Asset Allocation Programs: Regulatory Issues Surrounding Use with Variable Insurance Products

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1 ALI-ABA Conference on Life Insurance Company Products November 3-4, 2005 Asset Allocation Programs: Regulatory Issues Surrounding Use with Variable Insurance Products By Jeffrey S. Puretz Alison Ryan Dechert LLP

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3 ASSET ALLOCATION PROGRAMS: REGULATORY ISSUES SURROUNDING USE WITH VARIABLE INSURANCE PRODUCTS ALI-ABA Conference on Life Insurance Company Products November 3-4, 2005 Jeffrey S. Puretz Alison Ryan 1 Dechert LLP Tis the part of the wise man to keep himself today for tomorrow, and not venture all his eggs in one basket. --Miguel de Cervantes, Don Quixote de la Mancha, 1605 I. Introduction: A. What is Asset Allocation? Asset allocation is a fundamental investment decision. It involves a determination of the portion of assets in an investment portfolio that should be invested in each of several types of securities or asset classes. The asset allocation decision does not address which securities to buy, but rather how to divide the investor s wealth among asset classes. B. Developing the Efficient Frontier In making investment decisions an investor faces an inherent tradeoff between risk and expected return. The seminal work on asset allocation was done by University of Chicago trained economist and Nobel laureate Harry Markowitz, who in his doctoral dissertation, published in 1952, identified each possible portfolio that would minimize risk for a given level of expected return and maximize the expected return for a given level of risk. 2 When these portfolios are entered onto a graph, they form a curved line that Markowitz called the efficient frontier, 1 The authors wish to thank their colleague, Patrick Cowherd, for his assistance with this outline. 2 Harry M. Markowitz, Portfolio Selection: Efficient Diversification of Investments, New York: John Wiley & Sons 1959; Mean-Variance Analysis in Choice and Capital Markets, Oxford: Basil Blackwell Ltd, See also Paul D. Kaplan, Asset Allocation Models Using the Markowitz Approach (January 1998). Available at:

4 which graphically presents the tradeoff between risk and expected return confronting an investor. 3 Given the expected return and standard deviation for each asset class and the relationship between returns among the various asset classes, Markowitz s model, which is referred to as means-variance optimization, can compute the weight to be given to an asset class to provide a portfolio with maximum expected return for the corresponding level of risk. 4 Markowitz, along with American economists William Sharpe and Merton Miller, showed that each investment carries a quantifiable risk and expected rate of return, and that by diversifying assets, a portfolio may have a higher return potential with a lower level of risk than the portfolio's components would achieve separately. 5 Their work has made it easier for investment professionals to create asset allocations that can be adjusted for expected risk and expected return characteristics, which can be catered to an investor s risk tolerance and return expectation. 6 Asset allocation analysis is useful because it provides opportunities for investors to reduce risk through correlation across classes of assets. 3 See Harry M. Markowitz, Portfolio Selection: Efficient Diversification of Investments, New York: John Wiley & Sons 1959 and Mean-Variance Analysis in Choice and Capital Markets, Oxford: Basil Blackwell Ltd, Kaplan, supra note 2. Generally an estimate of an asset classes expected standard deviation is based on past standard deviations from a recent historical period. See also Scott L. Lummer, Mark W. Riepe, and Laurence B. Siegel, Taming Your Optimizer: A Guide Through the Pitfalls of Means-Variance Optimization,, Global Asset Allocation: Techniques for Optimizing Portfolio Management, ed. Jess Lederman and Robert A. Klein, John Wiley & Sons (1994). Available at: 5 Messrs. Markowitz, Sharpe, and Miller shared the Nobel Prize in 1990 for their pioneering work in asset pricing and allocation. 6 Scott L. Lummer and Mark W. Riepe, The Role of Asset Allocation in Portfolio Management, Global Asset Allocation: Techniques for Optimizing Portfolio Management, ed. Jess Lederman and Robert A. Klein, John Wiley & Sons (1994). The authors note that Markowitz s model, when initially developed, was only applied to portfolios of individual stocks. It has increasingly been used in the context of asset classes and may actually be better suited to asset class levels because the information needed for the Markowitz Means Variance model is easier to estimate for asset classes than for individual securities. Further, the range of asset classes available to investors is now considerably larger than it had been at the time that Markowitz first developed his model. Available at: 2

5 The initial step when applying Markowitz s model is to divide the capital markets into general asset classes, for example, large cap stock, small cap stock, foreign stock, bonds, and cash instruments. The next step would be to determine the expected return and standard deviation for each of the asset categories and what correlations exist between the groups. This information is generally drawn from various asset classes past returns and the present economic conditions. 7 Plugging this information into an algorithm produces the efficient frontier. Selecting an efficient portfolio can maximize the expected return for a given level of risk. II. Historical Note: Restrictions on Investment Discretion Early trust law restricted the investment discretion of trustees. English common law established the principle that trustees could only invest the trust s funds in government securities or real property-based securities. 8 States, including New York, New Jersey, Ohio, and others, enacted statutes that provide that in the absence of explicit authority in the instrument creating a trust, the trustee could not invest the trust s funds in corporate stock. 9 The rationale underlying these restrictions was the belief that corporate stock was too speculative and based too heavily on uncertainties such as public opinion, future earnings, and the character of the company s management. These elements were viewed as too unstable for trust funds. Rather, government securities and securities that were fortified by liens on tangible assets were deemed to be more suitable for trust investments because they were considered less likely to fail. 10 Courts, in discussing these statutes, have noted that the reason trusts were created was to preserve their funds until the purposes spelled out in the instrument had been fulfilled. Courts further noted that permitting the trust to make risky investments could defeat the purpose of 7 Kaplan, supra note 2. 8 White v. White, 230 Ala. 641, 162 So. 368 (1935). The Alabama Supreme Court noted a 1852 decision from the Supreme Court of Pennsylvania which stated that at that point, In England it has been held for more than a century past to be settled law, that a trustee can only protect himself from risk, when he invests the trust fund in real or government securities, or makes the investment in pursuance of an order by the court. 9 See Scott on Trust s, vol. III. See also Matter of Carnell s Will, 260 App. Div 287, 290, 21 N.Y.S.2d. 376,379, affirmed 284 N.Y. 624, 29 N.E.2d. 935 (1940). 10 White v. White, 230 Ala. 641, 162 So. 368 (1935). The Supreme Court of Alabama construed a provision of the state s constitution which established a policy that a trustee could not invest in corporate stocks or bonds. The court noted, however, that the provision did not apply in cases where a trustee had been given discretionary power under the trust instrument. See also Sims v. Russell, 236 Ala. 562, 183 So. 862, 863 (1938). See also In Re Durrin s Estate, 61 Wyo. 1, 154 P.2d. 348 (1944), noting that in Wyoming a trustee could only invest trust funds in corporate stock if they had been authorized by a court, who had considered the soundness of the investment. 3