Wharton Professor Takes Financial Planning Models to Task

By: Randy Myers

Wharton professor David Babbel has poked his head under the hood of a lot of financial planning models that purport to show investors their chances of having enough money to retire in old age. He doesn’t particularly like what he’s seen.

“The models have several flaws in them,” Babbel told participants at the 2011 SVIA Spring Seminar. One of the biggest, he said, is an assumption that future investment returns will follow what mathematicians describe as “nor- mal” distribution patterns.

Normal return patterns deviate from the mean in a neatly symmetrical fashion that creates a bell shape when plotted as a graph. The peak of the bell represents mean returns, while the lines forming the sides or “tails” of the bell on either side of the peak represent less frequent but more extreme returns.

Unfortunately, Babbell said, the chances of returns tracking that perfectly symmetrical bell shape in the real world are virtually nil. As a result, financial planning models make false inferences about future market activity and the odds of investors meeting their goals.

In fact, Babbel said, plotting historical stock market returns produces a bell shape that is shorter at its peak, with longer or “fatter” tails, than a normal return distribution would create. That means that in the real world, investors have had more opportunities to experience extreme returns. When registered on the downside of the curve, these tails have dramatically diminished an investor’s chances of having a financially secure retirement.

Investors can minimize such risks, Babbel noted, by investing in products that are less subject to volatility than the stock market. He cited in particular annuities and stable value funds, both of which are backed by investment contracts or wraps.

Babbel has been conducting research on stable value funds for several years, initially under con- tract to the SVIA. Recently, he has continued that research on his own time, in part, he told participants at the SVIA Spring Seminar, because of his continued interest in the surprisingly favorable data his initial research has yielded.

For example, Babbel has calculated that stable value funds stochastically dominate a number of other asset classes, namely money market funds and some sectors of the fixed income market. That is something no other asset class can claim, he reminded Seminar participants. As a consequence, he reiterated, even moderately risk- averse investors should logically make stable value funds a substantial component of their investment portfolio, to the complete exclusion of money market funds and to the almost complete exclusion of government bonds and long-term corporate bonds.

Most financial planning models don’t reach that conclusion. As Babbel sees it, that’s a shortcoming of the models, not stable value funds.