Choosing default investment alternatives for 401(k)s requires close due diligence
Posted by fi360 on May 27, 2016
By Blaine F. Aikin
Maximizing the potential for positive participant outcomes, and minimizing regulatory and litigation risks, requires close analysis of QDIAs
Target date funds are the runaway top choice to serve as the default option for 401(k) plans. According to the Plan Sponsor Council of America, over 80% of all 401(k) plans elect to use a Qualified Default Investment Alternative (QDIA) and over 75% of plans electing a QDIA use TDFs.
Brightscope reports that plan assets invested in TDFs already exceed $1.1 trillion ($700 billion as of 2014 invested in TDFs using mutual funds, $400 billion invested in collective investment trusts and pooled managed accounts) and are likely to hit $2 trillion by 2020.
But successfully gathering assets doesn't necessarily mean that a TDF is the right choice for every plan's QDIA. It certainly doesn't mean that TDFs are well-suited for every plan participant.
TDFs have become so ubiquitous and so heavily marketed that plan sponsors and their advisers often skip right past the essential question of which of three available QDIA options is most appropriate for the plan participants.
Instead, the plan fiduciaries assume a TDF is appropriate and move directly to decide which type of TDF (off-the-shelf or custom) and which TDF provider to use. The quick and overwhelming popular choice ends up being an off-the-shelf solution from one of the top three TDF providers — Fidelity, Vanguard, or T Rowe Price.
Plan fiduciaries should not act hastily in choosing a QDIA. The Pension Protection Act of 2006 created a safe harbor for plan sponsors to avoid fiduciary liability for placing plan participants who fail to specify how their contributions are to be invested in any of three pre-diversified alternatives. The three approved QDIAs are TDFs, a diversified product or portfolio with a target level of risk that is appropriate for the participants overall (such as a balanced fund), or a managed account customized to account for certain participant characteristics. The safe harbor protects the plan sponsor from liability associated with losses that may occur in the QDIA.
Safe-harbor protection is conditional on the fulfillment of certain conditions. While not explicitly stated in the rule, it stands to reason that plan fiduciaries should carefully consider how well-suited each of the three QDIA options is to serve the best interests of the participant pool as a whole and choose accordingly.
There are two due-diligence best practices associated with QDIAs. First, choosing the right type of QDIA. Second, choosing the right provider for the type of QDIA selected. Unfortunately, there is not currently a generally accepted set of protocols for either of these decision processes.
Due diligence on what type of QDIA to offer hinges on understanding why a person saving for retirement should choose each type of QDIA. It seems to me that the three types of QDIAs roughly align to three different client profiles. TDFs align most closely with what I will refer to as a “liquidity” profile. A diversified portfolio or balanced fund would fit a more date-independent “legacy” profile. The third profile (the one associated with managed accounts) would fall between liquidity and legacy. It is most appropriate for someone concerned with dealing with longevity risk – trying to prevent the risk of running out of income during retirement – a “longevity” profile.
I tend to agree with commentators like Ron Surz who argue that the term TDF should be restricted to what are now known as “to” TDF products. This would provide certainty in terminology that defines a TDF as having the heaviest concentration of risky assets 10 or more years before retirement and the most conservative allocation at the expected date of retirement. TDFs are well-suited for companies that have low employee turnover, a plan design that encourages maximum participation and saving (automatic enrollment, high employer match, participant education, etc.), and employees that are likely to be strong savers and stay with the company until retirement. The typical participant is liquidity-driven with a specific retirement date and income objective in mind.
The legacy profile is at the other end of the spectrum. The typical participant is not particularly retirement-income focused: she may be young, career-mobile, have other financial objectives that overshadow thinking about retirement income, and is likely to view the 401(k) plan as a wealth-accumulation vehicle. Conversely, this profile could include older, highly-compensated employees who have accumulated significant wealth and are thinking more in terms of estate planning, philanthropic objectives or leaving a family wealth legacy. They do not expect to need to rely on these assets for retirement income. A more static balanced or multi-asset class QDIA that is not tethered to a specific retirement date would be well-suited for this profile.
Finally, the longevity profile is harder to define but is most common. Participants are generally dependent on their 401(k) for retirement income, uncertain about when they will be able to retire, and not confident that their savings will provide sufficient income without taking some level of investment risk both before and after retirement. Ideally, the longevity profile would benefit from more tailored solutions because the financial needs and planning objectives of the participant pool are likely to be quite diverse. Managed accounts may be the most appropriate QDIA choice in this case.
From a fiduciary-process standpoint, plan fiduciaries should be able to demonstrate that they have considered all QDIA types and aligned their selection to the appropriate overall participant profile. Having done that, they can then more confidently proceed to perform due diligence on the products and service providers that can best deliver the chosen type of QDIA. Maximizing the potential for positive participant outcomes, and minimizing regulatory and litigation risks, depends on fulfilling both forms of due diligence.
