Grabbing the Right Option

In 2008, following the Department of Labor’s (DoL’s) issuance of final regulations, plans rapidly moved to adopt default funds that met those standards as qualified default investment alternatives (QDIAs). By complying with those terms, plan sponsors of participant-directed individual account plans avoided liability for investment outcomes of defaulted investments in those QDIAs, as long as they adhered to all the conditions for that decision. Although plans are not required to use the default investments provided for by the DoL, and can continue to use other default investments, many plan sponsors are doing so.

For example, at Prudential, 33% to 40% of defined contribution plans eligible to adopt QDIAs did so in 2008, says Jamie Kalamarides, Vice President of Retirement Solutions at Prudential Financial in Hartford, Connecticut. By September of 2008, 40% of Vanguard’s defined contribution plan clients had designated a QDIA, says Stephen Utkus, head of Vanguard’s Center for Retirement Research in Malvern, Pennsylvania.

The QDIA rules prescribe three investment options that provide fiduciaries safe harbor protection under ERISA section 404(c)(5): 1) lifecycle or target-date funds, which target a participant’s anticipated retirement date; 2) separately managed accounts that allocate an individual’s contributions among existing plan options based, at a minimum, on age or retirement date; and 3) a product that has a mix of investments and takes into account the characteristics of the group of employees as a whole, such as a balanced fund.

Of the three, the QDIA sponsors overwhelmingly are choosing is the target-date fund. Sponsors have been moving to target-date funds from stable value and other conservative investments, says Jason Roberts, a Partner with Reish Luftman Reicher & Cohen in Los Angeles.

According to PLANSPONSOR’s 2008 Defined Contribution Survey, 44.3% of plans now use target-date funds as their automatic default option, up from 33.3% in 2007. A 2008 Fidelity investment survey indicated 68% of Fidelity clients already had chosen lifecycle funds as their default, and another 14% planned to switch default funds—with 87% reporting the switch would be to a lifecycle fund. At Vanguard, 80% of the clients who have designated QDIAs have designated target-date funds as that default, says Utkus.

Target-date funds are the market leader, says Roberts, primarily because of the simplicity of the construction of the funds and the ability to communicate the objectives to participants and sponsors. Further, the simplicity of target-date funds makes them attractive because a plan sponsor only has to consider a participant’s age and retirement date. Using a balanced fund, by contrast, requires the sponsor to monitor continually its appropriateness with respect to the plan as a whole.

When selecting a target-date suite, says Roberts, advisers must understand the investment allocation strategy and glide path of a suite of target-date funds and be able to explain to a sponsor why a particular suite is appropriate for that sponsor. “It’s incumbent on the adviser to dig into the needs of participants and recommend funds that are consistent with those needs,” says Roberts. He cautions about simply selecting the fund offered by the recordkeeper, saying that, given the increased DoL enforcement, one could easily imagine the DoL determining that a fiduciary should have looked for solutions beyond that offered by a particular recordkeeper.

Managed Account and Balanced Funds

Although balanced funds and separately managed accounts were both included in the QDIA regulations, they have not been as widely adopted as target-date funds, says Roberts. At Vanguard, 20% of plans did not choose target-date funds as the QDIA, says Utkus, mostly selecting balanced funds instead.

With balanced funds, says Roberts, the problem is the requirement that whatever fund is selected must be suitable for the entire plan. This makes it hard for any plan with widely dispersed demographics to adopt a balanced fund as a QDIA. What is more, he says, there are potential litigation risks because it is easy to say, with 20/20 hindsight, that something was not suitable for the plan as a whole. Separately managed accounts also have not been as popular as target-date funds, says Roberts, because of their complexity. The complexity, he says, stems from the fact that not all plan fiduciaries are willing and/or allowed to manage participant accounts. There are several concerns relative to not only the propriety of the existing fund line up as it lends itself to creating “model’ managed account QDIA solutions, but also the management and administration of the models.

Separately managed accounts, however, were adopted by 95% of Prudential’s clients who chose a QDIA, says Kalamarides. The popularity of separately managed accounts at Prudential was due to a free asset allocation tool Prudential offers with its separately managed accounts called GoalMaker.

The move to QDIAs will accelerate over the coming year, says Utkus, even amidst the market turmoil, because it offers sponsors fiduciary protection. Even if the sponsor does not enroll employees automatically, a plan still needs a default for participants who fail to make investment choices. By year end, Vanguard expects that 75% of its defined contribution plan clients will have designated a QDIA. The dominant choice will continue to be target-date funds, he predicts, followed by balanced funds.

However, while target-date funds will remain the short-term favorite, they will lose favor in the long run because the financial turmoil exposed their weaknesses, predicts Roberts. For example, in 2008, he says, 2010 funds lost 41% of their value, and a participant who was defaulted into a 2010 fund may have a cause for a breach of fiduciary duty because the equity holdings of some of these funds, sometimes as high as 68%, was beyond what was suitable. The trend over the next five years, he says, will be to hybridized investment solutions with income and distribution options built in. There will be a real focus on guaranteed income or having a plan for the distribution of the money, he says.

Roberts says that, even though fiduciary relief is provided only if one of the investment alternatives described above is used as the default investment alternative, the DoL acknowledges that the use of other investment alternatives still may be prudent. For example, investments in money market funds, stable value products, and similarly performing investments may be prudent for some participants and beneficiaries, even though those investments are not QDIAs.

Utkus, however, believes that target-date funds will remain the predominant QDIA choice. “We are anticipating that a majority of clients will continue to designate target-date funds as QDIAs,” he says. Despite the market turmoil, automatically enrolled participants held steady. Less than 1% of Vanguard’s automatically enrolled participants for the entire year of 2008 switched out of target-date funds, says Utkus.

Utkus also does not believe that sponsors will soon change their QDIA designations following target-date fund losses. Right now, says Utkus, it is too soon to tell if the market shock of 2008 will have an impact on QDIA designation. Plan committees began their annual reviews back in February, but he expects them to remain with the choices they made through the current market cycle. “We believe that committees will work through the market cycle rather than switch,” he says.

Making Your Own

Managed accounts have been riding the wave that has swept 401(k) accounts, from the do-it-yourself philosophy in participant investments to having professionals design asset allocation models so participants will not have to do much thinking on their own at all. Managed accounts today amount to about $183 billion in 401(k) accounts, according to a study by the Investment Company Institute. In 1996, only $2 billion was lodged in professionally managed accounts.

Many advisers are even using professionally managed accounts as default investment options, now that the Pension Protection Act of 2006 legitimized them as qualified default investment alternatives (QDIAs)—with particular conditions. A primary appeal of managed accounts is that they can help assure that participants will not make emotional or foolish decisions with their assets, like buying high and selling low. “With the decline in the market, people more and more are seeing the need for professional management and diversification, so, if managed accounts are priced appropriately, they could increase more in popularity,” predicts John Barth, an investment adviser with Dawson Wealth Management, in Cleveland, Ohio.

A plan’s adviser, then, frequently must take responsibility for vetting that investment manager. The task takes on particular significance if the fund is being managed internally by the fund’s own agent or employee. “It could be the fox in the henhouse,” cautions Neil Netoskie, head of the retirement services group for BBVA Compass. “I want the manager to be independent of the provider managing the service.”

With a growing number of vendors offering managed accounts, advisers need to shop around for the product that fits a plan best. David McLeod of the Advised Assets Group, the registered investment adviser for Great West Retirement Services, suggests that advisers run through a check list of criteria to assess managed accounts. That list might include quality of services; reasonableness of fees; experience and reputation of the provider and the size and scale of its business; commitment to regulatory compliance; methodology used for advice services; ease of reaching call centers; strength of education and enrollment programs; and the smoothness of the provider’s relationship with recordkeepers. (Some recordkeepers have alliances with particular managed account providers, things advisers should be conscious of.)

Bonnie Fawcett, Director of Invested Interests for PNC Financial Services, says advisers need to be aware of the potential down side to the managed account concept. Who provides a benchmark, she asks, and how do participants get information about the investments underlying their accounts?

In the final QDIA regulations, the Department of Labor said the qualifying asset allocation approach is to be based on a participant’s age, target retirement date, or life expectancy, and that such allocation decisions are not required to take into account risk tolerances, other investments, or other preferences of an individual participant (though they may). Managed accounts frequently are highly customizable to the individual participant and can readily consider factors such as a participant’s age, risk tolerance, outside assets, and other retirement plans.

However, many advisers find target-date funds, which also provide an asset allocation model, but generally focus only on the specific target date, a better fit for their participants, Fawcett suggests.

Pricing

Barth recommends that advisers compare the pricing of managed accounts with target-date funds, as well as their returns, because pricing on managed accounts can be higher than on individual funds, sometimes by about 100 basis points, when one calculates the manager’s fee as well as the fee for the underlying funds. To determine whether the sponsor and participants are getting good value on the fees, advisers also should look at other managed account options offered by different providers, study performance records and the account managers’ five-year record, and, of course, look at the price itself. Some plans will pick up the cost of the managed account, but most pass it on to the individual participant investing in the account. As technology makes the administration of managed accounts more fluid, and as more participant assets pour into the accounts, prices are likely to come down, further enhancing their value, says John Ring, Managing Director of Retirement Plan Services for Brinker Capital.

Fund Composition

Netoskie warns that due diligence of the plan investment options can slip away from an adviser if the underlying funds in the managed account are part of the provider’s portfolio but not part of the sponsor’s investment menu. Yet, other advisers prefer to buy or design managed accounts that do step into new investment territory, giving participants more options and the opportunity for greater diversity—not to mention providing the adviser with additional flexibility in crafting the portfolios.

“I think an adviser should offer funds that are distinct from current options in the plan,” says Ring. “Diversification should be there.” Advisers also might consider offering a number of managed accounts with different risk tolerances to appeal to a wider array of participants.

Yet, like everything else that can benefit participants in their retirement plans, success comes only when a product or service is accompanied by a compelling education program. If advisers fail to proactively inform employees how a managed account works and can help them grow assets, the program will garner little attention. —Louis Berney

In the Details

Nothing requires that a plan’s default fund be a QDIA but, for those plans that wish to obtain fiduciary protection under the regulations, it is not as simple as selecting one of the three QDIA options. In order to obtain the safe harbor relief, plan sponsors must satisfy the following conditions:

• Assets must be invested in a QDIA.
• Participants and beneficiaries must have been given an opportunity to provide investment direction, but have not done so.
• A notice generally must be furnished to participants and beneficiaries in advance of the first investment in the QDIA and annually thereafter. The rule describes the information that must be included in the notice.
• Material, such as investment prospectuses, provided to the plan for the QDIA must be furnished to participants and beneficiaries.
• Participants and beneficiaries must have the opportunity to direct investments out of a QDIA as frequently as from other plan investments, but at least quarterly.
• The rule limits the fees that can be imposed on participants who opt out of participation in the plan or who decide to direct their investments.
• The plan must offer a “broad range of investment alternatives’ as defined under section 404(c) of ERISA.
• Further, any QDIA must be managed by an investment manager, plan trustee, or plan sponsor who is a named fiduciary or is an investment company registered under the Investment Company Act of 1940.

No matter what type of investment is selected, plan fiduciaries still are liable for prudently selecting and monitoring QDIAs. —PA

What Is a Target Date?

One of the more controversial philosophical differences in target-date fund designs is also one of the most basic: Is the “target date” the end, or just a bump in the accumulation highway? At PLANADVISER’s recent Future of Asset Allocation Funds conference, Epco Van Der Lende, PhD, Managing Director, Global Portfolio Solutions Team at Van Kampen Investments, said that the dominant factor of long-term returns in a target-date fund is strategy, not the underlying investments—and that makes the choice of a glide path that much more important in assuring the expected results.

How divergent are allocations at target dates? Consider that T. Rowe’s target-date series has an individual in retirement at 50% equity and 50% bonds (T. Rowe Price Retirement 2005 Fund, according to the company’s Web site), while the Dow Jones Target 2010 Index calls for 70% low-risk investments and 30% high-risk at that point, and Target Date Analytics’ most conservative benchmark indicates 100% in reserve assets.

According to T. Rowe Price’s Director of Asset Allocation and Portfolio Manager Richard Whitney, T. Rowe views target-date funds as a lifetime solution. He says that the retirement age of 65 is not a “magic’ number; it is just the number when a participant stops accumulating. Whitney said that the T. Rowe funds try to offer a good investment program that is also behaviorally friendly, as individuals have a difficult time dealing with the complexity of the market.

However, not everyone agrees that individuals should continue to have a substantial investment in equities at retirement. Joe Nagengast, Principal at Target Date Analytics, which offers a benchmarking tool for target-date funds, is one of those. “In our thinking, the target date is key—it should represent the end of the glide path,’ he said. “What is the target date? It should be the name of the fund.’ If it is a 2010 fund, 2010 should be the end—and, if it is not, it should be relabeled as “2040.”

The selection of a glide path is critical and advisers and plan sponsors must consider the question of whether someone is managing to retirement versus managing the portfolio for life, said Chris Karam, Managing Director at Sheridan Road Financial in Northbrook, Illinois. As an adviser, he commented, comparing all lifecycle funds does not make much sense when they all have such divergent strategies. So, at Sheridan Road, he said, when evaluating funds for a client’s plan, they base their choice on the participant group and its demographics. Choose a glide path that works for an employee base, which will narrow down the number of provider options, and then select the best from that group, he suggested. —PA

Illustration by Cristian Turdera