stable value available as a fourth stand-alone QDIA.

What Remains to be Seen
What remains to be seen is how persuasive these arguments have been with the DOL and OMB. While all sides have made their case, the financial markets have also emphasized SVIA's and CRS's concerns about market volatility and variability. Hopefully the case for stable value as a QDIA has been made successfully to the Department of Labor and OMB, so that stable value will be available in auto-enrollment programs for risk adverse investors. Stable value as a QDIA provides a safety net for risk-adverse investors and the Department of Labor if any of their assumptions for the safe harbor are wrong.

¹  Capital Ideas Evolving by Peter L. Bernstein, 2007, John Wiley & Sons, Inc., page 161

²  A discussion of the shortcomings of the ICI stochastic simulations comparing the returns from a lifecycle fund to returns from a stable value fund are discussed in SVIA's July 23, 2007 letter to OMB's Susan Dudley

³  This information is summarized from CRA International's Replication and Extension of ICI's Lifecycle versus Stable Value Funds Simulation, which is detailed in the attachments to SVIA's July 23, 2007 letter to OMB's Susan Dudley.

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