Industry Views on Customized TDFs, Managed Accounts

Retirement industry practitioners might have heard that using custom solutions for a retirement plan’s qualified default investment alternative (QDIA) can be overly complex, making the approach more appropriate for larger and more sophisticated plans. In reality, retirement plan experts say, custom target-date funds (TDFs) can be an attractive alternative to off-the-shelf TDFs, especially in cases where they use funds that are already in the plan’s core menu.

This is partly why the Department of Labor (DOL) issued guidance in 2013 that suggests retirement plan fiduciaries might want to consider custom TDFs, as investment manager Lord Abbett notes in its white paper, “Custom Target-Date Funds Differentiate Your Retirement Plan Business”

The DOL’s guidance includes the following suggestion for fiduciaries: “Inquire about whether a custom or non-proprietary target-date fund would be a better fit for your plan. Some TDF vendors may offer a pre-packaged product which uses only the vendor’s proprietary funds as the TDF component investments. Alternatively, a ‘custom’ TDF may offer advantages to your plan participants by giving you the ability to incorporate the plan’s existing core funds in the TDF. Non-proprietary TDFs could … offer advantages by including component funds that are managed by fund managers other than the TDF provider itself, thus diversifying participants’ exposure to one investment provider.”

Lord Abbett also notes in its paper that even just having the custom TDF conversation with sponsors can differentiate a practice.

“Consulting on custom TDFs enhances your value to a plan sponsor and can help you forge a deeper relationship with your clients,” the paper says. “Your expertise can differentiate your services from other advisers, for example, who only offer pre-packaged TDF solutions, and help solidify your reputation as a thought leader.”

A custom solution—be it a custom TDF, a managed account or a hybrid QDIA that defaults younger investors into off-the-shelf TDFs and those approaching retirement into managed accounts—may also satisfy a growing interest in more personalized retirement plans, says Tim Walsh, senior managing director at TIAA.

“According to our recent ‘TIAA Retirement Insights Survey,’ six in 10 employers consider their plan to be highly customized to the specific demographics of their employees and overall retirement offering,” Walsh says. “However, more than half (51%) of employees say they would prefer more personalization. We believe that as individuals expect more personalization in their broader lives, they will also come to expect more customization in their retirement plans.”

Then there is the growing proliferation of custom TDFs to consider. The 2020 PLANSPONSOR Defined Contribution (DC) Survey found that, last year, 76% of plans used TDFs as their default investment, and a 2019 Callan Associates report said 17.3% of sponsors had turned to custom TDFs. Pavilion Global Markets reports that the nation’s 200 largest plans had $185.1 billion in custom target-date strategies as of September 30, 2017, up 19.8% from a year earlier.

Factors Tipping in Favor of Custom TDFs

While all those reasons could give retirement plan advisers and sponsors reasons to consider custom TDFs, Callan Institute’s “2019 Defined Contribution Trends Survey” also found four specific reasons why some plan sponsors use custom TDFs.

Better cost structure, a desire to control the glide path and the ability to hire or terminate underlying managers without having to replace the entire TDF were each cited by 77.8% of respondents. That was followed by 55.6% saying they were seeking best-in-class underlying funds.

However, there are several requirements that retirement plan experts say need to be met at the sponsor level to justify this approach.

“Our first consideration is whether or not the sponsor has the scale and the pricing power to justify a custom solution so that the net cost to the participant is reduced,” says Mike Volo, institutional retirement adviser at CAPTRUST. “That is the first checkpoint. Then we look at the plan sponsor’s skills.”

David O’Meara, a senior investment consultant who specializes in TDFs at Willis Towers Watson, agrees with this point, saying, “The sponsor needs to have the appropriate governance oversight in place to manage that structure. If they don’t have the scale or the oversight, then that leads them right to an off-the-shelf solution, which is, generally, going to be the right answer for the majority of plan sponsors out there. However, as we have seen more plan sponsors delegate investment authority to independent, skilled 3(38) fiduciaries, that sets up the right governance that might facilitate more custom TDFs in the future.”

Volo says that for his larger, more sophisticated plan sponsor clients, he thinks custom TDFs can be a good fit. “When we look at many of the prepackaged TDFs, we find that no single investment manager can outperform the market in every single asset class,” he says. “When appropriate, it makes sense to use the best-in-class approach for underlying investments.”

Custom TDFs can make sense if a client’s workforce is dominated by atypical workers, such as those with strong union participation; participants such as pilots who retire earlier than other workers; or hourly workers, who also tend to retire earlier than salaried workers, O’Meara says. “We also find that custom TDFs can be valuable for participants who have additional complexities or needs than a traditional TDF may assume,” he adds.

In its “Custom Target-Date Fund (cTDF) Survey,” the Defined Contribution Institutional Investment Association (DCIIA) spells out all the various investment classes that custom TDFs embrace—and notes that the asset allocations vary by as much as 30 percentage points for each custom TDF vintage.

For the growth portion of their portfolios, custom TDFs turn to all equity asset classes, real estate, private real estate, real assets, commodities, infrastructure, multi-asset inflation, global real estate investment trusts (REITs), risk parity, absolute return and preferred stock, DCIIA says. For the defensive portion, they include all fixed-income asset classes, Treasury inflation-protected securities (TIPS), emerging market TIPS, currency, market neutral hedge funds, bank loans, structured securities, global tactical asset allocation and U.S. balanced funds.

When Managed Accounts Make Sense

If a sponsor has a high-net-worth or sophisticated workforce, managed accounts—which work best when the participant is engaged and willing to input personal financial data—may be a better offering, says Steve Gaito, owner of Retirement Resource Management.

“Let’s say the company was giving these employees company stock,” he says. “The managed account can account for that so that they are not too concentrated in one area of the market. Plus, it prevents these HCE [highly compensated employee] investors from saying to their employer, ‘You don’t give us enough choices.’ The more advanced the investor, the more choices they demand.”

Certainly, data from Alight shows that more plan sponsors are offering managed accounts, be it as the QDIA or an option on the investment menu. In 2005, a mere 6% of sponsors offered managed accounts, but this grew to 58% in 2017. However, the take-up rate by plan participants that year was only 7%.

Volo says participants don’t gravitate to managed accounts because they might cost more and, to be optimized, require active engagement. But overall, he says, customization is becoming more viable for retirement plans due to advancements in recordkeepers’ technology that has improved their ability to administer these options and to communicate their benefits to participants

“We also have more history and track records to compare off-the-shelf to custom, and when we look at the data, using both backward-looking and forward-looking analysis on performance and cost, we see that customized options can be really attractive,” Volo says.