This is a hidden column

getTagNameMorningstarCorporate:BigPicture

Selecting a QDIA: 3 Factors for Plan Sponsors to Consider

What to weigh when choosing a qualified default investment alternative

David Blanchett, Morningstar Investment Management LLC

 

I previously provided some insight into how many plan sponsors consider performance when selecting a qualified default investment alternative, or QDIA. In short, performance can be a difficult metric to apply successfully, given the multi-asset structure of default investments today.

So I’d like to expand on a few other important factors when considering a QDIA, particularly when choosing between target-date funds and managed accounts.

3 factors to consider when selecting a QDIA

  1. Risk Appropriateness. Target-date funds’ glide paths are generally created based on an average investor. But the efficacy of each glide path depends on how well it fits the actual characteristics of the employee population. When used as a QDIA, a managed accounts solution may have a relatively limited insight into an investor’s complete financial picture. (Outside assets, spouse finances and other factors are often missing regardless of the default investment). However, managed accounts typically deliver portfolio recommendations that can be more appropriate than those from target-date funds—especially for older investors. The efficacy of either solution tends to increase if unique information about the participant can be incorporated. But there’s an important distinction to note: While unique participant data can be incorporated in the target-date funds selection process (or in a custom glide path created for that plan), it can only be incorporated at the plan level—not at the participant level. This can be especially important for plans with frozen pension plans or other structural differences in retirement benefits across participants.
  2. Stickiness. The ability of a participant to stick with a default over time is important. My recent research suggests that managed accounts and target-date funds are both relatively “sticky” defaults, both at enrollment and thereafter. About 85% of participants tend to go with the default option, representing about half of the assets in the plan. Participants who use the default investment tend to be younger and have lower savings rates, lower salaries, and lower balances.
  3. Savings. Managed accounts may help participants save more, too. Research from me and my Morningstar Investment Management colleagues Daniel Bruns and Nathan Voris suggests participants who are defaulted into managed accounts tend to save at a rate 2 percentage points more than those defaulted in target-date funds. Participants defaulted in managed accounts initially defer 6%, on average, compared with 4% for those who default into target-date funds.* However, after controlling for various demographic variables and plan features, the difference declines significantly to approximately 0.5 percentage points.** It’s difficult to know exactly why participants using managed accounts as a QDIA saved more. It could be that managed accounts increased retirement awareness, or that increased communication drove the change. Regardless, the research does note a statistically significant difference in savings rates between the two default investment options.

The factors I’ve listed here are a just a few of those I explored in my research. Overall, it’s important to keep in mind that there are additional factors to consider beyond historical performance when it comes to selecting QDIAs.

Read the full research paper "The Default Investment Decision: Weighing Cost and Personalization."

Get My Copy

* Starting with an initial universe of data from Charles Schwab that included 195 retirement plans covering 66,297 participants, Morningstar Investment Management LLC conducted an analysis to determine how average deferral rates may change with respect to various enrollment options for a defined contribution plan. For purposes of this analysis, Morningstar Investment Management LLC assumed the participant was 45 years old, did not rollover a previous retirement plan account balance into his or her current defined contribution account, and stays in the defined contribution plan for 5 years. The participant had an average salary over the test period of approximately $54,000, an average total savings rate of approximately 8%. The analysis assumes monthly contributions and a portfolio real return of 4%. It was determined that a managed account annual fee of 2.4% would equalize the account balance of the average participant in a managed account option to one in a target date fund option after five years.

** The actual difference depended on the regression model.  Based on our study, plans that use managed accounts as the default tended to have older participants with higher compensation, which helped explain a significant amount of the noted differences.

Please see the research for additional information and data regarding the findings discussed above.

The Advisor Toolkit

Get practical behavioral finance tools to help clients avoid common pitfalls.