Defined contribution plan sponsors have eagerly embraced pre-packaged asset allocation products as a simple, all-in-one solution for their employees, most of whom lack the time, interest, or market savvy to make their own retirement investment decisions.
But that has led to a new complication: which simple program should 401(k) plans offer, and to which employees?
The big quandary is between target-date funds and managed accounts. (A third option, life-cycle or target-risk funds, has been steadily losing ground over the past half-decade.)
Target-date funds are based solely on the year an investor hopes to retire, with the asset allocation, or glide path, automatically adjusted to reduce risk as that year draws closer. The participant has to choose from among the plans off-the-shelf options for instance, ten funds in five-year increments.
Managed accounts are more personalized. In one common version, the employee inputs variables like age, goals for retirement, other savings, and risk tolerance into an online programming tool, which then concocts a portfolio using the plans existing investment options. As with target-date funds, the asset allocation is automatically rebalanced and adjusted over time.
Another major difference between the two approaches is price. Target-date funds charge minimal or no special fees to the plan and have been steadily reducing them. However, employees will probably pay 20 to 60 basis points extra for managed accounts.
Age is also a determining ingredient. Experts say a managed account doesnt make sense until a person is at least 40, because younger people dont have a complex enough financial portfolio to need expensive customization. Before the age of 42, our models suggest that just about everyone should be as aggressive as they can, approximately 90 percent in equities, says Josh Cohen, head of Russell Investments defined contribution practice. Thus, its more important for a company with a young work force to include a target-date option.
On the other hand, a company with a higher-paid work force might tilt toward managed accounts. When a nest egg gets above $60,000, employees may need some professional help in diversifying, says Jeffrey Snyder, a consultant at Segal Advisors.
But those distinctions arent the end of the story. After all, the younger workers will eventually turn 40. and presumably their portfolios will rise above that $60,000 level as they grow older. Will they want to switch to managed accounts?
Not so fast. Experts say that target-date funds should be a lifetime plan, and the new trend is for the glide paths to extend decades beyond the targeted retirement date. In that case, why would a participant who hoped to retire in 2040 abandon the fund named for that year? Besides which, says Pamela Hess, director of retirement research at Aon Hewitt, people are reluctant to change their retirement asset allocation. Often where they begin is where they stay, she says.
Perhaps a participant could split the assets? No again; both types of pre-packaged accounts at least, in theory are supposed to encompass the entire portfolio.
And dont forget that those twentysomethings may not stick around until they hit the magic 40 or 42, while new fortysomethings will be hired.
The clear winner so far has been target-date funds. According to Aon Hewitt, last year 83 percent of plans offered target-date funds, and 36 percent had managed accounts. Obviously, some companies offer both types, but the survey didnt include that question.
However, its too soon to draw a lot of conclusions, because both products are still so new that few of the target-date generations have yet reached their potential transfer age and therefore theyre not paying much attention. As participants get closer to retirement and build up more of a meaningful balance, points out Cohen of Russell, they start thinking about it more and looking at other tools.
Who knows? Maybe after a couple of decades of passivity, employees will decide to pull their money out of pre-packaged accounts and make their own decisions after all.
Fran Hawthorne is the author of the award-winning Pension Dumping: The Reasons, the Wreckage, the Stakes for Wall Street (Bloomberg Press) and Inside the FDA: The Business and Politics behind the Drugs We Take and the Food We Eat (John Wiley & Sons). She writes regularly about finance, health care, and business ethics.