The Markets June 1, 2015

Comparing Target-Risk and Target-Date Solutions

Even with the option to be more conservative or aggressive, most participants still stick to a moderate glide path.
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So says Nathan Voris, large market practice leader for Morningstar Investment Management in Chicago. Similar to the shift from defined benefit (DB) to defined contribution (DC) plans, many in the retirement industry have been moving from target-risk to target-date funds (TDFs). This reflects the trend toward automation as an answer to participant inertia, but are plan sponsors moving in the right direction?

According to PLANSPONSOR’s 2014 DC Survey, target-date funds are available in 69.8% of plans—generally growing in popularity from the micro- to the mega-sized market—while target-risk funds are in pace at just 39.5%—generally falling in favor from smaller to larger plans. Approximately one in four plans offers both types of funds. Interestingly, balanced funds have the highest availability among plans of all sizes, in place at 73.1% of plans overall.

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When it comes to participant understanding, Voris says, “With target-date funds, you need to know what a target-date fund is and be familiar with what you’re invested in. In contrast, if you look at a series of risk-based models, there’s a lot more work to do.” (See “A New Proposal for Monitoring TDFs.”)

Determining participants’ risk tolerance requires many more variables than just their birth date, and individual preferences are likely to change over time—without the participant updating his retirement profile. With risk-based funds, “the assumption is that individual is responsible enough to know he needs to come back and take the [risk-capacity] questionnaire periodically throughout his career.”

For most participants, that level of engagement with the plan is unlikely, and plan sponsors run the risk of having the decisions of a recent post-grad affect the investments of a pre-retiree. “A 25-year old, who may have a long time horizon and be willing to take on more risk, may be in an aggressive portfolio his entire career because he hasn’t come back into the plan; as his risk appetite and time horizon changes, his portfolio doesn’t change along with him.”

As engaged plan sponsors contemplate the challenges of getting the right investment lineup in place, some large and mega plans suggest a simpler approach will help participants perform better.

“What we see less and less of is a plan offering a series of target-date funds as well as a series of risk-based models, conservative to aggressive,” Voris explains. At plans that still have both in place, which account for roughly 25% of respondents to the 2014 PLANSPONSOR DC Survey, the risk-based funds are often a legacy from before the qualified default investment alternative (QDIA) safe harbor was established.

“If a company does decide to add target-date funds to its retirement plan offering, there is certainly going to be a pull to keep those existing risk-based options in the plan. You never want to see plan changes be perceived as a takeaway,” Voris notes. Maintaining a target-risk approach is often the result of a more cultural or corporate decision than an investment one, he adds.

Still, “in the large and mega market, having one risk-based model—maybe a balanced fund—along with a series of target-date funds [remains] relatively common. You see that structure if a balanced fund has been in the plan a long time, even if it has adopted a more modern QDIA,” says Voris. Balanced funds are much more prevalent, he says, and may serve an important purpose in a core menu.

“There are a few hybrid or matrix models, if you will. You might have three risk series—conservative, moderate, aggressive—and then there’s also a time horizon component.” However, Voris adds, “even in those hybrid structures, the overwhelming majority of participants either utilize the default, whatever that would be, or, if they are going through the exercise [to determine their risk preference], they’re nearly all in that moderate glide path.”

In plans where the hybrid option is not available, particularly in the larger end of the market, “You’ll still see a balanced fund, and often it is one of the most-utilized options beyond the QDIA.” All of this suggests that, when participants make active (or even passive) decisions about their investments, they prefer a moderate, or balanced, portfolio. This likely holds true at any age.

The reason for this phenomenon is uncertain. Plan participants are often their own worst enemy, so it may come as a surprise that many favor a course of action that would serve them well both during their career and throughout retirement. But perhaps it all comes down to participants’ lack of financial literacy—a balanced approach certainly sounds appealing, whether one is a new investor (who may not understand what “conservative vs. aggressive” really means) or approaching retirement—facing upwards of 30 years of living off investments.

According to Brian O’Keefe, director of research and surveys for PLANSPONSOR, “Overall, there’s some debate in the industry going on about how much equity exposure retirees should have. Some argue that, since retirees must live for 20-plus years in retirement, the glide path should have more equity exposure or increasing equity exposure during retirement. In many ways, a traditional balanced fund is probably the best solution, versus a more complicated target-date fund, but that’s for the plan sponsor to decide.”

For fiduciaries, who must be held accountable for the plan’s investments, a balanced fund is often perceived as the most defensible position in the target-date/target-risk debate. “[Plan sponsors] have to be aware that risk-based models carry a higher level of burden for the participants. When they’re comparing and contrasting the value of target-date funds vs. managed accounts vs. risk-based models, they really need to be aware and honest with themselves,” Voris says. He suggests asking this question: Are my participants equipped to use a risk-based fund correctly? If yes, sponsors must make sure to provide the education and guidance participants need to get on the right track to retirement readiness.

For plan advisers, who are often named as fiduciaries and must be held accountable for the plan’s investments, a balanced fund may be perceived as the most defensible position in the target-date/target-risk debate as well. But as a consultant to the plan, Voris says, plan advisers need to make sure their plan sponsor clients are aware of the added difficulties of risk-based models. “If they have an opinion that the target-date is superior to the risk-based, or vice versa, they need to make that opinion known.”

Client Service June 1, 2015

Plans Subject to Many Types of Errors

But working with an adviser, auditor, provider and ERISA attorney, sponsors can avoid them.
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Inadvertent errors that 401(k) plan sponsors make are “ubiquitous,” says Natascha George, a partner in the ERISA and Executive Compensation Group at Goodwin Procter LLP in Boston.

“Qualified plans are very complex,” she says. “There are many rules, and they ar­­­e technical.” In fact, she says, plan errors are so common that the IRS for the past two decades has developed formal procedures to help plan sponsors correct errors and avoid being disqualified from tax-exempt status.

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While there are a number of errors that retirement plans can make, if sponsors work with their adviser, auditor and providers, they can avoid them, says Steven Bogner, managing director at HighTower Treasury Partners in New York. It is also important to hire a seasoned human resources (HR) director who has experience overseeing 401(k) plans, he says. The most successful way to avoid mistakes “is ensuring good communication among all of the parties” that are responsible for the plan—human resources, payroll, the retirement plan adviser, the recordkeeper, the accountant, the third-party administrator, providers and Employee Retirement Income Security Act (ERISA) attorneys, George says. “It’s a multidisciplinary process,” she says.

Service providers can be instrumental in discovering mistakes, agrees Fred Reish, chair of the Financial Services ERISA Practice at Drinker, Biddle and Reath in Los Angeles. “In my experience, advisers and plan sponsors are not usually the people who discover the errors,” he says. “Most errors tend to be discovered when there is a change in service providers, third-party administrators or recordkeepers, or through IRS audits. And, on occasion, we are referred into cases where a company is being acquired by another company, and the acquisition due diligence team discovers errors in the administration of plans. Even when advisers find errors, it is usually in connection with some kind of change.”

Most commonly, information is missing on their Form 5500 or audit report, Bogner says. “The Department of Labor can fine you $1,100 a day if you do not file a Form 5500 correctly,” warns Marcia Wagner, principal at The Wagner Law Group in Boston. In addition, Bogner says, “if there is a pattern of failing to transmit contributions on time, plans need to look into that. Plans also sometimes improperly exclude employees from making contributions.” If an employee earns a bonus, sponsors can also have difficulty calculating their compensation and the company match, George says.

“The other area where we are seeing operational errors in the administration of automatic enrollment features,” George says. “Is the plan deferring contributions at the right rate? If the plan document requires annual deferral increases, is the sponsor making them?

The plan could also “be in conflict with its investment policy statement (IPS),” Bogner says. Part of what we do as advisers, is review the IPS as part of our annual fiduciary review,” Bogner says, adding that “a good IPS will not be restrictive because you don’t want to box yourself in.”

The most common error that Wagner sees is “plan documents that aren’t updated.” This occurs because many sponsors use plan document prototypes from providers, she says. “Practically every prototype plan is not updated with all of the legal and regulatory changes,” she says. Sponsors can avoid this error by running the document by an ERISA lawyer to do a “gap analysis,” she says. “401(k) plans are not plug and play; they are complex and worthy of attention.”

Plans also frequently handle automatic enrollment, re-enrollment and auto escalation incorrectly, Wagner says. When an employer acquires a company and ends up with two 401(k) plans, they need to terminate one of the plans or integrate the two plans into one, she says.

When plans reach the size of at least 120 participants, they need to do a full audit, and they frequently overlook this, Bogner says.

Another common mistake, Reish says, is not passing the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test. This can be due to not correctly identifying highly compensated employees (HCE), excluding those who elect not to defer salary from the test, or not using the correct definition of compensation, he says.

Two other common errors found in 401(k) plans are not giving an eligible employee the opportunity to make elective contributions and failing to execute an employee’s salary deferral election, according to the IRS. In both cases, employers can use the IRS’ Employee Plans Compliance Resolution System to make a corrective contribution of 50% of the missed deferral for the affected employee.

Plans can also be in error if they allow a participant to exceed the IRS’ limits on deferrals, Reish says. For 2015, they are $18,000, with an additional $6,000 catch-up for those 50 and older. “The excess contributions over the IRS limit will need to be withdrawn by April 15 in the year following the year the excess occurred,” and if they contributions are not withdrawn by April 15, they “will be subject to double taxation—taxes in the year they were made and in the year distributed,” he says.

Then there is the problem of a plan permitting a participant to take out a hardship withdrawal that does not meet the specifications for a hardship withdrawal, Reish says. “The distribution should only be made on account of an immediate and heavy financial need and should only be for the amount necessary to satisfy that need,” he says. Companies tend to make mistakes with hardship withdrawals when they handle them directly, rather than having their provider do so, Bogner says. As for loans, many plans do not ensure that the money is paid back in a timely manner, Wagner says. Plans also need to ensure that they do not permit loans in excess of the $50,000 maximum allowed, Reish adds.

Plans also sometimes fail to start required minimum distributions, or the required beginning date (RBD), for those who have retired or have reached age 70 1/2, according to the IRS’ website.

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