Why 401(k) advisers should stress-test client portfolios

Why 401(k) advisers should stress-test client portfolios
Traditional methods of performing investment due diligence use models that may not fully correspond to reality.
APR 29, 2019

Managing risk and return is a central responsibility of every investment fiduciary. Asset allocation and securities selection are the blunt instruments used to shape the contours of a portfolio's risk and return profile. The process of building and managing a portfolio is necessarily imprecise because of uncertainty associated with variables inherent to financial markets (endogenous factors) and unexpected major shocks in the world at large that can have financial repercussions, such as geopolitical events or natural disasters (exogenous factors). While exogenous factors are essentially unpredictable, the financial crisis of 2008 led to increasing attention to the development of better methods to evaluate the impact of endogenous factors — most notably, stress testing. A stress test applies simulations of outlier events or conditions to a portfolio to understand how the portfolio would hold up against those conditions. Ideally, a stress test will help fiduciaries better understand the likelihood and potential impact of those types of events and identify safeguards to protect against vulnerabilities. (More: Fiduciary duty and the choice between active and passive) Over the past decade, research has made progress in identifying and evaluating the potential impacts of major endogenous factors. This research explores what has happened at times of extreme disruptions in credit, currency, interest rates, equity valuation, energy supply and other aspects of the financial system. Stress testing then explores the possible impacts of future disruptions of like magnitude on specific portfolios. (More: Stress tests still unpopular with fund industry) Recently, Pew Charitable Trusts performed a pension stress test of the state of Connecticut's two major public pension plans for state employees and teachers. It serves as a good case study of the reasons for — and the results and ramifications of — stress testing. State officials, faced with serious underfunding of Connecticut's pension systems for public employees and concerned about the possibility of a recession or other economic disruption compounding the problem, recognized the need to stress-test the portfolios. The analysis was undertaken to uncover potential future liabilities and guide policymakers' decision-making about the retirement plans and future state budgets. Pew's independent analysis relied on two scenarios, one a "low return" scenario assuming a fixed annual return of 5% on the portfolio and the second an "asset shock" scenario based on the Federal Reserve's stress-test scenarios for banks. The latter scenario included a one-time loss in asset values followed by a period of market recovery and 5% returns afterward (versus assumed 6.9% and 8% returns for the state employees' and teachers' pension funds, respectively). The results were revealing. The state employees' pension fund would face minimal fiscal distress from a recession, but the teachers' pension funding level would fall dramatically without substantial funding increases. In December, prior to the end of his term as Connecticut's governor, Dannel Malloy announced that the pension stress test showed recent changes to the two pension systems "can be used to provide a path to help stabilize" the teachers' pension system, which was found to be in need of action to prevent future spikes in state aid. The projected outcomes for the state employees' system was strengthened by recent reforms that place new employees in a combination defined-benefit and defined-contribution plan, and include a risk-sharing provision that automatically raises workers' contributions if investment returns fall short of the return target. The Connecticut case study points to important lessons for investment fiduciaries serving the retirement-plan market and advisers working with individuals planning for retirement. The Employee Retirement Income Security Act of 1974 and the Restatement of Trusts generally require fiduciaries to act with the care, skill, prudence and diligence that a prudent investor acting in a like capacity would use. ERISA mandates diversification of portfolio investments "so as to minimize the risk of large losses unless under the circumstances it is clearly imprudent to do so." Traditional methods used to make asset-allocation decisions and perform due diligence on securities will usually satisfy these ERISA standards. However, traditional methods rely upon models that presume levels of market efficiency and rationality that are not fully satisfied in reality. Stress testing promotes a deeper understanding of a portfolio's risk-return profile and proactive management to refine that profile. The goal of stress testing is to provide the basis for improved decision-making. For the 401(k) plan adviser, stress-testing can add value in three ways: • First, to evaluate the potential susceptibility of pre-diversified options in the plan menu (default investments, especially proprietary model portfolios) to endogenous factors. • Second, to consider whether certain plan menu options may be particularly exposed or resistant to endogenous factors that may present the greatest current risks, thereby suggesting possible adjustments to the plan lineup. • And third, for advisers providing participant-level advice, to explore how endogenous factors may impact the risk-return profiles of retirement and nonretirement portfolio holdings and future funding needs and priorities. (More: The U.S. retirement system is far too complex)Blaine F. Aiken is president and chief executive of fi360 Inc.

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