- The adoption of managed accounts as a QDIA has been limited; however, there has been an up-tick in the percentage of plans utilizing them as an opt-in service.
- Deterrents for selecting a managed account service as a QDIA include: perceived higher fee levels, a lack of a clear benchmark, lack of employee engagement, and the demographics of those using the QDIA (i.e., younger participants).
- As an opt-in service, managed accounts can be viewed as an enhanced offering for those participants with more complex financial situations.
- Plan sponsors should have a clear understanding of the managed account provider’s construction methodology, level of experience, and most importantly, their asset allocation philosophy.
- If portfolios built for the “average” participant are insufficient, why would a portfolio built for an “average” market be sufficient?
- Customization should not come at the expense of flexibility. Unless providers have the ability to adapt to changing market conditions, gains made through customization may be limited.
When discussing multi-asset class products, in general, most of the discussion is centered around target date and balanced types of options (i.e., balanced funds or risk-based funds). Another type of multi-asset class investment option that has experienced increased adoption is managed account services (MAS).
As there is generally a lack of familiarly with MAS compared to the other types of multi-asset class products previously mentioned, this paper seeks to shed light on them. Here, we will focus on areas in which they may be considered for a defined contribution plan (i.e., as a Qualified Default Investment Alternative (QDIA) or as an enhanced offering) and considerations when selecting a provider.
What Are Managed Accounts?
Managed accounts are a service where an investment professional creates an asset allocation for an individual investor based on factors such as age, retirement date, contribution rates, spending needs, and risk tolerance. Unlike target date and risk-based funds, managed accounts are generally comprised of investments that are offered on the single asset class tier of a retirement plan’s menu.
While this initial description appears fairly simple, some providers may have prerequisites that need to be met in order to offer the service. Below are some potential prerequisites and their implications.
- In order to develop an appropriate asset mix, some providers may require plan sponsors to add or remove options.
- It is important to note that should an asset class that is not typical to a 401(k) plan be added (such as commodities), it may be possible to restrict those investments to use only by participants in the MAS.
- Providers may require plan sponsors to choose investments from a pre-selected list in order to offer the service.
- If this is the case, plan sponsors should have a clear understanding of the options and determine how this will impact those participants who have chosen to create their own asset allocation.
- Providers may require plan sponsors to utilize index-based options on the single asset tier of the menu.
- While index-based options may offer lower fees, plan sponsors should consider the potential tradeoffs of investing in a strategy driven by price instead of fundamental value.
Why Choose to Offer Managed Accounts?
As you can see from Figure 1, of the various types of multi-asset class products available, managed accounts are viewed as the most “personalized” option.
Starting at the bottom, balanced funds represent a single option for participants, generally with moderate risk profiles. The next step, a risk-based family, provides options to meet the needs of participants with varying time horizons and/or risk profiles. Taking a step further, a target date family incorporates participants’ age/anticipated retirement date into the equation when determining the appropriate asset allocation and automatically becomes more conservative as participants move closer to retirement.
Similar to a target date family, a custom target date family will be driven by participants’ age/anticipated retirement date; however, customization will be introduced at the plan level. For example, if the plan itself has unique demographics that are uniform across the participant base, a custom glide path is created to address those factors. If unique characteristics are not consistent across the participant base (i.e., longer-tenured participants are receiving benefits from a frozen defined benefit plan not available to new entrants), plan sponsors can introduce a MAS to tailor asset allocations at the individual participant level.
Not surprisingly, customization is a common reason cited in the industry for offering a MAS, the idea being that each person’s financial situation is unique and, therefore, their asset allocation should be representative of their personal situation.
While in theory the idea inherently makes sense, generally speaking, the further someone is from retirement (i.e., the younger they are), the less likely there are to be outside factors present that would suggest a need for a custom asset mix. For example, consider a person in their early to mid twenties. They are likely at their first “real” job and are just beginning to save for retirement. As such, conventional financial planning theory suggests that, given their multi-decade time horizon, growth is their primary objective. Rather than investing in a potentially more expensive custom portfolio, they may be best served by an off-the-shelf product (e.g., a risk-based fund or target date fund) with a growth-oriented objective.
Alternatively, as a person ages, their financial situation becomes more complex, potentially increasing the need for a greater degree of customization than a traditional pooled investment vehicle may offer. In fact, Vanguard’s 2012 report (“A Powerful Combination: Target-Date Funds and Managed Accounts”) found that older, long tenured participants with higher account balances tended to be primary users of managed accounts1.
Managed Accounts as a QDIA (Opt-Out Service)
According to Deloitte’s annual defined contribution survey, in 2015, managed accounts were used as the default investment option for 2% of the plans surveyed, down from 7% in 20142. The relatively low number can be attributed to a number of factors.
First and foremost, fees remain the primary deterrent for the adoption of managed accounts as a QDIA, as they are often higher than their target date counterparts. According to a 2015 report by Cerulli Associates, the spread between managed accounts and target date funds can be upwards of 50 basis points*. In addition to higher costs, there is also a lack of clarity regarding fees in general, as they are often asset-based by participant account balance, either fixed or tiered, and can vary based on a plan’s size*. Finally, it is important to remember that there are other fees to be aware of when using a MAS. Specifically, there are additional costs associated with the underlying options held in the managed account, which, as Cerulli notes, “can easily bring the all-in cost of the managed account to greater than 1% of assets*.” As an investment expense lowers a participant’s return, plan sponsors should consider whether or not those fees charged are reasonable relative to the value provided.
Assuming plan sponsors can become comfortable with a managed account provider’s experience implementing their strategy, a second possible deterrent for the adoption of managed accounts as a QDIA is difficulty in evaluating the effectiveness of the service. As a plan sponsor, one of the primary tasks is ongoing evaluation and monitoring of investment options on a plan’s menu. Given the level of personalization managed accounts may offer, there could be hundreds of potential portfolio combinations for plan sponsors to evaluate. Without a clearly defined benchmark for each individual portfolio, plan sponsors may have difficulty determining the effectiveness of the managed account provider. Furthermore, should a unique benchmark be created for each portfolio, plan sponsors may become overwhelmed by the potential number of individual portfolios they need to review.
Another possible deterrent for the adoption of managed accounts as a QDIA is the participant base’s level of engagement. Broadly speaking, participants using the default investment option tend to be disengaged. Instead of proactively selecting an investment option, their lack of choice has led them to be defaulted to what the plan sponsors have deemed appropriate. Here, the primary allure of managed accounts, customization, now becomes a potential limitation. For instance, the managed account provider may provide participants with a series of questions to tailor a portfolio to their unique circumstances.
If the participants are disengaged, they are less likely to provide this additional detail (e.g., outside assets), forcing the provider to rely solely on standard recordkeeper data (i.e., contribution rate, age, etc.). While this data is informative, the efficacy of the MAS is likely reduced.
Furthermore, data available at the current recordkeeper may be misleading in the event that participants have assets in a previous employer’s plan. As you can see from Figure 2 below, from a percentage of assets standpoint, the assets tend to stay in the plan upon employment termination. Given that the median length of time workers are with their current employer is 4.6 years3, participants likely have accumulated a number of accounts with varying balances over the course of their careers. For example, assuming someone began working at age 21 and planned to retire at 65, they would have been with roughly 9 different employers over the course of their careers. If that is the case, only a small percentage of their assets may be attributable to their current employer’s retirement plan. As such, the balance shown would represent an incomplete picture and may suggest a very different course of action than their actual circumstances indicate.
Finally, it is important to consider who the primary users of the QDIA are. In general, unless a re-enrollment occurs, participants defaulting into the QDIA are younger employees with low account balances. As previously discussed, at this stage of their careers, they are primarily focused on growth (i.e., wealth accumulation) and likely have little need for customization. As a result, a more cost effective solution (e.g., a pooled vehicle) may be more appropriate.
Managed Accounts as an Opt-In Service
While the adoption rate of managed accounts as a QDIA has been relatively low, the percentage of plans offering them as a broad investment option outside of the QDIA role has generally increased over the past few years (see Figure 3 on the following page).
This usage can largely be attributed to the evolution of the idea of personalization (the mantra of “one size does not fit all”) in the retirement industry. Though the issues discussed in the previous section persist, there may be a difference in perception fueling the growth of managed accounts as an opt-in service instead of as a QDIA. Specifically, as an opt-in service, plan sponsors may view managed accounts as an enhanced offering, where there is limited/reduced fiduciary risk compared to offering it as the QDIA.
Realizing that participants’ financial situations increasingly differ and often become more complex as they age, we believe that offering a managed account as an opt-in service may be a prudent decision. Under this structure, disengaged participants/newer entrants to the workforce would benefit from being defaulted into a pooled vehicle (i.e., a target date, risk-based, or balanced fund), which is likely to be a lower cost solution. Likewise, engaged participants could proactively choose to use a more tailored approach (i.e., a managed account) that may better reflect their individual financial picture.
Selecting a Managed Account Provider
Once a decision to offer an MAS has been made, the next question becomes which provider to select. Similar to traditional due diligence, factors such as manager experience and reasonableness of fees should be considered. In addition to those criteria, plan sponsors should also fully understand the provider’s investment philosophies and portfolio construction methodology.
While managed accounts may be customizable, generally speaking, providers will utilize some type of pre-set criteria and/or assumptions to determine participant allocations. For example, consider how the provider defines participant success. While a plan sponsor may view success as replacing 90% of a participant’s last working year’s salary, the provider may define it as 70%, potentially leading to very different asset mixes over time.
Other ways in which providers’ and plan sponsors’ views may differ is in their interpretation of participant data; specifically, in regard to savings rates and the presence of outside assets (e.g. access to a defined benefit plan, an Individual Retirement Account). For instance, if participants are saving at healthy rates and have considerable outside assets, how does this affect their capacity for risk? Some may argue higher savings rates and outside assets alleviate the need for participants to take as much risk with their defined contribution assets, resulting in a more conservative approach. Alternatively, others may argue that higher savings rates and outside assets indicate that participants are in a position to absorb larger portfolio losses without derailing their retirement savings progress, resulting in a more growth-oriented asset mix. Whichever the case, plan sponsors should evaluate the provider’s assumptions to ensure they align with both theirs and the participant base’s expectations.
Another essential part of the due diligence process is understanding the provider’s construction methodology and overall investment strategy. As previously mentioned, managed account providers may utilize investment options from the single asset class tier of the menu that have been selected by the plan sponsors, or they may require the plan sponsors to use a list of investments that they have pre-selected. In both cases, all parties should have an understanding of how the options were chosen, how they will be monitored going forward, and what “triggers” may be used to replace an option in the future.
While there is an intuitive/natural desire to select “best in class” managers on the single asset class side, we believe the asset allocation decision is even more important. In fact, several studies have been conducted on the importance of asset allocation versus security selection decisions. Although there has been debate regarding the specifics of these studies, the general conclusion has been that asset allocation plays a greater role in determining investment returns over time.
Accordingly, plan sponsors should take a close look at each provider’s strategy and methodology to determine whether they believe it will put participants on track to achieve their retirement goals. Below is a list of key questions plan sponsors should consider when selecting a provider.
- What factors are used to determine the appropriate allocation for each participant and do some factors carry more weight than others?
- Is standard recordkeeper data used (e.g., gender, age, income)?
- Is non-standard information utilized (e.g., risk-tolerance, outside assets/liabilities)?
- What type of methodology is used to construct the asset allocation?
- What is the provider’s experience with making asset allocation decisions?
- Does the provider use mean-variance optimization (MVO) or Monte Carlo simulations? If so, what are the underlying assumptions?
- Does the provider adjust the asset mix based on the risk and opportunities inherent in today’s market environment? If not, how often is the portfolio rebalanced (e.g., quarterly, annually)?
Broadly speaking, we believe that the personalization managed accounts offer through more precise allocations have the potential to improve participant outcomes; however, it should not come at the expense of flexibility. Just as customization can play a role in achieving successful retirement outcomes, we believe flexibility is an even more important ingredient; specifically, the flexibility to adjust the asset mix in light of the prevailing market environment. If a provider employs a passive (i.e., static) allocation, they may be too aggressively positioned when risks in the market indicate that a more conservative approach is prudent, and vice versa. As such, gains made through customization may be offset by the losses experienced as a result of the inability to adapt to the current environment. Simply put, participants may be taking one step forward by accessing a more personalized asset mix and two steps back if the provider fails to adjust said asset mix as market conditions change.
Keeping with the ideas of customization and flexibility, think back to one of the primary reasons for offering a MAS. Generally speaking, plan sponsors feel that each participant is unique and therefore, their allocation should be representative of their personal circumstances. If plan sponsors have come to the conclusion that portfolios built for the “average” participant are insufficient, why would a portfolio built for an “average” market be sufficient?
Providers that utilize a passive approach to asset allocation are essentially creating a portfolio built to withstand an “average” market environment. As you can see from Figure 4 below, if history has taught us anything, it’s that there are periods where markets can meaningfully vary from averages and for extended periods of time. As such, providers need to have the flexibility to navigate those uncertain periods, recognizing the risks and opportunities present, and having the ability to act accordingly.
The growth of managed accounts in the retirement industry today is a natural progression in the evolution of professionally managed products. As such, when deciding whether or not to offer them, it is important to take into consideration plan demographics and participant needs. Should plan sponsors ultimately decide to offer a MAS, like other options on the investment menu, they should incorporate a comprehensive due diligence process to determine which prospective provider best meets their plan’s needs.
With regard to selecting managed accounts as a QDIA, given their fee levels, difficulty in evaluation, varying degrees of customization, and the types of participants typically defaulting, we believe participants may be better served by utilizing a pooled vehicle (i.e., a risk-based or target date fund) as a QDIA. However, offering managed accounts as an opt-in service could be a valuable tool to help address the needs of participants with more complex financial situations and/or who wish to utilize a more tailored approach. That said, even when adopting a customized solution, we strongly believe one of the most important factors influencing participant success is the asset allocation decision. As such, if the managed account provider does not employ a flexible approach to asset allocation (i.e., adjusting the asset mix in light of prevailing market conditions), any potential benefits ultimately derived from customization may be limited.