Patience is essential in reaching lofty goals like helping defined contribution participants improve retirement income. It’s also important to celebrate progress that has a real impact. But there is a danger of becoming complacent before the “summit” is reached.
For example, automatic enrollment of employees into 401(k) plans, made safe for employers by the 2006 Pension Protection Act, has been successful as a way to get employees enrolled, but if plans stop at the minimum 3% deferral rate specified in the Act and do not also use an auto-escalation feature to get deferral rates up to at least 10%, not only may we not help participants reach their goals, but there is also a danger that they may think that they only have to save at a 3% rate.
The same principle applies to a match by employers that affects deferral rates, as people may tend to save only up to the amount that will trigger the match. If the plan sponsor is willing to offer a match of 50% of the first 6% saved by the participants, for example, why not stretch it to 25% of the first 12%?
Similarly, while target date funds (“TDFs”) have been valuable for the vast majority of 401(k) and 403(b) plan participants who want to delegate investment decisions, they are not the “ultimate” investment strategy. In our view, pre-packaged TDFs may be better investment options for participants than individual options that require participants to build, monitor and rebalance their own portfolios, but we also think that offering every participant born within a five-year period TDFs with the same underlying asset allocation is a crude approach at best.
Managed Accounts and Customization
What lies beyond TDFs? We believe it is individual managed accounts, especially in a world where people expect customization.
In our view, factors used in offering retirement investment strategies in defined contribution (“DC“) plans should mirror those in defined benefit (“DB”) plans, which use liability-driven investing, or LDI, methods. DB plans assume risk according to their liabilities. If the DB plan is well funded, less risk is taken; if not, then the plan has to either increase funding or be more aggressive.
Similarly, we believe that DC plan investment options should take individual participants’ risk appetites and liabilities into consideration. As such, plan recordkeeping systems’ data can be used to evaluate salary, deferral rates and account balances of participants, which, along with their available outside assets and risk tolerances, can inform the participants’ allocations within the defined contribution plan.
Increased Deployment
Use of managed accounts available in most DC plans is still in the single digits because participants are plagued by inertia and uncertainty. However, recordkeepers are increasingly deploying them as the qualified default investment alternative, which should boost usage just as it did with TDFs.
Not only do managed accounts provide for customized portfolios to match a participant’s assets with liabilities, but they give advisers a greater role in the selection of investments that go into the managed account. Many TDFs include only proprietary assets of the employer and very few if any allow the adviser to select the underlying assets—something that, in a sense, eliminates one of the valuable services they provide. With participants in a managed account, advisers interested in engaging with them can dive deeper, potentially helping them with outside assets.
But there are issues.
More Complex and Costly
Monitoring managed accounts is more complicated than with TDFs. How do you benchmark potentially hundreds if not thousands of portfolios?
Though many money managers are trying to offer their own version of managed accounts, they must get the cooperation of recordkeepers, which can be tricky, especially if that recordkeeper has its own. Firms like Morningstar and NextCapital are helping to build the plumbing, but platform cooperation is still required.
Some larger advisory practices are starting to build their own managed accounts so clients do not have to switch when there is a recordkeeper change, but that takes more time and resources than the average adviser has.
Moreover, the costs are greater, and some experts say they are not worth paying until the participant is 50 years old or has a significant amount of assets
A Great Next Step
Helping and engaging DC participants with minimal assets is a challenge—they cannot afford traditional advice. TDFs, while simple, are crude and do not engender engagement. Managed accounts are a great next step on the journey to improve retirement prospects for the masses as well as provide a greater role for advisers in the investment process.
