It sounds like the ever-elusive free
lunch—an investment strategy that reduces the potential for major losses while
still pursuing the market’s strongest opportunities for growth.
But that’s exactly
what an increasing number of investors are demanding in the wake of the 2008
financial crisis, says Bradford Campbell, counsel with Drinker Biddle &
Reath LLP and former head of the Department of Labor's Employee Benefits
Security Administration (EBSA). It’s an especially pressing demand in the
retirement planning context, where investors feel the long-term outlook that
dominates decision making about defined contribution (DC) plan investment menus
doesn’t sufficiently address shorter-term volatility concerns.
One important theme is
the particular set of challenges facing plan participants as they close in on
their projected retirement date. At this point the participant has less time to
recover from dramatic downturn events, but as average lifespans lengthen and
the cost of medical care and other necessities increases, there is also a
pressing need for continued equity exposure to help ensure workers’ assets last
considerations can leave a participant floundering for the right investment
choices, especially as he nears retirement age. Further compounding the
confusion is the fact that many of the target-date fund (TDF) products that
automatically reduce an investor’s equity exposure as he nears retirement also
suffered major losses in 2008, calling into question whether the general idea
of favoring bonds and fixed income in later years offers sufficient downside
protection to those who need it most.
One popular type of
product involves giving active fund managers the ability to convert much or all
of a portfolio into cash when indications arise that markets are going to turn
sour, Campbell says. This strategy may not protect portfolios from all loses,
but it should help active managers stop portfolios from losing one-third or
more of their value during major downturns—as occurred for many in 2008.
Campbell says, for
plan fiduciaries, it’s important to remember the duties imposed by the Employee
Retirement Income Security Act (ERISA) when thinking about these matters. He
says there is a common perception that ERISA is a conservative statute that
looks skeptically on new products and strategies that exist in the wider
investment marketplace but have not been popularized for workplace retirement
investors, but this is not necessarily true.
“The ERISA statute
does not demand that you always do what you’ve done before,” Campbell says.
“It’s a statute that says you have to go through a prudent process for the
circumstances you now find yourself in. So in that sense it’s a law that
requires ongoing monitoring and deciding whether new issues, products and
circumstances require you to make a change. So in fact you won’t always be
protected under ERISA if you keep doing the same thing.”
The upshot for plan
fiduciaries and the downside-protection conversation, Campbell says, is that
it’s not hard to imagine a future where it could be considered imprudent not to
offer participants better downside protection, should these products prove to
be effective and powerful tools. In other words, plan fiduciaries have a duty
to monitor new types of products and, in appropriate circumstances, to bring
those new products and services into their own plan.
So in the same way
that TDFs and other relatively new investment strategies are quickly becoming
normalized in the ERISA retirement plan context, so too could
downside-protection products become an essential part of the DC plan investment
lineup as market conditions change.
In the case of
products that move aggressively into cash when downturns start or appear
imminent, a fiduciary should be aware of what extreme asset allocations are
possible in the strategy. This is especially true when downside-protection
products are used as a plan’s Qualified Default Investment Alternative (QDIA),
as there are rules limiting extreme allocations in QDIAs.
When assessing the
risk tolerance levels of plan participants, fiduciaries may also find that some
participants have risk tolerances that are not static, but instead are adaptive
based on the market environment. These participants may prioritize the
protection of principal in weak markets, but could be willing to take on
greater risk when markets are healthy, suggesting more dynamic products are
necessary in the fund lineup.
Such participants may
not find the benchmark-centric risk structure of traditional equity funds or
intermediate bond funds to be an appropriate match for their particular risk
tolerances as—by design—these investments do not seek to protect against
significant market loss. For these investors, Campbell says fiduciaries should
consider offering investment options that have a focus on downside risk
here for the original article from Plan Sponsor.