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Asset Allocation Models: Finding the Way

Questions like “Does asset allocation really matter if equity markets only go up?” may send shudders up the spines of many investment professional but they also serve as a healthy reminder that the majority of today’s investors have not been in the markets long enough to experience a prolonged decline in stocks.

Defined contribution plan educational campaigns have an altruistic goal of creating an educated individual investor that is fully equipped to take his/her retirement future into his/her own hands.  However, they are about as prepared and empowered as a tourist trying to navigate the Washington beltway during rush hour without a map.  Not that materials and maps are unavailable, investors may have not yet taken the time to plot their course.

On the road without a map

Most studies confirm this “on the road without a map mentality.”  In fact, they go further.  John Hancock Financial Services’ Sixth Defined Contribution Plan Survey found familiarity with virtually all investment options is declining.  John Hancock found this trend was most pronounced with stable value funds.  They reported that familiarity with stable value had consistently fallen since 1993, when it ranked second to equities in familiarity.

Uniqueness creates complexity

So, is it any wonder to find sophisticated investment professionals like asset allocation model makers struggling with stable value while they are trying to provide a road map to defined contribution plan participants?  Simply put: yes.  Like the individual investors they are trying to help, most model makers are not taking advantage of the information and resources available to them.  Plus, the very qualities that make stable value unique create some complexity when translating stable value’s low risk and moderate return characteristics into models.

First the product, then the regulation

When SVIA first started looking at asset allocation models, there were rumblings from modelers that stable value was just an accounting gimmick.  Somehow FAS 94-4’s reaffirmation of book value treatment was viewed as the equivalent of a financial sleight of hand by the SEC sanctioned Financial Accounting Standards Board (FASB).

Stable value like passbook savings accounts was created long before 94-4 and ERISA.  First came the product, and then came the regulation.  The SEC and FASB do not permit or encourage financial sleight of hands.  That’s what they are designed to detect, prohibit and stop dead in its tracks.

She’s my sister. No, she’s my daughter

Now, as SVIA has dug in deeper, the classic and confusing line from the movie, “The Two Jakes” well applies, “She’s my sister. No, she’s my daughter.”  When it comes to stable value and asset allocation models, it goes, “Stable value is a money market.  No, stable value is a bond fund.”  In fact, like in the movie, it is a little of both.  It gets back to the unique characteristics of stable value:  money market liquidity and returns similar to intermediate bonds minus the volatility.

It is the journey, not the destination

Not wanting to sound too much like Deepak Chopra, but it is the journey, not just the destination when it comes to retirement savings and investment.  Once model makers recognize the characteristics of stable value, they have a second stumbling block focusing on the end point: retirement income.  The end-point or destination focus causes modelers to put the round stable value peg back into a square money market or intermediate bond hole.

This type of destination planning ignores the human condition.  Individuals care how they get there.  They focus on the short-term experience.  The journey matters.  It is not just the destination!

More risk or lower returns?

Models that force stable value into a money market or intermediate bond fund format do harm to the party that they are trying most to help: plan participants.  A destination or outcome mentality results in under-estimating Stable Value’s return or over-estimating Stable Value’s risk.  A defined contribution plan participant ends up in one of two undesirable and preventable positions: taking on more portfolio risk or having lower returns.  More risk or lower returns is not a choice that stable value fund investors have to make, if models recognize the unique qualities of stable value.

Efforts to set Stable Value right

That’s why SVIA as an organization and our members individually are involved in a dialogue directly with modelers, plan sponsors and policymakers to educate them as to how to best capture Stable Value’s unique characteristics: the marriage of minimal risk with strong, dependable returns.

SVIA’s Task Force on Asset Allocation Models is tasked with addressing this important issue.  The Task Force is chaired by John Hancock’s Wayne Gates and comprised of the following members.

The Task Force is drafting a paper that provides guidance as to how to appropriately represent the unique characteristics of stable value.  Wayne Gates provided a framework to address this daunting task that served as the straw man for the Task Force’s review.  Deutsche Bank’s Chris Cutler is refining the draft’s guidance on how to model stable value with able assistance from State Street’s Jim McDevitt and the Federal Reserve System’s Paul Lipson.

In addition to the dialogue and draft, SVIA’s Retirement Security in the New Millennium National Forum has dedicated Tuesday, October 10 to explore the challenges that asset allocation models pose.

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