Making Matters Worse: The 2006 Pension Protection Act

        Remarkably, Congress recently passed legislation strongly deterring financial planning software makers from ever departing from the two most dangerous flaws common to modern financial planning software: (1) modeling future performance with indefensibly optimistic historical returns, and (2) modeling future portfolios using historical asset class correlations.  Making matters even worse, the legislation strongly discourages software makers from calling attention to the benefits or comparative safety of TIPS.

Exempt computer software programs can only model the past?

        The Pension Protection Act of 2006 provides exemptive relief for a certified computer-program-based investment advice program from certain prohibited transaction provisions. To qualify, section 408(g)(3) requires that the computer model “appl[y] generally accepted investment theories that take into account the historic returns of different asset classes over defined periods of time” and “utilizes prescribed objective criteria to provide asset allocation portfolios comprised of investment options available under the plan.” 

        In 2006, the Department of Labor, pursuant to that act, issued a Request for Information regarding such computer models. In 2007, the Securities Industry and Financial Markets Association (SIFMA) responded to that request for information.  In a January 31, 2007 letter, SIFMA submitted – without qualification – that computer “[m]odels are based on mean variance optimization, and the program uses expected volatility and expected return, based on historical performance, to provide asset allocation and investment product results.” SIFMA also wrote: “The process used for designing the model is quite straightforward. The model is loaded with risk and return characteristics for each asset class represented in the plan, based on publicly available information.”  This can only mean that SIFMA endorses a history-will-repeat-itself approach to financial planning.

Exempt computer software programs cannot model the performance of an all-TIPS or TIPS-favored portfolio?

        Paragraph (d)(1) of a proposed Department of Labor regulation implementing the Pension Protection Act of 2006 would prohibit a qualifying computer model from “giving inappropriate weight to any investment option.” 73 Fed. Reg. 49895, 49899 (Aug. 22, 2008). This regulation would, in effect, prohibit a qualifying computer program from comparing the risks and rewards of a diversified portfolio with an all-TIPS portfolio. Prospercuity found no commentary discussing this potential consequence of the rule.

Conclusion

        Until the flaws of the conventional approach to modeling equity returns are widely recognized, and both the industry and the law are transformed by that recognition, millions of 401(k) participants and financial advisory clients will continue to have their expectations unrealistically raised, followed by almost inevitable disappointment and cynicism.

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