Getting personal: Innovation in 401(k) investments

next issue no. 7: On the horizon

There are certain conveniences we’ve all come to expect in our daily lives. Conveniences such as streaming services providing a menu of suggested shows based on our viewing preferences, meteorological services predicting the weather within a mile of our exact location, music software curating customized playlists based on our listening history and medical websites providing possible diagnoses for our health issues. We are increasingly expecting predictive technology to improve our daily lives. This begs the question, why don’t we expect the same level of customization in our retirement plans?

This is not to say that the retirement industry has been stagnant. On the contrary, legislative and regulatory changes (the Pension Protection Act of 2006), operational advancements (auto enrollment and auto-escalation) and product innovation (dynamic asset allocation in target date funds) have all had a major hand in shaping defined contribution plans over the past two decades.

However, increased focus on fees and vehicles coupled with a dramatic rise in DC litigation seems to have shifted attention away from long term outcomes, thereby stalling innovation.

Investing in employee financial wellness

With this information in mind, it’s no wonder nearly half of plan sponsors view their retirement plan as a way to attract and retain talent. To do so, they’re focusing on the needs of employees, which are increasingly intertwining with the needs of the company.

Financial wellness, planning and education offered by employers are adding value to the employee experience. A successful financial wellness program often includes planning tools, advice models, education seminars, access to financial planners and sound investment solutions among other things, all tailored to an individual employee’s personal situation. A common exception to financial wellness programs are investment solutions, which were created for a more general audience.

In earlier times, the popular default investment options were balanced funds and stable value funds, which are arguably a ‘one size fits all’ approach to asset allocation. Target date funds evolved to take a ‘one size fits most’ approach by shifting a participant’s asset allocation based on age cohort and the corresponding expected retirement year. Managed accounts have the ability to further tailor asset allocation based on an individual’s data beyond just birth year and predicted year of retirement.

The concept of a standardized risk-return model becomes increasingly challenged as employees’ age, retiree longevity, health concerns, family planning and income changes all mean that employees need different solutions. As decades pass and retirement grows closer, an argument can be made for more complex risk-return profiling. Additionally, evidence shows employees become more educated and engaged regarding retirement options over time.

Without additional information, customization will be of a lower quality. Data that a managed account provider may request includes date of birth, detailed demographic information and the participant’s current financial situation. To be clear, target date funds are a solid first step toward customization, especially when compared to placing assets in fixed asset class allocations that are not rebalanced over time. Target date funds still present an adequate asset allocation strategy for the majority of plan participants. However, for those with balances or circumstances that require a more customized solution, managed accounts can provide a higher level of service.

Participation required

As we have seen across our interactions on the web, the user has to be willing to give up personal data in order to share a level of specificity with the system. Furthermore, to truly build a customized managed account the provider would need to do additional data gathering, including surveys and deep financial information. While those steps will yield a more customized solution this presents a significant deterrent for participants. As such we have identified two levels of managed account product for participants. The higher level is based on general data the participant has already shared with the provider. The second level is much deeper. It is based on supplemental data that produces more refined investment options. This is done by factoring in broader asset classes, risk levels and overall tolerance of the client.

An emerging component of managed account customization provides further advantages as the accounts can now use non-core options. A known limitation of managed accounts is that they are typically constructed with the 20 – 25 funds on the plan’s core menu of available investment options. Non-core options mean managed account providers have the ability to select options a participant may not otherwise have been able to invest in. The active manager is able to utilize a much broader range of alternative asset classes that may require expertise, such as direct commodities exposure. This capability has the power to add significant levels of diversification and additional return, and include options that the participant may not have the required expertise or ability to otherwise invest in, such as direct commodities exposure. This obviously requires that the record keeper and plan sponsor have the necessary capabilities in order to have noncore options. We believe the benefits are worth the additional work.

Personalization will also help drive in-plan annuities offerings, and annuities will in-turn drive that personalization. Managed accounts help generate better income options tailored to participant needs, and core options for annuities enhances that optionality. Therefore creating a mutual symbiotic relationship. The inclusion of managed accounts and annuities in core offerings empowers participants to incorporate guaranteed lifetime income into their plan, which is a significant area of growth and opportunity.

Key considerations

It is necessary to discuss the value versus cost of personalization. Additional customization and complementary investment options within managed accounts generally carry higher fees compared to other vehicles. During a period of declining fees and tough conversations justifying fees it is important plan participants understand the reason behind the price tag. We would like to emphasize this solution is not for everyone. The target date glide-path might be sufficient for the risk-return profile of most participants. However, for participants who want or need the custom tailoring, the structuring could well be worth it.

The record keeping element of managed accounts is another important factor. The emphasis is firmly on the record keeper to set up the managed account access, but this is often outsourced to a technology provider. This of course carries its own risks and requires due diligence. It is important to implement a system to facilitate a conversation with a third party consultant or advisor. This system is necessary to facilitate pipes from the investment advisor into the record keeper into the plan down to the account before they can manage that. Many record keepers only offer one managed account service to participants as a result of the complexity, but this is still an emerging market and we see progress being made.

Our advice

Leaving well enough alone is not an option for plan fiduciaries. Putting participant outcomes at the forefront of the decision-making process and understanding the evolution of investment design are critical. The retirement industry is heading for a period of innovation, and plan fiduciaries will be at the forefront of that change.