A QDIA in Transition

Art by Nick Little

“One thing we’ve learned as an industry is that ‘auto’ solutions work,” says Sangeeta Moorjani, head of workplace product marketing and advice at Fidelity Investments in Boston. Fidelity is now among the providers pioneering an evolution in automated plan design: qualified default investment alternatives (QDIAs) that seek to move participants by default into the right investment at the right time. Most often, that will mean automatically switching participants, unless they opt out, from a default target-date fund (TDF) into a managed account when they reach a predetermined trigger, such as age 50.

“‘It’s a very appealing concept,’ is what we’re hearing from the [sponsor] marketplace,” says Holly Verdeyen, senior director of defined contribution (DC) strategy at consultant and asset manager Russell Investments, in Chicago. “In terms of evaluation, we’re talking to sponsors about it. But in terms of movement, we haven’t seen sponsors start using these hybrids yet.”

Investment consultant Callan LLC has no plans so far that have implemented hybrid QDIAs, but it has talked with sponsors about the approach’s viability, according to James Veneruso, senior vice president with Callan in Summit, New Jersey. “There are very good arguments for it,” he says. “But, practically speaking, there also are issues.”

Advantages of Going Hybrid

“[TDFs] are admittedly a pretty blunt instrument, and they take into account just one aspect about a participant: age,” Veneruso says. A managed account can incorporate other factors, such as a participant’s outside assets and risk tolerance, in its allocation. “It can really give participants a more finely calibrated asset allocation, and that becomes a bigger issue as a participant ages,” he notes.

The idea behind hybrid QDIAs makes sense, says Michael Esselman, director of investments at 401k Advisors Intermountain, in Sandy, Utah. “When we graduate college, we are all in the same boat financially. But, as people get older, the gap in their circumstances and their finances widens. By the time you turn 55, your financial picture of where you’re heading to in retirement starts to finally become a little clearer,” he says. “If at that point you can get a customized asset allocation based on a holistic picture of your savings, it helps.”

According to Verdeyen, the key is to make the transition from a TDF to a managed account at a time when the participant can benefit from it the most. “Pre-retirees have a shorter time horizon to retirement, and they have a more complex financial picture than younger participants do,” she says. Moreover, “pre-retirees’ need for additional financial-planning resources cuts across a lot of demographics.”

To get an initial idea of whether it makes sense to consider switching to a hybrid QDIA, advisers can help plan sponsors look closely at their participant demographics. “If they know their demographics are unique in some way—maybe they have a frozen DB [defined benefit] plan, for example—the greater the differences in the demographics of participants, the less likely that a single default investment solution will be able to satisfy participants’ needs,” says Brian Cosmano, vice president of strategic product initiatives at Great-West Investments, in Greenwood Village, Colorado.

If a plan has an older and/or heterogeneous population, this is more reason to consider a hybrid QDIA, Veneruso says. For instance, the different employee groups in a hospital—doctors, nurses, support staff and administrative workers—likely have very different financial circumstances, especially on the cusp of retirement. “That definitely provides an argument to go in the direction of something more customized for the QDIA,” he says.

Awaiting the Early Adopters

Empower Retirement’s recently launched hybrid, Dynamic Retirement Manager, tries to correct two limitations of TDF defaults, Cosmano says. First, the hybrid can give older participants a customized asset allocation in a managed account. “We don’t believe that a single target-date fund can be the right solution for every investor, at every stage of their life,” he says. “By age 50 or 55, you see some participants who are in a very good position and others who are just starting to save. Those are very different positions that require very different investment allocations.”

And, second, once older participants get switched to a managed account, they can get help with broader decumulation-planning issues, such as finding the right rate at which to withdraw their money once they retire. Empower has a handful of plan clients that scheduled an early 2018 implementation of its hybrid QDIA, Cosmano says.

With its hybrid Smart QDIA, Fidelity has opted not to limit sponsors to age only as the trigger for transitioning to the managed account. “We felt very passionately about allowing plan sponsors the functionality to use multiple criteria if they want to do that,” Moorjani says. So, for example, a sponsor might choose to default participants into the managed account only when they reach age 50 and have at least $50,000 in their account.

Fidelity has been actively dialoguing with several sponsors about using Smart QDIA, but, as of early this past December, none had yet implemented it. Once a handful of large sponsors start using the hybrids, sponsor and provider interest may grow, says Jason Shapiro, senior investment consultant at Willis Towers Watson in New York City. “Right now, Empower and Fidelity are the providers actively marketing these hybrids,” he says. “I have talked to other providers about this hybrid concept, and they’re consistent in saying that when the demand gets there, they can create something quickly, from an operational perspective. Providers have told me, ‘We would do this, but we just haven’t seen the demand yet.’”

Not all recordkeepers, however, feel comfortable with hybrid defaults. The Vanguard Group Inc. has a couple of concerns, says James Martielli, head of defined contribution advisory services at the company, in Valley Forge, Pennsylvania. “One is the engagement. Yes, once participants get close to retirement, there tends to be higher engagement. But it’s not universal, for sure,” he says. “The second thing—and the key thing—is that it’s about defaulting participants into a more expensive investment they haven’t actively chosen. When you transition a participant into a managed account, you have a certain increase in cost, with uncertain benefits to the participant in return.”

The Value of Customization

Certainly, concern about fees may explain the tentative sponsor interest so far. Shapiro explains that fiduciaries under the Employee Retirement Income Security Act (ERISA) need not offer participants the lowest fee option available, but they do need to make sure participants get value for the fees they pay. “So the first question to ask about hybrids is, ‘What [is the] cost, and what are the value points my participants are going to receive in return?’” he says.

If a managed account were cost-competitive with a TDF, “that [would be] a great service for participants,” Esselman says. “But, in reality, you’re moving participants into a managed account that probably costs at least 10 to 20 basis points [bps] more than a plan’s target-date fund. Many managed accounts are 50 to 75 basis points, and that’s pretty high, especially if you’re defaulting people into those investments without knowing whether they will engage.”

To justify the fee, sponsors may want to feel confident that many of their defaulted participants will voluntarily play an active role once they transition to a managed account. The challenge with hybrids lies in getting participants involved and motivating them to use tools such as a risk-tolerance questionnaire at the time they are defaulted, Esselman says. “If you can get a 50% utilization rate or higher on managed account tools, then the added expense may make sense,” he says. “The actual utilization varies by plan, but we find that it’s often in the 8% to 10% range for managed accounts.”