Hybrid QDIAs Can Help Preserve Retirement Income

DC plan sponsor clients can leverage both TDFs and managed accounts together to maximize outcomes.

There are different ways the industry is defining hybrid qualified default investment alternatives (QDIAs), but generally it is when a certain segment of a defined contribution (DC) plan participant population is first defaulted into one vehicle, and then later defaulted into a different vehicle when certain triggers are met, according to James Martielli, head of Vanguard Defined Contribution Advisory Services, in Malvern, Pennsylvania. The triggers for changing defaults could be account balance or age.          

Holly Verdeyen, senior director, defined contribution strategy at Russell Investments in Chicago, adds that a hybrid QDIA blends multiple types of QDIAs, such as a target-date fund (TDF) or balanced fund with a managed account. For example, she says, a younger participant may be defaulted into a TDF or balanced fund then moved to a managed account based on age or what she calls “funded status,” which is the amount of income replacement in retirement the participant’s account balance would provide.

“TDFs and balanced funds tend to keep static allocations until participants are in their late 30s or early 40s, then derisking occurs,” Verdeyen says. She notes that an age trigger would probably be 10 to 15 years prior to retirement, and a funded status or account balance trigger would be when someone is approaching fully funded status based on their retirement income need. “A managed account can preserve that funded status better than a TDF,” she contends.

According to Verdeyen, a properly structured managed account will be able to adapt to changing participant circumstances and market conditions; if market conditions lower a participant’s funded status, a managed account could adjust for that. Likewise, if market conditions improve a participant’s funded status, a managed account could derisk, like a pension plan, to preserve the higher funded status. “A TDF will keep rolling on its glidepath, but a managed account could change with market conditions,” she says.

As for participant circumstances, Verdeyen notes that if a participant gets a raise, which would help his or her funded status, a managed account portfolio could be adjusted. The same is true if the participant stopped contributing to the plan, hurting his or her funded status.

NEXT: To default or not to default

Martielli says a TDF series and a managed account program can be complementary in a DC plan investment lineup. “A managed account can be good for participants, but they are particularly effective for those who are engaged and will provide the managed account manager with more information, such as risk preferences, assets outside of the plan, and desired income replacement ratio,” he says. “So we believe there is a place for managed account programs in a DC plan investment lineup.”

But without that engagement and without knowing a lot about participants, defaulting participants into a managed account program when they reach a certain age or balance will increase costs for them, Martielli says. He notes that managed accounts are two or three times more expensive than TDFs. “However, the benefit of a hybrid QDIA may be uncertain, especially for non-engaged participants who don’t reveal customization drivers,” he adds. “If we know nothing more than age, the most important thing is a gradual derisking as participants age and approach retirement.”

“We are still big believers that TDFs are the most appropriate QDIA option for plans,” Martielli states. He notes that Vanguard’s How America Saves study finds that of the 53% of participants who use professionally managed funds, 46% hold a single TDF, 49% hold a single target-risk fund or a balanced fund and 4% use a managed account program.

According to PLANSPONSOR’s 2016 DC Survey, 65.7% of plans use a TDF as the default investment option, 10.9% use a balanced fund and 7% use a managed account program.

Verdeyen says with a hybrid QDIA, the managed account provider is able to get more information, due to technology, from recordkeeping platforms. They can automatically pull more data such as a participant’s salary, gender and contribution amount.

However, Martielli argues Vanguard found in its research that the biggest levers in portfolio customization are risk preference and outside assets, and managed accounts can’t get that from a participant who is not engaged or from the recordkeeper.

Verdeyen concedes that a managed account cannot always get outside assets from the recordkeeper, but she says, with managed accounts, it is easy for participants to provide that information. “Participants are given their funded status and encouraged to provide additional information, and technology makes that easy,” she says.

“Managed accounts can be a complement to TDFs and should be a part of a DC plan’s investment lineup, but we are not a big believer in defaulting to them if participants are not going to be engaged and give the manager critical info to make a customized portfolio,” Martielli says.

NEXT: Costs and other considerations

“When talking about defaults, the only thing we know for sure when it comes to returns is the costs participants are going to pay, so we would recommend TDFs as an appropriate lower-cost asset allocation, absent knowing additional information in order to customize managed accounts,” Martielli says.               

Verdeyen concedes that costs for managed accounts could be a prohibited factor to hybrid QDIAs, so it is an important consideration for plan sponsors. But, with enhanced service and customization, there is some value with managed account that warrants slightly higher fees. “Managed accounts include advice costs which can’t be controlled, but investment costs can be controlled by deciding which underlying investments are used,” she says.

Verdeyen adds that since managed accounts keep working through retirement, it makes sense to pair them with a TDF that goes to retirement so participants will have a “through retirement” strategy.

She also says DC plan sponsors might want to consider whether a managed account makes sense for the entire plan as a default, as they offer several benefits to younger and older participants. Many younger participants change jobs often, and managed accounts offer the ability to accommodate outside assets. And, customizing asset allocation based on market conditions and changing participant circumstances is an advantage to the young and old alike.           

In addition, Verdeyen says, managed accounts report participants’ funded status even when they are far from retirement, so they can do something about it and make decisions all along their working career.