Making Age a Factor in Choosing QDIA Options

Target date funds (“TDFs”), are the most popular 401(k) qualified default investment alternative (“QDIA”), and were designed to meet the investment needs of typical plan participants, no matter how old they are. Since TDF portfolios are automatically adjusted from aggressive to more conservative as employees approach and proceed through retirement, the theory is that employees can essentially “set it and forget it.” That theory, however, has been challenged by research pointing to participants’ failure to use TDFs as intended.

Resulting Improper Allocations

Since TDFs are designed to give retirement investors an appropriate asset allocation, plan participants may want to consider investing their entire portfolio in the age-appropriate TDFs. But, research has shown that participants are often supplementing the TDFs with other funds to avoid “putting all their eggs in one basket.”

This strategy of supplementing the TDFs becomes a problem, if, for example, 35-year-old participants whose optimum retirement portfolio allocation should be 80% stocks and 20% bonds, have 75% of their retirement portfolio in a TDF with that allocation, and the remaining 25% in bond funds. The resulting aggregate picture would be a 60/40 stock/bond allocation.

How big a problem is this?  In 2009, the Employee Benefit Research Institute (“EBRI”) raised concerns about the matter. The EBRI Notes publication it issued in December of that year called attention to an emerging “new class of 401(k) investor” that it dubbed the “mixed TDF investor.” This study concluded that “some mixed TDF investors didn’t   understand either the purpose or the benefit of a TDF,” which could result in “ending up with a potentially inferior portfolio.”

This situation can be blamed, to some extent, on inertia — when a TDF became available, participants who started contributing to it simply may have left their prior investments in place. Other research by Financial Engines (an investment management firm) has raised another concern: the same inertia that’s fueling the “mixed TDF investor” phenomenon is keeping younger participants who began investing exclusively in a TDF from the start from ever considering other investment options several years down the road.

Age-based Patterns

Additionally, the study by Financial Engines found significant correlations between participant age and TDF investment patterns. Younger participants with smaller accounts are much more apt to have all their 401(k) assets in TDFs. This equals 10% of total plan assets. This means that 90% of defined contribution plan assets aren’t benefiting from use of TDFs, even with widespread default usage as a QDIA.

Today, participants are looking to diversify more than just their investments and seem to be seeking diversification among investment managers and among funds. This tends to point to the possibility of a design flaw that may limit TDFs’ long-term ability to meet the needs of mid-career participants with average-size accounts.

While younger participants with small account balances may be well served by TDFs, older participants with more substantial account balances and complex financial situations might not be, due to the “one-size-fits-all” age-based structure of the typical TDF.

Managed Accounts as a Qualified Default Investment Alternative (QDIA)

Managed accounts featuring participant access to professional investment advice and customized investment solutions could be more suitable for older participants. Financial Engines, which is a provider of managed account funds, researched the question, “How to use QDIA for older participants? Specifically, it compared investment results of TDFs with those of managed accounts, by five-year participant age brackets.

The results of the study were as follows: (1) concluded that median returns from managed accounts and TDFs were the closest for the youngest and oldest participants, and (2) the most divergent (with superior results for managed accounts) for participants in five-year age brackets between 35 and 55.

In general, employees in that 20-year middle age bracket generally have more dollars to contribute to a 401(k) plan than younger employees, and a greater time horizon before retirement than older employees. Therefore, achieving the best possible investment returns for that group will have the greatest impact on the ultimate size of their 401(k) portfolios at retirement.

What Is the Next Step?

Plan sponsors should not rush out and reinvent their QDIA strategy, however, it does raise questions about whether the category of QDIAs should be uniform across all participant age brackets. Learn more by talking with your employee benefits specialist and financial advisor.

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