If you ask industry consultants what kind of effect qualified default investment alternatives (QDIAs) will have on the investment advisory industry and retiring boomers, they’ll use words like “revolutionize.” If you ask which of the three QDIAs will be most widely used–managed accounts, target date funds, or balanced funds–you’ll get a variety of answers.
Lou Harvey, president of Dalbar, says that for plan sponsors, QDIAs represent “the best fiduciary protection under ERISA at no cost.” For participants in 401(k) plans, QDIAs offer “the best investment mix,” and for advisors, while “their world becomes a bit more involved in that they have to monitor the QDIA,” the upside is the compensation they can earn from any of the three QDIA options.
But which QDIA is best? It depends on the type of plan being managed. For instance, with a “clustered” plan that includes participants of about the same age and risk tolerance, Harvey says a balanced fund would be the easiest to administer. For a “grossly segmented” plan, in which there are participants of different age groups working for a small firm, a target date fund fits best, he says. Managed accounts are most suitable for large plans with thousands of diverse and unclustered participants. This type of plan is the most difficult to administer, Harvey says, but the advisor can collect the most fees from it.
Tim McCabe, senior VP for PMFM/401k Toolbox in Watkins-ville, Georgia, a provider of advice and managed account services to plan participants, opines that the advent of managed accounts as a QDIA “challenges plan sponsors to understand the extraordinary differences between managed accounts and lifecycle or target date funds, the two options most likely to be used.”
While lifecycle funds are growing in popularity, McCabe notes, he advocates using managed accounts. One problem with target date funds, he says, is that they’re not all created equal. For instance, “if you a took a sampling of 2020 funds, you would find some with very high equity exposure, perhaps 70% or more, while others have equity exposure in substantially lesser amounts,” McCabe says. The target funds “may also seek differentiation by varying holdings, international versus domestic, or allocations of holdings.”
What’s more, McCabe argues, target date funds are “fully invested, which means they will experience downside volatility in bear markets, perhaps more so than many 401(k) investors can handle.” Participants may then lose confidence and opt out of a QDIA to an inappropriate investment choice, like a money market fund, he says. An actively managed account, on the other hand, “provides opportunities for the money managers to take cash positions to mitigate risks in a declining market, thus lowering volatility.”
Patrick Cunningham, managing director of Manning & Napier, an asset manager specializing in lifecycle funds based in Rochester, New York, agrees that “most lifecycle funds do not have significant risk protection.” Lifecycle fund “participants want risk management,” he says. With Manning & Napiers’s six collective investment trusts (CITs)–the firm’s target date funds–and four risk-based balanced mutual funds, “We have been able to protect our clients during bear markets and therefore better meet their retirement needs over time.” The next bear market will cause a “shake up” in the target date funds industry, Cunningham says, because so many of these funds lack a risk management component.
This is precisely why balanced funds make sense, says Chris Brown, portfolio manager of the Pax World Balanced Fund. “Balanced funds in general take a look at market risk and make adjustments for that while target date funds are just basically adjusting allocation based on one’s age,” he says. “Typically, a traditional balanced fund looks at the market and makes allocation decisions based on that; [balanced funds] are looking at ‘Does the risk/reward favor stocks over bonds or bonds over stocks?’” Whether a participant is “right on the cusp of retiring at 65 or [is] 35, the traditional balanced funds make a great core holding.”
But questions are still swirling around about how target date funds and managed accounts can be used under Department of Labor (DOL) rules, and DOL plans to issue further guidance by year end, says Ellen Goodwin, counsel at Groom Law Group in Washington. For instance, in the preamble to the DOL’s final rule on QDIAs, a QDIA is required to be invested in a blend of fixed income and equity products. But “with target date complexes, the funds for the young are all in equities and ones for the older [participants] would be all fixed income,” Goodwin says. As for managed accounts, the “programs basically have a manager invest assets among the available funds in the plan–maybe 15 to 20 funds–and the manager has some standard allocations for specific ages. Some of those funds impose redemption fees and transfer and withdrawal restrictions and these are problematic under DOL’s rules.”
Washington Bureau Chief Melanie Waddell can be reached at firstname.lastname@example.org.