Most people aren’t very good investors, plan participants included. The notion that making each 401(k) participant a portfolio manager would somehow lead to better outcomes hasn’t exactly panned out, we now know, with the benefit of hindsight.
The growing recognition that participants need help managing their 401(k) account is why target-date funds (TDFs) currently have $3 trillion in assets and are the default option of choice in defined contribution (DC) plans today.
Plan sponsors and consultants typically love TDFs because they radically simplify investment decisionmaking for participants, who get a portfolio based on their expected retirement age. TDFs aren’t perfect, but they’re a good starting place for most investors.
In plans that offer a TDF as the default investment, roughly 75% of participants initially select it, and roughly 2% to 5% opt out per year. Even if the plan sponsor does a re-enrollment annually, it will probably have no more than 80% of plan participants in the TDF. Why? Because many want something else.
Most participants who don’t want to use the TDF or who opt out of the plan end up building their own portfolio—or “self-directing.” Yet some who don’t want to self-direct would like something more personalized than a TDF—something that reflects their specific, unique circumstances.
They can get this type of advice/solution in about 50% of 401(k) plans today via a service called managed account. Managed accounts generally provide some form of robo adviser, the primary means of engagement being a website, although many providers offer additional forms of support, such as a call center or even local financial advisers.
Many consultants, and some plan sponsors, view managed accounts as competing with TDFs and compare them on performance and other metrics. In economic terms, this would make the two “substitutes” for each other, producing, effectively, a zero-sum game between them; participants can choose only one. This is very much the wrong perspective.
In reality, managed accounts and TDFs aren’t mutual substitutes, they’re mutual complements, because when offered together they actually increase the total number of participants in a plan using a professionally managed investment option. This achieves a goal that plan sponsors and consultants alike typically are working for.
This is a topic I explore in detail in my co-authored research brief “Complements, not substitutes: Together, managed account and target date funds improve retirement plan outcome.” We found that, while TDF use did decline slightly when a managed account option was offered, the effect was relatively small, and the overall percentage of participants using a professionally managed investment option—i.e., a TDF or a managed account—increased significantly. We estimate that about 80% of participants who choose a managed account would likely self-direct if a managed account option was not available, while about 20% would end up in a TDF.
This perspective is really important when thinking about the appropriate benchmark for managed accounts—and sometimes the decision of whether to offer them at all. If a plan sponsor compares managed accounts with TDFs using the “substitutes” perspective, it may decide not to offer the service, as the performance between the two will likely be similar—i.e., they are both professionally managed multi-asset portfolios. While to not offer managed accounts would likely increase the use of TDFs only slightly, it could also mean that many more participants will self-direct.
In other words, the benchmark for managed accounts probably shouldn’t be just TDFs because that fails to capture what participants do when managed accounts aren’t offered. Rather, the benchmark should be some combination of participants self-directing (~80%) and those who do opt for a TDF (~20%), which is a significantly lower bar. In other words, comparing a managed account with a TDF is a bad comparison because lacking the managed account option, many participants might simply self-direct.
While TDFs and managed accounts lend themselves to comparisons because they are both professionally managed investments, it’s important to realize that each is apt to appeal to a different cohort of participants. Participants who use a TDF tend to be younger with a lower income, while those who use a managed account tend to be older with a higher income.
In summary, managed accounts and TDFs should be viewed as complements of, not substitutes for, each other, because by offering a managed account option, plan sponsors are more apt to get additional participants into a professionally managed solution than if they offer a TDF alone. From my perspective, that’s a solid win.
David M. Blanchett is managing director, head of retirement research, at PGIM DC Solutions.
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