The participant experience in qualified retirement plans has come a long way since investors were asked to create their own portfolio from a simple list of standard funds. A better experience began to emerge as plan participants were offered a “prepackaged” choice of target-date funds (TDFs), which have become increasingly popular. Today, a new trend is taking shape, as many plan sponsors are now considering whether the benefits of managed 401(k) accounts make them worth adding to their lineup.
Why this potential for a shift away from TDFs? Although TDFs provide investors with easy access to a diversified portfolio, their limitations have become apparent. But are managed accounts the answer? Before you hop on board with this idea and encourage plan sponsors to do the same, you should consider the pros and cons and how such plans affect your fiduciary responsibilities. Let’s start by comparing the benefits of managed 401(k) accounts and TDFs.
Download our complimentary brochure, “1:1 Retirement Plan Business Consulting,” to learn how Commonwealth’s retirement experts can help you maximize every opportunity to grow your practice.
Managed 401(k) Accounts Vs. TDFs
With a managed account option, plan participants can elect, for a fee, to have their 401(k) professionally managed by an investment manager who chooses a group of funds and builds a specific allocation and portfolio for each participant’s unique needs.
TDFs are asset allocation portfolios named by the year in which the investor plans to retire or use the assets. Based on the designated time horizon, the fund’s manager builds an investment strategy using traditional asset allocation models. The TDF’s mix of asset classes and degree of risk become more conservative as the target year approaches. This shift, which varies by investment strategy, is considered the “glide path.”
We can see that customization is a big differentiator here. A managed account is developed for a specific participant, based on his or her goals, risk tolerance, and overall financial situation. TDFs don’t take those factors into consideration—they’re more of a one-size-fits-all option with a set path to follow. And TDFs don’t account for the ongoing nuances in investors’ financial situations as they prepare to retire. Managed accounts are more flexible; the asset allocation can be adjusted as the participant experiences various life events.
So, comparing these two options, I believe we can give the nod to managed accounts as a more customized, and potentially more beneficial, option for meeting the needs of 401(k) participants.
Pros and Cons to Consider
Another plus in managed accounts’ favor is the higher savings rates and higher investment returns that participants realize over those who invest in TDFs alone, according to findings from Alight Solutions. Over a five-year period, between 2012 and 2016, the human capital solutions provider found, “workers who consistently used managed accounts . . . earned an average annualized return that was 1.15 percent higher than that of the consistent TDF users.”
That said, managed 401(k) accounts are not the right solution for everyone. Some of the advantages of managed accounts could be offset by higher costs, so plan sponsors should be sure to consider how the account’s fees are structured and implemented. Some costs may be bundled with recordkeeping fees, for example, whereas other fees might be add-ons for the participant and plan sponsor.
And what about participant demographics? If relevant information about a participant (e.g., outside assets or other risk tolerance factors) is not factored in, the managed account may not achieve its intended outcome. That’s another potential limitation.
All this considered, managed 401(k) accounts must deliver increased saving rates and improved investment returns to outweigh their higher costs. If you believe in their advantages, however, should you think about recommending a change to a retirement plan’s qualified default investment alternative (QDIA)?
Selecting a Managed Account as the QDIA
Approximately seven out of ten retirement plans that use auto-enrollment select a TDF as the QDIA, although the type of target-date vehicle varies in management style, from active (33.5 percent), to indexed (25 percent), to custom (10.7 percent), according to the 2018 PlanSponsor Defined Contribution Survey. Conversely, another PlanSponsor survey found that only 7.9 percent use professionally managed accounts as the QDIA. And there’s a reason for that.
Plan sponsors are expected to follow a prudent process, as Morningstar noted in a report on QDIA selections, in order to meet safe harbor regulatory protections. This involves thinking about the specific demographics of their participants and what’s best for them—and not making a decision based solely on which QDIA is cheapest. Regulations don’t say exactly how this evaluation should be accomplished. But advances in technology have provided sponsors with better information about their participants so that they can make the right QDIA choice. Sponsors also need to factor in the latest trends, and the QDIA space has changed significantly over the last five to ten years.
So, it’s essential to be diligent when selecting a managed account as the QDIA. At minimum, be sure to ask these questions:
- Is there a minimum plan size to offer a managed account service?
- What are the fees for using the managed account service?
- How is the managed account provider paid? From plan assets or participant accounts?
- Are the fees reasonable for the services provided?
- How is the managed account contract constructed? Who are the authorized signers?
- What data points from the recordkeeping system does the managed account take into consideration?
- How many potential asset allocation models does the managed account system offer to the participant?
Will Your Role Change?
Regardless of whether a plan establishes a managed account as its QDIA or simply adds this feature as an option, it’s possible that your role as the plan advisor will change. Managed accounts come with a fiduciary duty on the part of the investment manager, who must act in the best interest of the client. For the plan sponsor and advisor to the plan, it’s important to understand in what type of fiduciary capacity the investment manager is acting. The two models are:
- 3(21): Defined under ERISA section 3(21) as any advisor who provides investment advice to plan clients
- 3(38): Defined under ERISA section 3(38) as a plan’s investment manager
If your service model is to provide individualized participant investment advice and help with asset allocation, a managed account would take the place of that service. As the plan consultant and 3(21) investment fiduciary to the plan sponsor, however, you would still influence the recordkeeper selection, as well as the investment selection within the plan’s menu. You would also review and update the investment policy statement and ensure that the managed account is consistent with that policy. But by hiring a managed account provider, and, possibly, a 3(38) investment manager, you would benefit by alleviating fiduciary responsibility for both yourself and the plan sponsor.
A Potential Win-Win-Win
The potential benefits of managed 401(k) accounts as a qualified retirement plan option or QDIA are many. Advisors can maintain a consultative role by supporting the plan sponsor’s fiduciary responsibilities (i.e., ensuring that the plan funds used meet the investment policy statement). And by helping to identify and evaluate the capabilities of managed account and recordkeeping providers, advisors gain another opportunity to demonstrate their value to the plan sponsor.
In turn, plan sponsors can benefit by efficiently leveraging a managed account’s core menu options, which might prevent the necessity of performing redundant due diligence on investments. Because managed accounts are designed to provide robust financial service offerings, they allow sponsors to look good by improving the plan’s financial health and participant outcomes.
Finally, with a managed account solution, participants can benefit from having access to active, discretionary, and holistic portfolio management, which could help them achieve better retirement savings outcomes. When weighed against the higher cost involved, a prudent fiduciary would be wise to consider offering this type of investment service.
What do you think about the pros and cons of managed accounts? Do you use, or have you considered using, this option in the retirement plans you manage? Please share your comments below!