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How to evolve default options for retirees in DC plans

Retirement|Investments
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By Jason Shapiro | November 21, 2019

Here are several forward-looking ideas for defaults within the industry’s reach that can facilitate better outcomes through creating a path for current and future innovations.

Target-date funds, which have become a popular default investment in defined contribution (DC) retirement plans, are a great tool to help American workers prepare for retirement, but we feel they are not necessarily designed to serve the needs of retirees who are living longer.

U.S. employers and their workers have a lot riding on their DC plans: Four out of five organizations offer only DC plans to their new hires, making them the primary source of retirement income for many, according to our research.

At the same time, target-date funds have become the Qualified Default Investment Alternative (QDIA) of choice for nine out of 10 plans, and according to our research the vast majority of new entrants invest in them.

Target-date funds were designed as a cost-effective means to build retirement savings through a diversified portfolio that rebalances over time, but I think target-date funds don’t address the competing objectives of participants crossing into retirement well.

Some participants may stay in their plan after retirement and rely on target-date funds’ asset allocation for retirement income for possibly 30 years or even more. Others will roll their assets out of the plan to be invested elsewhere.

The first case calls for a strategy that combines income and growth, managing risk over time — such as a typical “through” glide path. The second suggests the glide path should significantly de-risk near retirement to protect the account balance for whatever next step participants have in mind – such as a typical “to” glide path. What matters more than the “to” versus “through” labels, however, is what the relevant risk level is at various points in participants’ life cycles.

Current target-date structures tend to manage the competing objectives above through trade-offs. Sponsors are generally responsible for determining which target-date design makes sense for their participants, given demographics, behaviors, and fund objectives. This is a challenging task, and while the industry has developed most of the elements of a more complete retirement solution, in my opinion they have yet to broadly create more versatile and complete forms of QDIAs. On its own, change occurs slowly, so as an industry we need to encourage progress by combining these existing components into more useful solutions.

The ‘hybrid’ model

One development that has sprouted, dubbed a “hybrid QDIA” by its providers, delivers age-appropriate and individually customized portfolio allocations. A few record keepers have devised such arrangements, where a participant’s account is routed from the standard target-date fund to an individually managed account a few years before retirement. Thus a participant gets personalized advice near and in retirement when it’s arguably most needed. But during the accumulation years, when most people are investing for growth and personalized allocations are likely to be less valuable, investors avoid the higher fees associated with managed accounts.

Figure 1 shows a stylized transition at age 55 from a target-date glide path to the range of allocations that might be prescribed by the managed account provider.

More diversification

Another idea is a target-date fund with a more efficient investment design, going beyond stocks and bonds to a more diversified portfolio that includes less liquid assets. In 2018 my colleague David O’Meara and I partnered with the Georgetown University Center for Retirement Initiatives to explore possible evolutions for target-date fund asset allocations and published a paper on the idea.

Through stochastic modeling of portfolios containing a diversified combination of direct real estate, private equity and hedge funds — we found that versus a baseline scenario, expected risk was considerably reduced, and median expected retirement income increased by 17%.

Figure 2 depicts the two portfolio strategies: The proxy target-date fund is heavy in public equities throughout, while the diversified glide path allocates decreasing proportions to public equities in the later years, replacing them with more diversified assets.

Figure 2: Distribution of potential retirement income for a full-career employee

Source: The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes, Georgetown Center for Retirement Initiatives, June 2018

Annual inflation-adjusted retirement income per $100,000 in pre-retirement annual wages

Baseline Diversified glide path
75th percentile $77,000 $93,900
50th percentile $53,000 $62,200
25th percentile $36,300 $41,900
5th percentile $21,200 $23,500

This option offers significant potential improvements over current target-date funds, but calls for some serious innovation by investment solution providers in bringing less liquid private market assets into DC plans.

The ‘unwrapped’ model

Another idea I like is an “unwrapped” target-date fund — a hybrid combining traditional model portfolios and custom target-date funds. A sponsor or advisor develops a series of model portfolios that suit the demographics and behaviors of its employee base. The model portfolios are assigned spots on a glide path, according to their risk levels and any other objectives (e.g. ability to generate income). They are invested in the plan’s core investment menu to benefit from asset scale. Non-core investments could be added as well, to create more diversified exposures.

An unwrapped structure requires greater flexibility from a plan’s record keeper and places additional demands on fiduciary providers. But it may provide more advantages than the five- or 10-year vintages of typical target-date funds so that asset allocations ideally can track the glide path more closely (see Figure 3) while also providing potential operational and investment benefits. It also may be more cost-efficient than a traditional custom target-date structure.

Moreover, the flexible design allows the QDIA to evolve as the sponsor wishes, allowing for the addition or refinement of retirement income options and distribution strategies. (A more detailed discussion appears in our recent white paper “QDIA evolutions—Moving defined contribution plans into the future”).

Where customization is most crucial

A separate — and accelerated — evolutionary track is needed for retirement income solutions in DC plans. This is where customization is most crucial, as participants’ retirement needs vary widely due to differences in asset levels, spending needs and preferences. A QDIA designed to provide sustainable income can work much like a target-date fund or managed account, offering components for guaranteed income, dynamic spending and coordination that manages tax liabilities and Social Security benefits.

Plan sponsors place many demands on target-date funds to meet the needs of a diverse population of plan participants. Some they fulfill quite well, such as professional asset allocation, helping reduce costs, and simplifying the participants’ experience. Other needs, particularly retirement income, are largely unmet. As an industry we need to address the issue: Now is the time to design a full-featured QDIA, to serve the waves of DC-dependent participants ready to move into retirement.


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