Default Thinking

“If target-date funds [TDFs] are the first iteration of the QDIA [qualified default investment alternative], I see managed accounts emerging as QDIA version 2.0,” says Andrew Harbour, head of the Atlanta office of Graystone Consulting at Morgan Stanley.

But Harbour’s practice currently has no clients using managed accounts as their plan’s default investment. “Everybody is asking about [them], but nobody wants to be the first to take the plunge,” he says. “Plan sponsors are wondering, ‘What is this managed account solution that everybody is talking about, and why would we use it as the QDIA?’”

Harbour explains it this way: Think of two 45-year-old employees who have been automatically enrolled into the same target-date fund. “In reality, those 45-year-olds may be in totally different phases of life,” he says. One may be a high earner who has saved steadily for retirement throughout his career and who wants to retire early. The other employee may make a much lower salary, have an uncertain retirement timeline, and may have only recently begun saving for retirement. “So, to make the argument that these two people should get the same target-date fund glide path and the same investments does not make a lot of sense,” he says. “Managed account solutions can take into account factors such as an individual participant’s risk tolerance, account balance, compensation and current deferral rate.”

Yet, just 7% of plans utilize managed accounts as the default investment, compared with 34.5% using active target-date funds and 21.6% using indexed target-date funds, according to the 2016 PLANSPONSOR Defined Contribution (DC) Survey. Harbour understands the current hesitation. “In most cases, it’s an expense ‘drag’—it’s an added cost. Clearly, it is easier and cheaper to use target-date funds,” he says. “But if sponsors’ goal is the best outcome for their employees, taking the underlying investments in a plan and doing a customized allocation for participants will interest them.”

Analyzing the Need
If a sponsor wants to re-evaluate what type of investment to use as its plan’s QDIA, that process starts with fully understanding the value proposition of managed accounts, balanced funds and target-date funds, says Shawn Sanderson, senior product manager at Manning & Napier Advisors LLC in Rochester, New York. “With managed accounts, their prime benefit is the ability to consider a number of factors, beyond a participant’s age, to do the asset allocation,” he says. A sponsor should analyze whether its participant base needs the more customized offering.

That means sponsors need a good understanding of their participant demographics. Asked about the most relevant data to consider, Sanderson points to those relating to new hires, as automatic enrollment generally focuses on that group. If most of a company’s new hires are young, early-career employees, “[they] come in with lower balances, and the conventional wisdom is that they all just need to focus on growth,” he says. So, target-date funds can work well. “But if you have a lot of dispersion in the new-hire demographics, managed accounts could be a viable solution,” he says. Older workers often have more varied finances, he notes.

Harbour recommends taking a closer look at the average retirement-readiness gap of an employer’s staff. “Are the employees ahead of schedule saving for retirement or behind schedule?” he asks. “If an employer has significant concerns about its employees not saving enough, managed accounts would give them an extra level of [customized] glide path, to help them accumulate more. We have two main ways to help participants better prepare for retirement: encourage them to increase their contribution, and offer them a glide path that is more customized to their individual situation.”

Managed accounts can work well for older employees, says Joe Connell, a partner at Sikich Retirement Plan Services in Maple Grove, Minnesota. “But, for young people just starting out, how much financial data does a 25-year-old have to give to a managed account provider to customize the managed account solution?” he says. If an employer has mostly younger workers, that may make it harder to justify managed accounts as the default, he says.

“But if we had an employer that said, ‘We only tend to hire people who are age 50 or older and have complex finances,’ managed accounts could make sense as the default investment,” he continues. “Or, if a sponsor does re-enrollment, you could think about a managed account solution as the QDIA. If re-enrollment picks up everybody in the default investment, that could lower the managed account fee for all participants, so everybody benefits. And, obviously, you would still give re-enrolled participants the ability to opt out of the managed account.”

Gauging the Desire
Besides ascertaining whether a plan’s participants need the increased customization that managed accounts offer, sponsors should get a sense of whether those people want it enough to get engaged. “It is really about trying to determine whether most participants will give the managed account provider the information necessary for it to have a fuller picture of their financial situation,” Sanderson says. Key data points needed include a participant’s individual risk tolerance and assets outside the retirement plan.

Realistically, most average participants do not get involved enough to provide personal data or utilize additional services such as individualized help with retirement-phase budgeting, says Steven Glasgow, senior vice president at advisory firm Avondale Partners LLC in Nashville, Tennessee. Automatic enrollment and default investments are, by their nature, designed for employees who fail to engage with retirement saving.

The issue boils down to a cost/benefit analysis, Glasgow says. “The hurdle there is that, if participants don’t engage with the managed account, for a plan sponsor to make it the plan’s QDIA is just taking on additional expenses in this litigious environment,” he says. “For those participants who will provide that information, I think it can be a great option. But if you’re talking about the percentage of participants who will answer all the questions to customize a managed account allocation, you’re usually talking about a small group—maybe 10% to 15%.”

Recent technological advances do allow managed account providers to get increasingly more data about individual participants, even if they stay uninvolved, says Jason Shapiro, senior investment consultant at Willis Towers Watson in New York City. “Ten years ago, the only piece of information that a managed account provide got was usually a participant’s balance, and maybe the participant’s age and salary,” he says. “Today, managed account providers can often get data such as a participant’s contribution rate, whether [the person] has pension plan benefits or any other retirement plans in the current workplace, and sometimes data on a spouse’s retirement plan accounts.” The growing availability of data about defaulted participants who fail to provide additional information themselves “helps respond to the argument that if participants don’t engage, all you as a sponsor are providing them [with a managed account] as a QDIA is a more expensive target-date fund,” he says.

Advisers can help sponsors look at several kinds of data to judge whether their participants engage enough to make managed accounts worthwhile, Connell says. Examine email-response data from the plan’s recordkeeper to see what participants’ “open” rates and “action” rates are for educational emails, for example. Also, review attendance numbers and patterns for group meetings held to discuss the retirement plan, he suggests.

Connell notes that an adviser also can help put together a brief employee survey, using a tool such as SurveyMonkey, to gauge participant interest in managed account features. He mentions a couple of possible questions: Is the participant interested in a more hands-on professional management of his 401(k) account, including a customized investment allocation and recommendation concerning the appropriate savings rate? Would the participant feel comfortable providing more-detailed information about his life to the managed account provider?

“Keep it pretty simple: just a few questions, and yes or no answers,” he recommends. “Then, if participants don’t respond to that survey, do you really think they are going to fill out a managed account provider’s questionnaire?”

Considering the Fees
Some of Avondale Partners’ larger-plan clients are considering switching to managed accounts as the default, Glasgow says. “But the issue is that managed accounts do come with pretty high fees. They can carry a price tag that is 50 or more basis points [bps] higher than target-date funds—maybe less, depending on the size of the plan,” he says.

It costs more money to provide more customized investments and services, of course. Another factor: The market for such services in 401(k) plans remains concentrated among a few companies, Shapiro says. “Less competition is one of the reasons why the fees remain at the levels they do. Most of the market is being serviced by the three main providers,” he says, meaning Fidelity Investments, Financial Engines Inc. and Morningstar Inc. “If you look at the major recordkeeping platforms, one of those three providers often is the sole choice for managed accounts.”

Complicating the issue of sponsors justifying managed accounts’ higher fees, they and their advisers face more difficulty benchmarking the investments’ performance, Sanderson says. Customization means managed accounts have more varied allocation models for a plan’s participants than do target-date funds. “If target-date fund families have 10 or 11 investment vintages, managed accounts might have 50,” he says. “It is just an overwhelming amount of performance data to benchmark. And, in many cases, you don’t have peer groups: There’s not as much publicly available third-party data for managed accounts.”

Advisers working with sponsors that are evaluating this default-investment change should help them document the process carefully. “If sponsors are going to think about managed accounts as a default, they need to have a clear understanding of, ‘Why do we want to go that way?’ If they are going to introduce a more expensive QDIA, they need to have a rationale for it,” Glasgow says. “If I have one piece of advice for sponsors that are going to do it, it is this: Be explicit  in the committee minutes about your reasons for doing it and document your analysis.”

Sources say managed accounts likely will not make major headway as a default until fees decline. Shapiro sees potential in hybrid default investments being rolled out by providers including Fidelity and Empower Retirement. These combine target-date funds and managed accounts. “Younger new hires are defaulted into age-appropriate target-date funds. And then, at some trigger point determined by the sponsor [such as reaching age 50], they are automatically switched over to a managed account, unless they opt out,” he explains. The hybrid model could help address sponsors’ cost concerns, he says.

“It’s exactly the idea,” he says. “Early on, participants pay a target-date fund fee. Then, once they have the crossover to a managed account, they pay a managed account fee.”

Key Takeaways

• Unlike target-date funds, managed accounts take into consideration factors such as a participant’s risk tolerance, account balance, compensation and deferral rate.
• While lower-cost target-date funds may be a good solution for younger investors, managed accounts may serve older ones better, as these people have more complex finances.