When participants retire, should their QDIA retire as well?
May 10, 2017
Many retirement plan sponsors are increasingly recognizing the benefits of allowing retired employees to leave assets in the defined contribution (DC) plan. This arrangement can be a win-win for both plan sponsors and participants. Fat retiree balances may improve plan economics, allowing plan sponsors to negotiate lower fees. And participants can take advantage of funds that are overseen by fiduciaries, often available at lower costs.
But even as more retiring participants may decide to leave their assets in the DC plan, for some it may not be much of a decision at all. These may be the disengaged or perhaps uninformed participants – often the same ones who were swept into the plan by automatic enrollment. Those passively enrolled generally also have their contributions invested by default in the plan’s qualified default investment alternative (QDIA), may tend to stay in the QDIA, and may very well take an equally apathetic approach at retirement. As a group, they may simply fail to move their assets from their DC plan account.
In light of this, plan sponsors and their advisors may ask: The plan’s QDIA may be appropriate for younger workers, but is it the best choice for retired participants? For that matter, what about near-retirees and other participants who may have different risk profiles, but who simply remain in the default investment? The upshot is that plan sponsors may want to consider whether QDIAs work as an ongoing investment, especially for retirees.
Why designate a QDIA?
QDIAs were designed by the US Department of Labor to protect plan sponsors from liability when they invest assets on behalf of those employees who join the plan who fail to select investments despite being offered the opportunity to do so. This safe harbor system was established in 2006 by the Pension Protection Act (PPA), primarily serving to remove barriers to automatic enrollment systems (in which new employees are automatically included in the plan unless they actively choose to opt out). But QDIAs can also provide protection in more traditional enrollment plans and other instances, such as when participants don’t complete enrollment forms properly or they roll over assets from a previous employer’s plan without designating investments. QDIAs also provide a safe-harbor landing spot for employee assets when a plan’s investment options change.
To be designated as a QDIA, an investment must be appropriate either for a particular individual’s age or retirement date, or for the characteristics of an entire group of employees. Balanced funds, managed accounts, and target-date funds all have the potential to meet these criteria. The PPA also allowed for stable value funds to be used, but, in general, they’re allowed for just the first 120 days after enrollment. Their main purpose is to provide a temporary investment for those selecting to opt out of automatic enrollment.
The target-date QDIA dilemma
Of the common types of QDIAs (see above), target-date funds have become the runaway favorite among plan sponsors and their advisors. They are viewed as easy to communicate and, because they’re built via a glide path to grow more conservative over time, they are seen as helping to keep participants’ assets reasonably allocated over the span of their careers.
While target-date funds can offer advantages for many employees during the savings accumulation phase, they also can pose potential pitfalls for some participants, especially near and in retirement. One potential drawback is the tendency of many participants to “set it and forget it” — once invested in a target-date fund, especially if they were defaulted into it as a QDIA, many participants may simply ignore it, no matter what their circumstances. Plan sponsors may want to address this in their communication strategies to near-retirees, although it may be worth considering wider communications to all defaulted participants about examining whether they are invested appropriately.
Still, retirement can bring up special investing needs. Retiring participants’ personal financial situations can vary widely, which can mean their investments may need to be adjusted as a result. Some will have accumulated much greater balances than others, and some may have access to pensions or other financial assets that will help fund their retirements. Others may still be supporting adult children, plan to buy or sell property, or have other major spending goals. All of these variables help determine when and how participants will need to draw down their assets, including their DC plan savings.
By their nature, target-date funds can’t take these individual differences into account. That’s why as participants near or enter retirement, the QDIA that many may have defaulted into, and which they may have stayed with through their working years, may no longer be quite as appropriate an investment vehicle come retirement.
“To retirement” versus “through retirement” can be important
To analyze the appropriateness of a target-date fund for a plan’s retirees, start by looking at its glide path. The glide path represents how the allocation between equity and fixed income changes over time. While glide paths for all target-date funds become more conservative over time, no two are exactly alike, with one key differentiator: Is the fund designed to go “to retirement” or “through retirement”?
Funds implementing a “through” strategy follow glide paths that continue to become more conservative after the target date. These can be most appropriate for participants who plan to make periodic withdrawals over a much longer period of time, or who may tap other retirement vehicles for income first, delaying withdrawal from the target-date fund.
Funds that follow a “to” strategy feature a glide path that plateaus at its target date, and allocations stay consistently conservative afterward. These funds are designed for those who plan to start withdrawing most or all of their money from the fund upon retirement.
The “to” fund strategy raises several questions for plan sponsors:
- Do participants understand what type of target-date fund they have, and the implications for retirement income planning?
- If they keep their retirement savings in the plan’s QDIA at retirement, is it an informed choice?
- What is the plan sponsor doing to call attention to the type of target-date fund?
Because of these considerations and the difficulty in knowing the circumstances of all retiring participants, it may be time for plan sponsors to think about investments specifically earmarked for retirees.
Retirees may need different types of investments
Even if a plan sponsor believes that the plan’s retiree population is a good match for a “to” or “through” glide path, it’s still important to consider the changing needs of retired participants — needs that may no longer match either type of glide path. As a result, you may want to consider discussing with plan sponsor clients the idea of helping to steer retirees to more appropriate investments in the plan lineup, or even introducing to the lineup funds that might be better suited for retirees. Either way, a retiree communication strategy can be important.
There are a number of individual investment types to consider to help support the needs of participants, both near retirement and already retired. For example, plan sponsors may want to consider adding risk-managed, multi-asset allocation funds designed to deliver both growth and income as a starting point. It could be supplemented with a fixed income fund to support the more immediate financial needs of retirees and for more risk-averse investors. Retirees with higher risk profiles — those who don’t need to tap their assets immediately — may want more access to equities, perhaps in specialized areas like small-cap and emerging market funds, to help infuse more diversity into the growth portion of their portfolios that won’t be tapped until later in retirement.
Are participants misusing target-date funds — or are target-dates not working for them?
While target-date funds have become commonplace in DC retirement plans — rising from 33% of plans offering them in 2005, to 90% in 2015, according to one study1 — many plan participants may not be investing in target-date funds quite the way the original designers intended. For example, a Financial Engines 2016 report2 indicated that of those invested in target-date funds, only one in four uses a target-date fund for their whole retirement portfolio. Among all retirement investors, only 11% uses target-date funds alone without other investments mixed in.
Source: Financial Engines, 2016.
While target-date funds are designed to be all-in investments, their one-size-fits-all approach may simply not work for different circumstances. An Aon Hewitt study3, which found that slightly less than half (49.7%) of investors were using target-date funds “correctly” as their sole retirement investment, suggests some retirement investors may have valid reasons for partial target-date use.
For example, the study noted, two 50-year-old participants may have different financial circumstances. One might have a defined benefit (DB) plan, a child who has completed college, and a house that’s paid off. The other might not be eligible for a DB plan, has children just starting college, and has significant mortgage payments. These two participants may need different retirement portfolios, but a target-date fund would treat them in identical fashion. With that in mind, it may not be surprising that as participants age there’s a decrease in the percentage of those using target-date funds for their full portfolio, as shown in the chart below.
Source: Aon Hewitt, 2016.
RMDs: Another factor to consider when keeping your 401(k)
Another aspect to bear in mind for retired plan participants is that the federal rules on required minimum distributions (RMDs) apply to retirement plans the same as they do with IRAs. RMDs generally are required to begin the year the retirement account holder turns age 70½, but if the retirement assets are held in a plan (or several plans, including any Roth plan accounts), the RMD must be calculated separately and distributed separately from each plan. The IRS website has a helpful table on RMD rules for IRAs and employer plans.
A focus on retirees staying in the plan
For more about serving the needs of retirees who leave their assets in their employer-sponsored plans, read More retirees in DC plans? Helping plan sponsors prepare for a new reality.
Asking the right questions
Advisors can help plan sponsors stay ahead of the trends by analyzing their pre-retiree and retiree populations now to answer these questions:
- When will most retirees across the population likely need to tap their plan assets?
- Do the current QDIAs meet those needs?
- Should new retiree-focused investments be designated?
- Does the fund lineup need to be expanded to meet the diverse needs of retirees?
- What is the plan’s approach to educating near-retirees on this issue, and possibly tying it to other financial wellness efforts?
When discussing this topic with plan sponsors, it’s particularly important to stress the importance of communication with the near-retirement segment of the plan population. Participant education that addresses whether a QDIA remains the most appropriate investment — especially for those participants who are inclined to simply set it and forget it — can be a good idea for all groups. But educational resources and managed account services targeted to pre-retirees and retirees can help these participants implement strategies that make sense for their own situations and their retirement years.
About target-date funds
Target-date funds, which are among the most common QDIAs, generally involve selecting an investment by the target year closest to the anticipated year of retirement (such as a “2040 Fund”). As the investor nears the target date, the fund would gradually shift from more aggressive to more conservative investments along what is known as a glide path. Although the intent is to reduce risk, an investment in target-date funds is not guaranteed at any time, including on or after the target date.
1Aon Hewitt, 2015 Trends & Experience in Defined Contribution Plans.
2Financial Engines®, Not so simple: Why target-date funds are widely misused by retirement investors, March 2016.
3Aon Hewitt, Target-Date Funds: Who Is Using Them and How Are They Being Used? November 2016.
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