Glide-Through or Glide-To: Which Slippery Slope Is Right For Participants?

When the government decided to allow corporations, who sponsor 401(k) plans, to use automatic enrollment features, it had to ensure the funds that participants were defaulted into were going to be managed in a prudent way.

 Default investments do not just apply for first time-enrollments. An increasing number of 401(k) participants actively choose to use default investments throughout their employment. Others roll over 401(k) plans from other companies and likewise, chose to use them. The important point to understand is that these “default” investments are not meant to be just a temporary place to invest money until a participant finds some better alternative. They are meant to be a qualified selection under ERISA (Employee Retirement Security Act). These investment choices fall under the acronym; Qualified Default Investment Alternatives, or QDIA’s.

 QDIAs are beneficial for both employees and employers.

 EMPLOYER-SPONSORED BENEFITS:

 If certain conditions are met, when an employee is defaulted into a QDIA or chooses a QDIA as their investment option, plan sponsors are shielded under the Pension Protection Act from fiduciary liability for any losses that may occur from the investments in a QDIA.

 QDIAs are considered “safe-harbors” as investments. The word “safe” doesn’t mean they are risk-free; instead it means the employer is provided with relief from liability associated with the investment choices on behalf of their participants and from liability if the fund loses money.

 This applies to and on behalf of non-responding participants, i.e. those who do not make the investment elections and are automatically defaulted into a QDIA. In addition, if a participant fails to make an investment election after Dec 24, 2007, the effective date of the QDIA rules and after receiving the required notification, fiduciary relief will extend to all assets invested in the QDIA and without regard to whether the investment was made as a result of a default investment or an affirmative election.

 This clarification provides welcome relief for plan sponsors who fail to maintain records indicating whether assets were invested by default. However, if a participant has not been give the opportunity to direct his or her investment, fiduciary relief will not be available.

 QDIA DEFINITION:

 The Department of Labor (DOL) defines a QDIA as an investment fund or model portfolio that’s designed to provide both long-term appreciation and capital preservation through a mix of equity and fixed income exposures. Management of the fund’s portfolio investments must be based on an employee’s age or target retirement date; or an overall age of the plan’s employees.

 To qualify for a QDIA, the fund must be professionally managed by an ERISA investment manager, plan trustee, or an investment company, which is registered under the Investment Act of 1940. (Investment funds or products lacking either a fixed income or an equity exposure generally can’t qualify as a QDIA. Most stable value and guaranteed income contracts will not qualify as a QDIA for this reason.)

 Once approved there: are generally three investment categories available:

§          Target–Date Funds (Life-Cycle Funds)

§          Balanced Funds

§          Managed Accounts

 I would like to focus on Target-Date Funds, as they are receiving the most press and scrutiny from the DOL since the credit crisis. Much of the coverage has been negative and focused on the extreme negative returns that some “glide-through” retirement Target Date Funds experienced.

 The four largest 2010 Target Date Funds, representing 87% of all 2010 assets lost 25.8% on average in 2008.  These were respectively: Fidelity Freedom 2010 (-45.5%); T.R. Price Retirement 2010 (-57.4%); Vanguard Retirement 2010

(-53.6%); and Principal L/T 2010 -48.2%. The S&P 500 was -38.0%*

*Source Morningstar

Balanced Funds did even worse; the four largest funds were down 29.9% on average in 2008.

GLIDE PATHS:

 Target Date Funds (TDF) are basically named according to the year of one’s Age 65 retirement or “target-date. For instance, an employee who elects a 2030 TDF would be expecting to start taking an income in 2030.

 These funds focus on altering asset mixes between stocks and bonds (and other asset classes) as the target date approaches. You’ll often hear this called the “glide path.” In other words, the fund attempts to “glide you safely into retirement.”

 And therein lies the rub of the recent criticism (and 2008 returns). Just what exactly should one’s investment mix be at retirement age and how do you define (and design) it safely?!

 GLIDE-TO TDFs manage the participant’s investment exposure “to retirement.”

These funds will more rapidly reduce their exposure to riskier investments, i.e. equities as an investor gets closer to their retirement age. Assuming age 65 is the chosen date of the fund, when a participant begins drawing money to generate their income, their equity exposure is 30% or less and their bond/cash exposure is 70% or more. You can bet that those TDFs that had “Glide-To” as their mantra did not suffer as huge a loss in 2008 and protected their participants’ retirement assets.

 GLIDE-THROUGH TDFs, on the other hand, manage their investment exposure “through-retirement” all the way to life expectancy. This glide-through approach uses a rational argument, based on historical rates of return and patterns of inflation, combined with increasing life expectancies, that an individual investor will not suddenly pull 100% of their money out of their TDF immediately upon retiring to meet their income needs. Instead, that investor needs their money managed through their life expectancy which could be another 25 years. These funds as I have already noted suffered the worst in the credit crisis, down as much as 45-65%.

 These kinds of losses have gotten the attention of government agencies that are now trying to determine how to avoid such losses in the future for the average, unsuspecting 401(k) participant.

 The DOL and the SEC held a joint hearing on June 18th to look into how Target Date Fund managers determine the asset allocation of their funds. New regulations are likely to be made from both agencies.

 More regulation from both the DOL and Congress will be counter-productive and I fear will further tie the industry’s hands with the added layers of more government requirements for disclosure. What is needed is greater and ongoing education for participants on what is an appropriate investment choice and risk tolerance for them along with detailed disclosure of how each Target Date Fund operates its glide path and investment mix.

 One 401(k) provider has recently begun offering Target Date funds with a conservative, moderate or aggressive strategy offering, which is determined through a risk-profile questionnaire. The provider allows the participant to articulate whether they want a Target Date Fund that will “protect capital” at their retirement age (i.e. have at least 70% exposure to bonds and cash), or dial up their risk tolerance to equities at retirement. The latter may be an appropriate alternative and strategy to a 401(k) participant who has other assets and is not looking for their 401(k) to be their primary source of generating an income for life starting at age 65.

 The thrust of this new offering is again; greater education and communication for and with participants, regarding what is in their best interest in terms of “glide-to” or “glide-through” their retirement with these investments.  I am confident that, you the advisor is the one who really benefits from all the exposure and dialogue around Target Date Funds. It opens up a wonderful opportunity to go back and hold education meetings for all your 401(k) participants to insure they (and you) understand the logic behind the Target Date they have selected. It is also critical that your plan sponsors understand the nature of the Target Date Funds they are offering and that you document the decision making process that was used to make available the glide path TDFs that were elected by the trustees. In addition, remember that while participants may be able to set the Target Date on auto-pilot for 30-40 years, plan sponsors are still required each year to perform investment due diligence on these funds to insure they are still appropriate choices for their participants.

 The last thing we want is government agencies mandating what is the appropriate glide path for everyone. Heck they can’t even figure out how to get the mail moved from one town to another without losing $7 billion dollars. Do you really want them telling you what retirement glide path is right for you?!