Asset Allocation Models Are The Only Way Forward For 401k’s

By Neil Plein
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As an introduction, there are a few main points that will outline this article. First, the majority of participants are not engaged in their 401k plan. Second, this realization has recently influenced a substantial movement in the industry to simplify investment management for participants. Third, the industry response has been primarily target date funds which have increased in popularity and inclusion as a result of the first two points; though they fall very short of being the best solution for plans and participants.

If any of those above assertions shook you, here is the hard data. Last month, at the Dimensional Fund Advisors (DFA) Annual Defined Contribution Conference, distinguished MIT professor Robert C. Merton, delivered a presentation which showed that only 41% of participants were actually engaged with their 401k plan. This is to say that the majority of participants are un-engaged. With a statistic like this, it is no surprise to learn that target date fund assets have risen more than 82% in the past 3 years.

The primary objective of such funds is ease and simplicity; both extremely positive developments. Target date funds deliver to the majority of 401k participants an investment vehicle which allows them to be un-engaged and still receive something better than not participating in their plan or attempting to determine investment decisions on their own; participants receive professional investment management for both the short and long term.

Figure 1: A target date fund glidepath demonstrating changing asset allocation over time. Source: Vanguard

Managers in the target date funds make minor changes to the mix and weighting of investments in the short term while making more major changes to the overall asset allocation mix of the funds in the long term. Allowing these things to happen automatically for participants is a great step forward. Prior attempts at delivering professional investment direction from pre-designed models delivered through some medium (print or online) required engagement which as the DFA data shows, fails to address the needs of most participants (the un-engaged).

These aspects, coupled with the heightened attention on 401k plans from fee disclosure debates, have created a momentum of change within the industry; something which could be very good for participants provided things head in the right direction. Here are some general principles for plan design which should be considered in the evolution:

1.)   Participants who choose to be un-engaged (the majority) should receive the best default solution

2.)   Participants who do choose to become engaged (the minority) should have a meaningful experience which results in a benefit exceeding the option to be un-engaged

The popularity of target date funds clearly demonstrates the strong demand from participants for a simplified, un-engaged solution. This benefit does not come cheap, however. According to Morningstar, the average target date fund costs participants 1.02%. So in this regard, target date funds are not yet the ideal solution for addressing the surging demand for ease within 401k plans.

Cost is not the only concern, however. But cost is the starting point of what has been deemed “the equation for retirement success- cost, compounding and contribution- the 3 C’s.” Cost should be low, so participants can keep as much money in their accounts as possible to grow for retirement. The growth of this money comes from compounding returns which should be good (the popularity of target date funds demonstrates the preference for such compounding to come from professional management rather than participant self-direction of investment selection). And finally, contribution; even with the lowest cost investments and best returns, participants will not reach their retirement goals unless they are contributing enough. Of these “3 C’s,” target date funds are only designed to address compounding, which makes them fall short of being an ideal option for participants.

With this macro schema in mind to deliver retirement plan success (cost, compounding and contribution) and the general principals outlined for plan design evolution to meet the needs of engaged and un-engaged participants; where does the solution exist if target date funds have been ruled out on the basis of cost?

The answer is asset allocation models, designed by professionals to be age based and built using low-cost investment options- Exchange Traded Funds (ETFs). These could also be used as qualified default investment alternative’s (QDIA’s) if managed by the right type of ERISA investment manager, such as a §3(38). This solution addresses cost and compounding but not contribution, for a very practical reason; contribution rate is at the discretion of a participant. Even with auto-enrollment, auto-escalation and company match, determining whether the contribution rate is sufficient requires engagement form the participant. With this in mind, cost, compounding and contribution can be distributed amongst the general principles for plan evolution in this way:

1.)   Participants who choose to be un-engaged (the majority) should receive the best default solution- Low cost investments managed by professionals (Cost and Compounding)

2.)   Participants who do choose to become engaged (the minority) should have a meaningful experience which results in a benefit exceeding the option to be un-engaged- Clarity of retirement goals and the contribution rate required to reach them (Contribution)

Participants who engage receive the greatest benefit, not simply cost and compounding, but contribution as well because it can only be addressed and understood through engagement. Even if target date funds were low cost, they would not meet the above conditions because they would have no way of accommodating the needs of the engaged; because target date funds hinder the clarity needed to determine contribute rate.

In “Retirement Calculators Threaten the Stability of Your Entire Plan,” this is examined in greater detail. Target date funds not only have a changing asset allocation over time, but lack the transparency to comfortably understand performance past, present and as a consequence; future. In fact, even if a participant did somehow figure out the rate of return they needed to target, comparing it to what the target date fund would be a nearly impossible task.  This further discounts the effectiveness of target date funds as a default option; essentially there is no benefit to becoming engaged in a plan with a target date fund, all they do is target a date and an asset allocation, not a particular income or wealth level- something once established or understood relies on contribution rate to attain. Asset allocation models, on the other hand, as shown below, have the necessary performance history data points to allow the engaged to accurately calculate contribution rate.

Figure 2: Asset Allocatio Model performance history can be used as data points to calculate contribution rate. The asset allocation models and historical returns are for illustrative purposes only.

By using asset allocation models on a platform which allows investment managers to design models for participants, then have these participants move automatically through the models based on age (similar to how participants would automatically receive an adjusted asset allocation in a target date fund), the needs of the un-engaged are best satisfied by low cost investments (cost) and growth from professional management (compounding). Likewise, the engaged receive added benefit (contribution), allowing contribution rate to be easily calculated and presented with clarity. This process can be further enhanced through the use of an integrated retirement calculator (as the primary engagement option) which incorporates payroll data with the long term performance history of each asset allocation model. The result- contribution rate is calculated automatically; no manual entry or external statement reference required. Implementing plans in this way could have an absolutely substantial impact on the ability of participants to develop adequate retirement funds.

Those who stand to gain the most are mid to large sized plans; especially those which are de-centralized. Smaller plans by comparison, often have the benefit of working closely with an advisor in a cost effective manner. This same level of attentiveness is neither feasible from a cost standpoint nor realistic from a simple geographic perspective in the mid to large plan market; the area where the highest level of target date fund inclusion is taking place as a solution, according to DFA. 80% of plans with assets exceeding $5 million offer a target date fund feature, whereas only 47% of plans with less than $5 million in assets make such funds available. Given the inadequacy of target date funds to fully serve the needs of their markets, as has been established here; asset allocation models are the only way forward.

Retirement Calculators Threaten Your 401k Plan

By Neil Plein
View Neil Plein’s profile

Having a retirement calculator should be a good thing. It helps to perform computations and projections that would otherwise be out of reach to the common 401k participant. The intent of calculators are primarily twofold; to help a participant understand what their retirement savings goal is and to present the necessary contribution rate needed to reach that goal. Calculators are not designed to compute investment performance history, but rather, to use such information along with contribution rate to give the participant an idea of whether or not they’re on track to reaching their savings goal.

Consider your savings goal for a moment. Most calculators, without much input other than simple variables like age, salary and retirement age; can determine what your savings goal should be; how much money you’ll need to save to live on some percentage of your current income for some number of years until death based on standard actuarial tables. This is common, most people know their age, salary and usually that they want to retire at 65; so figuring out a retirement savings goal, at least through the use of a retirement calculator(s), is something which can be done with relatively little resistance or confusion (I’m omitting mentioning inflation, salary increase, etc.).

But with a goal established now what? Logic would follow that you would look at where you are currently (point A) and determine how you will get to your goal (point B). Between these two points is your path and following that path depends on growth; which comes from investment returns and contribution rate working together. Needless to say, managing these two variables is exceptionally important.

Unfortunately, for the average participant, this is the point at which their comfort with plan tools (their retirement calculator) begins to slip away. This can be observed very easily by thinking of how your own retirement calculator works.

The odds, which are overwhelming in this case; are that you log in somewhere, go to your retirement calculator and are then presented with a series of questions that require you to enter personal information manually. Examples are questions like: how old are you? What age would you like to retire at? What is your salary? How much are you contributing? What is your current retirement balance? What is your target rate of return? Now stop. Can you feel the ease with which answers entered your mind fade away on that last question? The first few questions were fairly obvious, came to your mind quickly; but do you have any idea what your target rate of return even is?

According to Warren Cormier, of the Boston Research Group, most participants don’t even know what their portfolio returns are[1], so by lacking this fundamental understanding, how would they even have a chance at grasping what their returns would need to be in the future?

If we consider the hypothetical retirement calculator example above, and acknowledge the troublesome nature of this question; how would it be answered? What data would go in? After all, this target rate of return, the growth component, is essential to understand because of its relationship to contribution rate and therefore the path which leads you to your retirement savings goal; so how do you answer this important question?

Most calculators, through the convenient aid of a help screen, provide some relief through a definition which sounds something to the effect of “rate of return you expect from your portfolio in the future.” Some help screens even provide historic rates of return from major indexes. So seemingly, this could help a participant provided they were 100% invested in one of the referenced indexes. As this is usually not the case, we can mentally focus back on that little blinking cursor in the box marked “what is your target rate of return?”

With the help screen essentially useless, there are two ways to approach answering this question (what is your target rate of return); start with the calculator by guessing some number and seeing what contribution rate the calculator provides or start with your quarterly statement by examining your rate of return (if provided) and using this as your target rate of return. Both of these approaches will lead you to the same confusing conclusion.

Consider approaching from the calculator end, guessing a target rate of return and examining the contribution rate it outputs. Now what? Well, unless this target rate of return is consistent with your current investment portfolio (an 8% target rate of return is not realistic if you’re invested 100% in stable value, for example), this will not help you and your path will be shadowed by uncertainty. The output is only as reliable as the input and the input must then be consistent with your actual investments, requiring, once again, the participant to act in the capacity of a financial expert to make that so.

Now try approaching from the other direction, starting with the portfolio return presented on your quarterly statement, if it is presented at all. Assuming it is, how is it presented? If it is annual, this is not reliable; 2008 is an example of that and surely nobody would argue that examining annual return alone would be sufficient for use as a strategic figure like target rate of return. Another example of this complexity is with popular target date funds, which target not a retirement savings amount or a particular income stream, but a target asset allocation. Since the asset allocation of these funds change over time, what rate of return would a participant use in this case?

These are the types of decisions participants face, even outside of a target date fund, to get any type of return history, you have to look at where history is presented on the quarterly statement; the 1, 3 and 5 year returns of the funds you own. If you can convert all that information into an accurate representation of your portfolio’s performance history and therefore a fairly reliable target rate of return number, then you’re in good shape, that’s all you have to do! But if you can do that, you’re also probably an investment professional.

Since approaching an answer for this great question (what is your target rate of return?) leads ultimately to confusion and uncertainty regardless of how the average participant approaches it, what does this mean? It means that there is a major flaw in the system. But this is encouraging actually, because retirement plans are just that, a system- meaning technology lies at the core, so it is in technology that the system can be fixed.

First of all, in a perfect world, participants would never have to leave their retirement calculators; they wouldn’t have to reference data or perform computations on their own; these things would be handled by the calculator. This shouldn’t be that difficult, the information already exists from payroll, so integrating it into a retirement calculator, where fields are all pre-populated with a participant’s unique information, should be an obvious advancement.

But this is merely one facet, after all, as we discussed above, most participants could input this data anyway, the investments and contribution rate are where they need the most help. So if nothing more, participants should have more comprehensive performance history available for their accounts on quarterly statements, so if they must make the leap from quarterly statement return to target rate of return, at least it will be more meaningful. Ideally, however, this would be done for them.

With personal information pre-populated, personalized investment performance history should also be calculated and pre-populated. Two problems which immediately arise from the self directed approach are that participants change their investment mixes all the time, like a target date fund (figure 1); so what return reference points should be used to calculate contribution rate with any degree of certainty?

Figure 1

Target date funds provide no return reference points for participants to use in determining target rate of return; they only provide an outlined asset allocation mix that will change over time. Source: ICI Resource Center

One solution would be to bring things to an even level for everyone, killing two birds with one stone. By using asset allocation models, rather than target date funds, participants receive the benefit of professional management and changing asset allocation over time, rather than picking their own investments; and at the same time, this approach offers meaningful data points for use by the retirement calculator. A plan with 5 asset allocation models ranging from aggressive to conservative, for example, would have 5 historic rate of return data points for the calculator to use as target rates of return for calculating contribution rate. A participant would use the historic rate of return from their asset allocation model as their target rate of return (figure 2).

Figure 2

Asset allocation models allow participants to receive the benefit of changing asset allocation over time and professional management, but also data points of performance history which can be used as target rate of return. Above return information is for illustrative purposes only. 

In this way, participants receive the benefit of professional management and changing asset allocation, like a target date fund, but rather than targeting only an asset allocation mix at retirement, asset allocation models allow the performance history to be calculated and integrated into the retirement calculator along with general census data to easily present a retirement savings goal, whether a participant is on track to reaching that goal based on their current rate of return and contribution rate or if a change is needed, which could also be presented in exact terms (you need to increase your contribution rate by X% exactly to reach your goals based on the current data). This also accommodates the latitude of lump-sum retirement decisions; rollover, work with a financial planner, annuitization and other options, at the discretion of the participant. Regardless of which option they choose at retirement, they’re going to need a lump sum to make it happen, so that should be the ultimate goal focus.

With an approach like this, the confusion goes away, because participants merely have to click one button to get an idea of their savings goal and whether their on track. Participants, who were not, would only be required to adjust a few simple human decisions; do you want to contribute more? Target a higher rate of return by moving to a more aggressive asset allocation model? Retire later or retire on less income? That’s it. By adjusting these simple variables (actual decisions a participant would have to make that could not be made automatically for them), retirement peace of mind can finally be made available to the majority of participants in retirement plans.

This approach may not be relevant to “fix” some plans, particularly smaller ones. Such plans, where sponsors and participants are satisfied, can usually attribute their success to a diligent advisor, who takes the time to meet individually with participants every step of the way to keep them on track. Most plans, however, do not have this benefit. One restriction is that this would usually be too expensive (especially in light of new fee disclosure regulatory changes), not to mention activities like educational sessions are usually poorly attended and poorly understood. In fact, Lou Harvey, CEO of Dalbar, Inc. asserts; “Continued efforts since 1996 to help participants make informed decisions through educational sessions have been futile.”

Comparatively, professionally managed asset allocation models offer the benefit of professional management to all by default. This benefit of this default can be enhanced even further if asset allocation models are built using low cost investments like ETFs; the Department of Labor stated that a 1% reduction in investment expense could impact an average participant’s balance at retirement by around 28%. ETFs have the potential to reduce a plan’s expenses by this amount and therefore offer a risk free option to increase returns by the reduce investment expense.

A “golden plan,” so to speak, which offers all of this; asset allocation models built professionally using ETF’s, automatically changing asset allocation and an integrated retirement calculator so participants who choose not to be active receive the best benefit and participants who choose to be active receive an even greater benefit- easily attainable retirement peace of mind. Without scientific basis, it could reasonably be assumed that word of such ease would be contagious within a company, spreading to those who have not engaged their plan and encouraging them to do so, increasing the potential for the plan as a whole to deliver a comfortable retirement to all. I know of only one platform that can offer all of these features.

To see an example of a FULLY INTEGRATED retirement calculator, look here for a demonstration:

http://www.youtube.com/watch?v=Z7RofujI-Ng

To see the prevalence of manual retirement calculators which depend on a participant knowing “target rate of return,” here is a list of links to the calculators of several major service providers:

ING®

http://ing.us/individuals/tools-calculators/retirement

Mass Mutual®

http://www.massmutual.com/mmcalcs/RetirementPlan.html

Fidelity®

http://personal.fidelity.com/planning/retirement/content/myPlan/index.shtml

T. Rowe Price®

https://www3.troweprice.com/ric/ricweb/public/ric.do

John Hancock®

http://www.jhfunds.com/Calculators.aspx?CalculatorID=%7b22E35DC9-F670-488D-AC70-8B0E0D7A183A%7d

Charles Schwab®

http://www.schwab.com/public/schwab/planning/retirement/retirement_savings_calculator

American Funds®

https://www.americanfunds.com/retirement/calculator/index.htm

TIAA-CREF®

https://ais4.tiaa-cref.org/dmscalculators/targValCalc.do

Wells Fargo®

https://www.wellsfargoadvisors.com/market-economy/online-financial-calculators/retirement-planning-calculator.htm

Principal®

https://secure05.principal.com/MLSTWWeb/WebMilestones.jsp

Prudential®

http://www3.prudential.com/SmartMoney/retirement/intro.html

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[1]
Warren Cormier speaking on July 13, 2011 at the Dimensional Fund Advisors
Annual Defined Contribution Conference at the University of Chicago Booth
School of Business.

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