What Is a Prudent Investment? Using Simulation to Evaluate Investment Selections
Under the Employee Retirement Income Security Act (ERISA), plaintiffs may file suit alleging that the selection of certain retirement investments was imprudent. Such litigation occurs after a retirement plan incurs substantial losses.
In his article “Expert Analysis: Using Simulation to Assist Courts in Assessing the Prudence of Retirement Plan Investment Decisions” (Bloomberg BNA’s Pension & Benefits Daily), Managing Principal D. Lee Heavner describes some approaches that experts use to evaluate issues related to the procedural and substantive prudence of the selection of a retirement plan investment. He also offers a case study that illustrates how simulation analysis can be used to evaluate whether a decision resulted in an appropriate balance of expected return and risk.
The case study involves a dispute over the prudence of the selection, in December 2007, of a target date 2020 fund for a retirement plan. The selected fund had a higher allocation to equity than most other target date 2020 funds and incurred substantial losses when the stock market declined precipitously in 2008. Plaintiffs alleged that the selection of the fund was imprudent because the fund’s asset allocation made the fund excessively risky.
However, the defendant’s expert’s simulation analysis in this case showed that there was a 75-percent probability that the selected fund’s asset allocation would outperform the allocation that the plaintiffs’ expert opined was prudent. The analysis showed that this greater likelihood of outperformance came with a 1-percent increase in the probability of negative returns. Based on these and other analyses, the expert opined that the selected fund’s asset allocation was appropriate for the fund at issue.
Moreover, the simulation approach allowed the expert to explain the return-risk tradeoff associated with investment selection without requiring the court to understand more complex statistical concepts. According to Dr. Heavner, “Simulation not only offers a way to evaluate the statistical properties of longer-period returns, but it also provides experts with a more ready format with which to communicate these complex findings in a way that is intuitive and accessible to the court.”
For a retirement plan investment that selected a 12-year target date mutual fund, simulation analysis can assess the return-risk tradeoff of asset allocations by generating average annualized returns for thousands of 12-year return series for 80/20 allocations and 65/35 allocations.
Simulation Results: Allocation to Equity/Fixed Income Distribution of 12-Year Annualized Returns 80/20 65/35 Average annualized return 9.8% 9.1% Standard deviation of annualized returns 4.8% 3.9% Probability that ... ... the portfolio outperforms 75.4% 24.6% ... the annualized return is at least 0% 97.8% 98.8% ... the annualized return is at least 5% 84.0% 85.5% ... the annualized return is at least 6% 78.2% 78.6% ... the annualized return is at least 6.25% 76.8% 76.8% ... the annualized return is at least 7% 72.3% 71.1% ... the annualized return is at least 8% 64.9% 61.8% ... the annualized return is at least 9% 57.3% 52.2% ... the annualized return is at least 10% 48.6% 41.7%
Adapted with permission from Pension & Benefits Daily, Vol. 14, July 15, 2014. Copyright 2014, The Bureau of National Affairs Inc. www.bna.com