June 8, 2011

QDIA - Default Assumptions

Five things that confuse employers about QDIAs

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Plan sponsors have a lot at stake in their choice of QDIAs (qualified default investment alternatives). The percentage of defined contribution plans using automatic enrollment jumped from 24% in 2006 to 57% in 2010, according to an Aon Hewitt survey. Among those that currently do not have automatic enrollment, 36% told Aon Hewitt that they are somewhat or very likely to add it for new hires in 2011.

Many employers now need to select a QDIA or evaluate their previously chosen one—and they should look closely, since the past few years have shown that most participants stick with the default investment. Advisers can help them navigate the following five areas that employers often find perplexing:

The Selection Process

Some sponsors worry that picking an automatic-enrollment default investment has a higher fiduciary standard than other funds in the plan lineup. “We generally do not see any difference, whether it is a QDIA or a stand-alone investment. We essentially tear apart the investment strategy and put it together again,” says Kevin Vandolder, a Principal at investment consultant Hewitt EnnisKnupp. “The standard of care would be the same.”

ERISA’s “prudent man” standard of care applies to QDIAs as it does to other plan investments, agrees Roberta Ufford, a Washington-based Principal at Groom Law Group. Employers “demonstrate prudence by the process: They gather the appropriate information, consider the possible options, and consult appropriate experts, but the standard is totally tied to facts and circumstances. So, you have to take into account what the QDIA does. This might be the only investment option for a participant who does not give you direction.”

The U.S. Department of Labor says that employers need to consider factors like performance, investment strategy, fees, and administrative convenience, Ufford says. Many employers selecting a QDIA go with what their existing provider offers, she says. That might offer participants the best overall value, but a sponsor and adviser should document the pros and cons considered in making that decision. “Where employers may get into trouble is if they take the provider’s target-date funds without looking at them like they would look at any other investment option,” she says.

QDIA = Target-Date Fund

Although QDIA guidance does not favor any default, saying the selection has to consider plan demographics, about 70% of sponsors use target-date funds, says Lori Lucas, Defined Contribution Practice Leader at consultant Callan Associates Inc. “However, some plan sponsors already have balanced funds they have used for many years that are low-cost and well-received by participants, and that have lots of assets in them,” she says. Other employers may want to shift from balanced funds to target-date funds, but have decided to see how potential new rules and regs for target-date funds play out, she says.

Some employers still think that a balanced fund works better as a generic solution for a plan, says David Wray, President of the Chicago-based Profit Sharing/401(k) Council of America. They believe balanced funds benchmark more easily than target-date funds. Some feel they do not know enough about their workforce’s overall financial situations, like outside-the-plan assets, to pick a glide path.

Meanwhile, a small pool of employers go with a managed account QDIA. “It starts with some kind of target-date glide path structure and customizes off that,” Wray says. “Some sponsors feel that this more-customized approach makes sense.” Some smaller plan sponsors want to leverage their plans’ existing funds, Lucas says. “The challenge that some plan sponsors have with managed accounts is that they do have an added fee because they are tailored,” she says. However, if participants do not provide the necessary information to tailor the accounts, employers fear “they will end up with a glorified target-date fund with an added fee,” she says.

Glide Path Nuances

“Before, the plan sponsor would look at the quality of the organization and the fee structure, but not look in detail at the glide path,” Wray says. However, the market crash made clear that “this is a long-term, philosophical decision for the plan,” as he says.

There has been a lot of back and forth on to-versus-through glide paths, but Lucas thinks of that as almost a false debate. “There are some very aggressive ‘to’ allocations and some very conservative ‘through’ funds,” she says. So, advisers and employers need to look at glide paths’ details. “It is not just equity exposure, but factors like whether there is inflation protection in near-dated funds, or the duration of fixed income,” Vandolder says.

“We see a lot of variety even within the allocations to equity and fixed income” of target-date funds, Lucas says. If a glide path has a lot of fixed income, it could be cash-oriented and conservative, or more of an aggressive investment. “We also are seeing the introduction of investments like commodities into the glide paths, and more diversification of international holdings, including emerging markets,” she says.

Keeping Fees Low

Large sponsors that customize their QDIAs already have pricing leverage, Wray says. Overall, he expects QDIA fees to come down as assets grow and providers feel pressure from fee-conscious employers to drop prices.

Some plan sponsors focus on fees to the point that they prefer index funds within a QDIA, to keep costs low and limit the swings in performance relative to the index, Lucas says. A Callan survey indicates that 53% of sponsors use actively managed target-date funds, but 24.4% use indexed target-date funds and 22.2% use a mix of active and passive target-date fund management. “Some actively managed target-date funds have done well relative to the index,” Lucas says of their continued popularity. “When you think about it, there is no such thing as a truly indexed target-date fund, because there always has to be an active decision relative to what the glide path looks like.”

On the other hand, the fee picture gets more complex with active funds. “The index target-date funds are more aligned,” Lucas says, “but the minute you get into a mix of active and passive management, the fee really varies depending on the degree of active management.” Plan sponsors need help figuring out whether the higher fees for active management are merited for their participants.

Monitoring a QDIA’s Effectiveness

Advisers can help employers approach this more thoroughly. Seventy-four percent of sponsors surveyed by Callan indicate that they use the passive benchmark provided by their investment manager. “So, all they are really doing is comparing whether a target-date fund beat a similar indexed allocation,” Lucas says. “Even more critical, is the glide path doing what you expected it to do? Hold the investment manager responsible for the glide path.” Indexes based on a consensus such as those done by Standard & Poor’s and Callan can help, she believes. “That shows you: Here is your opportunity set. So, if you are being more or less aggressive, at least let it be intentional and consistent with the plan,” she says.

Monitoring the effectiveness of a default also can go beyond the investment itself, to looking at participant behavior with the QDIA. “There has been a lot more focus in the past couple of years on, if participants default into a QDIA and then make a change, are they doing so because it will be productive, or because they just do not understand the role of a target-date fund in their portfolio?” Lucas says.

That can have implications for education done by advisers. “Before the market collapse, there used to be a mindset of ‘set it and forget it’” for participants among many employers about target-date funds, Lucas says, “but there is a sense now that there may be a need to do more education. Especially as people get near retirement, they need help to understand the role of a target-date fund, particularly if it is a ‘through’ fund. They need to know that this is meant to be a very long-term investment.”

—Judy Ward

Target-Dates Did Well in 2010

Morningstar chalks up much of the growth to TDFs’ use as QDIAs

Bull-market gains in 2010 helped target-date funds (TDFs) perform well, as compared with standard market benchmarks, according to Morningstar’s Target-Date Industry Survey.

The range of returns among Morningstar categories for TDFs was relatively narrow, with the average fund in Morningstar’s 2000-2010 category, the most conservative of the target-date group, gaining 10.68%, while the 2050+ category averaged a 14.45% return. By comparison, the S&P 500 Index returned 15.06% in 2010, and the Barclays Capital U.S. Aggregate Bond Index was up 6.54%.

Longer-dated categories (those with target years of 2035 and later) averaged returns of 14% and better. Those gains were in line with the return of the broad stock market, which is encouraging considering that most funds in that range carry some fixed-income allocation.

Shorter-dated funds unsurprisingly surpassed the bond benchmark, owing both to sizable equity allocations and investments in high-yield and other types of securities not included in the benchmark, Morningstar said. Differences were less extreme than in 2009’s rally for riskier securities or in 2008’s steep decline. The 10.68% gain in 2010 for the 2000-2010 category was slightly lower, however, than the Morningstar conservative-allocation category’s 11.19% return.

Target-Date Flows

Target-date funds continued to attract investors’ retirement assets in 2010, according to Morningstar’s Target-Date Industry Survey. TDFs had net inflows of $47.5 billion in 2010, a small increase over the $45 billion net inflows of 2009. Total net assets in open-end target-date funds reached $341 billion.

On an organic growth-rate basis, however, the 2010 results are not quite as impressive as in years past, Morningstar said. The average organic growth rate for the target-date industry was 22%, off from 2009’s 39% and well below the 2007 high of 76%. Compared with the meager results of both the equity (negative 2.5%) and balanced (1.84%) asset classes, the latter of which excludes target-date funds, target-date fund growth is still a bright spot.

As in previous years, most new cash in 2010 went to the longest-dated funds, in particular those with target retirement years of 2040 (34.6%) and 2045 (41.2%). All other categories, with the exception of the 2000-2010 funds, had growth rates in the range of 15% to 25%.

Fidelity, Vanguard, and T. Rowe Price maintain their relative lock on industry assets. The Big Three control 76% of industry assets, down slightly from 81% in 2007. Fidelity has suffered the biggest absolute decline in market share, from 48% in 2007 to 37% at year-end 2010. T. Rowe stayed flat over that period, while Vanguard saw a market-share increase from 17% to 23%.