“Every sweet hath its sour, every good its bad,” Ralph Waldo Emerson wrote in his essay, “Compensation.” So it seems to be the case with the two main asset allocation constructs offered to DC investors: target-date funds and managed accounts.
TDFs are easy to communicate, are simple default vehicles and require a low energy commitment on the part of the DC investor. These are the core reasons that TDFs have experienced such a tremendous amount of growth over the last decade, now being adopted by 40% of newly enrolled DC investors. One of the main challenges of TDFs is their one-size-fits-all glidepath for DC investors.
Managed accounts are growing in popularity in DC plans, especially among large account balance holders nearing retirement. However, managed accounts are more challenging to communicate. They work best with investors who actively engage with the program, who have always been a minority of participants. Finally, managed accounts tend to be costly and can represent a significant added cost to the core fund lineups. In some cases, such as when the fund lineup is all-passive, the managed account fee can double and even triple the cost of accessing the underlying asset classes.
What has been growing in popularity are DC plans that offer three different strategies in the same plan: TDFs (which may or may not be customized to a specific plan’s demographics), managed accounts (which allow for customization, especially at the investor level) and a core fund lineup of individual asset classes.
In most cases there are also on-line calculators that, while rarely used, add to the confusion. Many smaller plans with higher per-participant revenue (usually imbedded in higher investment fees) allow for individual one-on-one enrollment — something that is rarely found in large, geographically dispersed employee groups. Without the personal help of a financial advisor (in person or over the phone), a DC investor must navigate the confusing assortment of investment choices.
Given that the vast majority of DC investors just want someone to do it for them, this emerging complexity in choice architecture, though rich in options, is just creating more confusion for the average participant.
In my 30 years of experience leading three different full-service firms, I’ve observed that DC investors are best served when given two clearly delineated choices: either be their own asset allocator or outsource this function to a money manager.
Based on my familiarity with the investment patterns and behavior of hundreds of thousands of participants in every major industry, when DC investors clearly understand the outsized impact of the asset allocation decision on outcomes, and their decision gate is a clearly defined binary choice of do-it-yourself or do-it-for-me, roughly 80% will choose the latter. Uptake percentages less than this, in my view, are the result of a poor choice architecture that ignores the degree in which asset allocation is simply Greek to the majority of DC investors. The assumption that collateral material sans an advisor can fix this problem has been proven wrong in study after study.
At some point it would seem that there will have to be a convergence of TDFs and managed accounts. Some money managers are agnostic and offer both; some lean toward TDFs and see managed accounts as more of an add-on option; and some are more committed to managed accounts than TDFs. The plan sponsor and their advisors are in the unenviable position of having to figure out how the best investment lineup should be structured. Most plan sponsors are choosing to use TDFs as the core asset allocation vehicle with managed accounts as an option — but not often as the default (QDIA) option, which, more often than not, is a TDF lineup.
A technology/financial services firm, NextCapital, recently announced that they and Russell Investments have developed and deployed what is essentially a hybrid TDF/managed account asset allocation program called the Russell Adaptive Retirement Accounts (ARA) solution. Russell Investments is the first rollout of this new asset allocation solution.
Based on my recent interview with Dirk Quayle, NextCapital’s president, the core features of Russell's ARA program are:
- From the perspective of the plan sponsor and its advisors, this program looks and feels like a TDF and can serve as a QDIA. Furthermore, it is customized based on data provided by the plan’s record keeper and the sponsoring employer. The more data (e.g., salary, projected Social Security income, other employer retirement plans) received, the more customized the default TDF-like option.
- Once a DC investor is in the ARA account by choice or default, they can, in turn, customize the solution further by providing additional input via a web interface. Therefore, there is no need for a two-tiered asset allocation offering.
- The ARA offering is in the position to pull down the cost of providing a customizable asset allocation overlay due to the economies of scale leverage that web delivery provides.
- NextCapital and Russell have no intention of disintermediating the plan advisor. Instead, their intention is to augment advisors’ efforts to become more effective in servicing their clients. One of the first implementations, the Ingham Retirement Group, has developed its own custom asset allocation overlay strategy.
More enhancements to the program will be forthcoming after the first of the year.
The program has exited the “vaporware” stage of development. After implementing it for their own employees, Ingham is now taking the program out to their clients.
Conclusion
Here’s my take: I believe that where NextCapital is moving is in the direction of providing an industry-wide chassis that is money management/advisor neutral. If it is successful, it is conceivable that this could create a more diverse marketplace that brings down the barriers to entry for many money managers — many of whom are on the outside of the DC space looking in. Additionally, the program creates the potential for advisors to put their personal stamp on their own asset allocation strategy. This dovetails with the trend toward advisors increasingly taking an explicit fiduciary role relative to the plans they advise.
At the end of the day, it’s about:
- Simplifying the choice architecture (binary as opposed to a maze structure) and customizing programs so that DC investors can achieve better individual as opposed to fund level outcomes.
- Creating as much individual customization as possible — while retaining the simplicity of the TDF/QDIA structure that has a much broader and deeper penetration than managed accounts, which is critical as increasing numbers of plan sponsors choose the default approach over enrollment.
- Using the web as the primary delivery mechanism while supporting the plan advisors efforts to do what they do best: high level consulting, ongoing client servicing and, of course, business development.
Russell's ARA offering is a promising development to watch. No doubt, some of the incumbent asset allocation providers may pivot to this approach. However, the challenge of mimicking NextCapital’s strategy is that many managed account providers will have a hard time converting their platforms to an investment chassis that can be retrofitted to suit a plan advisor’s own asset allocation strategy. In fact, many managed accounts providers have taken a go-it-alone approach — giving financial advisors little or no say over the asset allocation strategy being deployed by the managed account provider.
However, as we have seen since the 401(k) feature began being adopted by old and new DC plans in 1982, legacy practices tend to persist (and resist) new innovations. That typically changes once new practices become established and disrupt current models. It took more than 10 years for the first TDF to be developed, and another 10 years for these programs to gain some serious traction. However, numerous factors — the swelling of DC plan assets, industry competition, the demise of DB pension schemes, concerns about the viability (or the level of future benefits) of Social Security and the maturation and ubiquity of the web interface as an every increasing means of communication — may coalesce in a way that increases the pace of innovation in the DC space. Innovation that, in some cases, is way overdue.
