Blending the Benefits of Managed Accounts and TDFs

The April 2016 issue of “The Cerulli Edge – U.S. Monthly Product Trends Edition,” examines managed accounts in defined contribution (DC) plans “as a complement to target-date funds, not a replacement for them.”

According to Cerulli, a number of hurdles exist for managed accounts if they are going to effectively replace target-date funds (TDFs) as the go-to choice for Employee Retirement Income Security Act (ERISA) retirement plans’ qualified default investment alternative (QDIA) designation in defined contribution (DC) plans. First and foremost is simply the current popularity of TDFs, especially among younger workers, the recently hired, and those swept into retirement plans through automatic enrollment features.

“The target-date fund has been a success story for the retirement and asset management industries,” Cerulli explains. “They have become the investment option of choice for many DC plan investors, elegant in their simplicity and ability to offer one-stop diversification.”

However, Cerulli says there are some important arguments against the use of TDFs that all ERISA fiduciaries should consider: “The chief argument against target-date funds is their homogeneity as they do not account for an investor’s risk tolerance, specific retirement plans, or other assets.”

In this sense, the managed account approach “appears to be a worthy alternative to the target-date fund as it can provide a level of customization that the target-date fund cannot by taking into account factors such as an investor’s income, age, and access to a defined benefit plan.” Of course, there is no free lunch, and similar to other fee-based platforms, a managed account in a DC plan charges an additional fee. This can be a highly sensitive proposition for some plan sponsors, given the current litigation environment. 

Matching the findings from the most recent PLANSPONSOR Defined Contribution Survey, Cerulli finds plan sponsors are increasingly split on where they come down in this discussion—on the side of managed accounts or TDFs as the preferred QDIA. While TDFs are still dominant, Cerulli finds plan sponsors have “increasingly recognized the value of the managed account and adoption has increased at the plan level. As of year-end 2014, 22% of DC plans offered a managed account, a figure that has doubled since 2009.”

NEXT: Managed accounts and TDFs working together 

Important to note, Cerulli’s report goes on to explain managed accounts are “available to better than half of plan participants, meaning adoption of these platforms is greatest in larger plans.” Despite growing availability, participant adoption remains limited—just 7% of participants used these accounts as of year-end 2014, according to Cerulli.

“The added degree of customization in managed accounts has led some to argue it is a superior solution for DC participants, but as currently constructed, a number of obstacles exist. First, managed accounts come at a higher cost than packaged target-date funds,” Cerulli explains. “Supporters will argue that costs are justified thanks to greater customization and could decrease with higher adoption. Second, managed accounts are viewed as a ‘black box’ with no practical way to benchmark them. The third objection is the use of the risk tolerance questionnaire.”

Without greater transparency into the way the managed account factors a plan participants attitudes, goals, and risk tolerance, the added benefit of customization relative to a target-date fund is less clear, Cerulli warns. “Furthermore, inertia is a powerful force in the DC industry. Automatic features, such as auto-enrollment and auto-escalation, have become important as ways to get intransigent participants to take action. Thus, including the extra step of a risk tolerance questionnaire is unrealistic and counterproductive.”

Taking all this together, Cerulli suggests a blended approach may be best, seeking to leverage both managed accounts and TDFs—with the former perhaps being better suited for those who have larger balances and have spent more time considering their retirement plan and engaging with an adviser. The TDF, in this scheme, remains the “QDIA for the masses.” This analysis may also shift over time as the managed account industry develops, Cerulli says. 

“Currently, the DC managed accounts industry is highly concentrated,” Cerulli adds. “Financial Engines is the monolith, with more than $100 billion in assets and 60% share among the top eight providers as of year-end 2015. Morningstar Retirement Advice ranks second with $40 billion in assets and 21% market share. One can take two opposing views of the extreme concentration.”

Information on obtaining Cerulli research reports is here.