Are TDFs really the best QDIA? 4 other options for structuring retirement plans

Target-date funds have revolutionized the 401(k) market over the past decade. With well more than $1 trillion held in mutual funds, and hundreds of billions more in collective investment trusts, TDFs are by far the favored qualified default investment alternative of plan sponsors large and small. Data from various recordkeepers shows nine out of 10 sponsors use TDFs as their QDIA.

But are all those sponsors, and the tens of millions of savers invested in the funds, missing the boat?

Jason Shapiro, director, investments, at Willis Towers Watson, thinks sponsors and savers have better options than traditional TDFs. And he says those alternatives are available to all, not just large and mega sponsors.

“We don’t want to be prescriptive,” said Shapiro. “There are a lot of different ways for sponsors to structure plans for an eye to better retirement outcomes. But the ideas are out there, and we think each has merit and can be implemented in most plans.”

1. Managed accounts

Shapiro says managed accounts, which use data inputs beyond the age of a participant to create personalized savings strategies, are now offered in about half of retirement plans.

But while there has been growth in the offering of managed accounts, adoption is still low—around 9 percent when plans do offer them.

Cost-conscious sponsors may be playing defense in a litigious world by defaulting savers into TDFs, and not managed accounts, says Shapiro.

And some have been critical of managed accounts because the level of participant engagement needed to make the model cost efficient often isn’t there.

“Adoption is low because sponsors and not defaulting savers into them—participants have to opt in,” said Shapiro. “If you defaulted more participants in to managed accounts, it could be argued there would be less engagement overall, and less customization.

2. Hybrid model

Empower and Fidelity are among the record keepers that have rolled out a hybrid QDIA that defaults TDF savers into a managed account in their 50s.

The elevator pitch: the individual gets personalized savings advice near and in retirement, when they most need it.

A paper authored by Shapiro shows the wide disparity of return-seeking assets in TDFs and managed accounts.

A 55-year old invested in a TDF would hold between 50 percent and 75 percent in return-seeking assets. In the hybrid model, the same saver could hold between 42 percent and 95 percent in return-seeking assets after being routed to a managed account, indicating the higher level of personalization to the individual’s needs.

The low engagement knock doesn’t apply to the hybrid model, says Shapiro.

“Savers in their 50s will be more engaged in the customization of their accounts,” he said. “The overall numbers on managed account engagement are skewed because they account for all the universe of savers—the 28-year old that may not be engaged with their account, and the 55-year old that is.”

3. The “unwrapped” TDF

The unwrapped TDF—Shapiro says it’s a term coined by Willis Towers Watson—allows a sponsor to customize a target date series to its workforce’s demographics, but doesn’t involve the high costs and in-house labor of customization.

“There’s a level of operational, hands on support needed for customization,” said Shapiro. “And there are trust and custody costs. It can cost up to $20,000 to create a new fund, depending on the asset classes, and for and entire TDF suite, that can mean up to $300,000 in costs. That’s why custom TDFs are typically seen in larger plans.”

But the unwrapped model, which is seen more often in the advisor-driven small and midsized market, allows sponsors to build custom glide paths with a record keeper’s model portfolio or managed account solutions.

“It creates an experience for a participant that is very similar to a traditional TDF, but done in a way that is more like a managed account,” said Shapiro. “It’s personalized at the plan level—you get customization along the glide path that you would not get in a traditional TDF. And you avoid the costs of customization.”

4. Weaving alternative assets into TDFs

Shapiro recently co-authored a paper exploring the potential of alternative assets—private equity, hedge funds, and real estate investment trusts—to grow retirement income in TDFs.

The findings were appealing. Diversifying TDFs with alternatives reduced risk considerably, and the median increase in retirement income was 17 percent.

Only eight of the 41 TDF managers tracked by Morningstar include alternatives in their funds.

Others in industry are calling for the type of diversification in 401(k) plans that is used in public and private pensions.

But the reality is change won’t happen over night. “Serious innovation” will be needed from investment providers, says Shapiro.