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Managed Accounts as a Defined Contribution Plan Option

Over the past three decades, participant-directed defined contribution plans have replaced defined benefit plans and Social Security as the dominant source of retirement income for most Americans. The shift toward defined contribution plans has, in effect, shifted the burden of creating an adequate retirement nest egg away from investment professionals and to individual plan participants. Unfortunately, the average plan participant lacks the investment knowledge and know-how to make informed and optimal asset allocation decisions – decisions that have a significant impact on asset accumulation. Both target date funds (TDFs) and managed accounts have emerged in response to this dilemma, providing participants with the option of professionally managed asset allocation in their accounts.

TDFs and managed accounts share the same overarching objective – to bolster asset accumulation in participant accounts through professional management of the asset allocation process. However, they take different approaches to accomplishing that objective. TDFs are quickly becoming commonplace in defined contribution plans and their assets have grown exponentially in recent years. Conversely, managed accounts are not as well understood, and certainly not as popular. In addition to providing a broad overview of managed accounts and discussing some of the key considerations in evaluating a managed account provider, this paper will highlight some of the benefits and drawbacks of adding these vehicles to a DC lineup, particularly as they compare to TDFs. Understanding some of these key issues can help answer the question that a growing number of plan sponsors is asking: When does it make sense to offer managed accounts in a defined contribution plan lineup?

Managed Accounts Overview

For both managed accounts and TDFs, a registered investment advisor is responsible for the ongoing asset allocation in a participant’s account, rebalancing the asset mix as the participant approaches retirement. While TDFs use time until retirement as the governing factor in determining the asset mix of the portfolio, managed accounts consider a more holistic view of the individual participant when determining the asset mix. Managed accounts take personalized information about the participant – such as age, desired retirement age, account assets, assets held outside of the plan (i.e., savings accounts, IRAs, spousal retirement accounts, etc.), state of residence for tax purposes, salary and contribution rates – to create a customized asset mix for each participant. Theoretically, information about investments held outside of the defined contribution plan can have a big impact on the asset mix of the managed account.

After initial implementation, any time a participant updates personal information, a reforecast is made of the probability of achieving retirement goals, prompting a shift in the asset mix. At a minimum, if the participant does not provide or update personal information, the managed account provider, having the participant’s date of birth, would make changes in the asset mix once a year. All other variables remaining constant, the asset mix would become increasingly conservative over time, similar in concept to the TDF glide path – the glide path being the pace at which the percentage of growth-seeking assets is reduced as a participant ages.

The managed account provider uses only the existing options in the plan lineup as its underlying assets. Therefore, the available asset classes for the managed account are limited to those represented within the plan lineup. TDFs, on the other hand, are not limited to invest in only those funds offered as stand-alone options in the plan. TDF portfolio managers can add, remove and/or replace any of their underlying investment options without authorization from the plan sponsor. As such, TDFs typically have a much broader spectrum of underlying investments with which to diversify, including international fixed income and equity, high yield fixed income, real estate, commodities, as well as equities across the capitalization spectrum.

Managed accounts are typically offered as an alternative investment option in defined contribution plans that also offer an array of stand-alone investment options. Participants can choose a managed account or invest in the plan’s stand-alone options as they see fit. The participant cannot do both. TDFs, on the other hand, are offered in conjunction with stand-alone options and participants can choose to invest in a TDF, in the stand-alone options, or both.

Differentiating Factors Among Managed Account Providers

In most cases, the plan sponsor is not in a position to choose between managed account providers. For most, the choice is simply the provider that is available through the plan’s recordkeeping system. However, understanding the key differences between managed account providers does provide insight as to the suitability of the available managed account provider for the unique plan sponsor and plan lineup. An assessment of these products is complicated by several factors. Comparisons between managed account providers cannot be based on performance, as performance is unique to each participant account. Additionally, the available funds for investment are different for each plan and the asset mix for each participant account is both a function of the asset classes represented as well as personal participant information. Likewise, and for the same reasons, it is difficult to compare managed account providers in terms of their glide paths. There are, however several distinguishing features, which may be more or less important to any given plan as they evaluate the managed account provider available on its recordkeeper’s platform.

  • Plan Requirements: Managed account providers generally do not advise the plan sponsor on the plan design or the investment lineup. However, they have differing views on the specific asset classes and number of underlying funds deemed necessary to make offering managed accounts feasible. Most providers require that a plan offer, at a minimum, U.S. equity, international equity, fixed income and cash options. However, other providers require that a plan offers small cap equities also. Depending on the plan, such requirements may necessitate unwanted changes to the plan’s existing lineup.
  • Asset Mix Methodology: In most basic terms, managed account providers determine optimal asset mixes based on assumptions for rate of return, risk (volatility in returns) and correlation between the asset classes represented by a plan’s investment options. Some providers use assumptions for the applicable asset classes and map funds accordingly. Others take the historical data and/or expense ratios of the underlying funds into consideration when determining risk, return and correlation assumptions. Among other things, the manner in which fund expenses are accounted for can impact the managed account’s use of passively and actively managed investment options. Specifically, a managed account provider that integrates fund expenses into its assumptions may favor investments in passively managed options. The investment strategy (active or passive) being favored may or may not correspond with the plan sponsor’s philosophical view or with participant preferences. Additionally, the favored investment strategy may impact revenue sharing for the plan, which may merit additional consideration.
  • Relationship Among Underlying Funds, Plan Recordkeeper and Managed Account Provider: Understanding the financial relationship among these three parties is important. As an example, there are some managed account providers that also offer investment management services. If the managed account provider is also the investment manager of any of the plan’s investment options, it is important to determine if there is any preference given to proprietary funds in the asset allocation process.
  • Analysis of Underlying Investments: While some managed account providers can readily access the daily holdings of the funds in which they invest, and monitor the asset mix and style of each on a holding-by-holding basis, other providers use returns-based analysis to monitor and evaluate whether each fund is performing as expected given the asset class represented. For example, if a plan’s existing large cap equity option has significant exposure to international stocks, how a managed account provider monitors the underlying holdings and, in turn, allocates participant assets to this fund, becomes very important. It may be that the participant has a much higher overall allocation to international equities than the managed account provider has deemed optimal.
  • Company Stock: The general consensus among managed account providers is that participant accounts should have limited exposure to company stock, as a single stock is considerably more volatile than a diverse portfolio of stocks. That being the case, many of these providers do not permit company stock within their managed accounts. Instead, the company stock is treated as an “outside” investment and as a separate asset class. This effectively means that the more company stock a participant owns, the more conservatively invested the managed account. Alternatively, some managed account providers allow participants the decision to disregard company stock altogether, so that the company stock has no bearing on the asset allocation of the managed account. Then there are managed account providers that do include company stock in the account. In such cases, it is treated as a distinct asset class, with its own set of risk, return and correlation assumptions. The managed account provider typically sets a maximum allowable amount of company stock and sells unrestricted company stock in excess of that amount incrementally over the course of one year.
  • Costs, Fees and Expenses: How expenses are charged varies widely among managed account providers and requires careful attention and consideration. Unlike TDFs, whose expenses are paid by the participants, managed account expenses can be paid by the plan sponsor, the participant, or a combination of both. Generally, the total cost of managed account services varies depending on plan size, number of participants in the plan, actual usage of the service, whether managed accounts are offered as QDIA, and/or whether the service is offered on an “opt in” or “opt out” basis. It is important to keep in mind that regardless of how the managed account expenses are being charged, the participants are still paying the investment management expenses (expense ratios) of the product’s underlying funds. In almost all cases, managed accounts are more expensive than TDFs.

Benefits and Drawbacks of Managed Accounts and TDFs

Benefits: For the most part, the primary benefits of managed accounts are also benefits of TDFs.

  • Professional Asset Allocation: Both managed accounts and TDFs aim to make more sensible allocations for each participant than if the participants made those decisions on their own.
  • Investment Discipline: Both managed accounts and TDFs provide a disciplined approach to equity reduction over time and offer regular rebalancing.
  • Customized Approach: Managed accounts offer the most customized, holistic approach, as they theoretically take into account many more factors when creating the participant’s asset mix, including company stock and out-of-plan investments. TDFs are only customized based on years until retirement.
  • Personalized Progress Reporting: As part of the managed account’s individualized approach, most providers can deliver personalized reports to participants communicating the probability of achieving a specified retirement income goal given their current situation. Managed account holders are often provided with a wide array of interactive tools that are designed, in part, to increase participant contributions to the plan. These tools also help participants view their account balance in terms of the regular income it will provide in retirement. TDF investors are not typically provided this kind of personalized reporting.

Drawbacks: While the theory behind customized managed accounts is laudable, there are several drawbacks to its practical application, especially when compared to TDFs.

  • Potentially Limited Diversification Opportunity: As the managed account provider only allocates among the plan’s existing investment options, the available asset classes are limited to those represented by the plan’s stand-alone investment options. TDFs are typically more broadly diversified, as TDF portfolio managers can add, remove and/or replace underlying investments as they see fit.
  • Dependency on Participant Involvement: The degree of customization in the managed account is largely dependent upon participant interaction with the managed account provider. If the participant does not give the managed account provider personal information with which to customize the managed account, the managed account becomes very similar to a TDF, in that time until retirement would be the sole factor in asset mix determination. In these cases, the managed account would likely be more expensive and less diversified than the TDF.
  • Expenses: In most cases, managed accounts are more expensive than TDFs.
  • Lack of Portability: Managed accounts lack portability. If the plan considers changing its recordkeeper, it would have to consider that its participants’ managed accounts would likely need to be dismantled. Managed accounts cannot simply be mapped into a managed account with a different recordkeeper. TDFs, on the other hand, can be more easily mapped to other TDFs with the same target retirement date.
  • Benchmarking Challenges: Managed account performance is difficult to benchmark against an index or a peer group, as the asset mix is theoretically different for each participant and the underlying funds are different for each plan. TDFs are also difficult to benchmark, particularly against a peer group, as the glide path is different for each investment manager. Unlike managed accounts, however, the asset mix of a TDF for any given target retirement date can be compared against those of other TDFs with the same retirement date.
  • Potential for Plan Changes: Offering managed accounts may necessitate changes to the plan’s lineup, whereas TDFs do not require any changes to plan design.
  • Low Utilization: While more plans are offering managed accounts, actual participant usage has been languishing at around 3-5% for several years. In contrast, TDFs have experienced both high implementation and utilization rates.

Conclusions: Managed Accounts, TDFs or a Combination of Both?

Both managed accounts and TDFs allow participants the opportunity to have the asset allocation of their retirement accounts professionally managed, helping to better drive asset accumulation in their accounts. TDFs provide a solution to participants on the basis of retirement date, whereas managed accounts offer the benefit of a more customized and holistic approach to asset allocation. However, when comparing managed account services to TDFs, in most cases, we find the drawbacks of managed accounts (including higher expenses and less diversification), outweigh the benefit of personalization. As such, if the choice for a plan is to offer TDFs or managed accounts, in most cases and for most participants, TDFs would be the better option.

Both TDFs and managed accounts qualify as QDIAs, yet TDFs are more widely accepted as suitable QDIAs. Retirement plan assets have been pouring into TDFs as a result. Offering managed accounts as a QDIA makes much less sense. First, as previously discussed, the level of customization within the managed account is a function of participant interaction. Given historical utilization rates for these products, it does not appear that a significant number of participants is interested or willing to provide personal information that may impact the asset mix of the managed account. Part of the reason TDFs are so popular is that they provide participants the opportunity to “set it and forget it.” Integral to the objective and approach of managed accounts is that the participant not “forget it.” Secondly, the incorporation of “outside” investments into the asset allocation decision is less of an advantage for younger participants, as they are less likely to have significant retirement savings outside the plan. In such situations, the managed account can effectively become a more expensive, less diversified TDF.

All said however, managed accounts may be appealing to those participants seeking a more customized approach and who are willing to interact more fully and regularly with the managed account provider. Participants with a significant percentage of retirement savings invested in company stock, for example, may find a more customized approach to professional asset allocation an attractive option. Managed accounts may also be more attractive to older participants, who are nearer to retirement. Typically, this participant population has bigger account balances, has more complex arrays of outside investments and is more likely to hold significant amounts of company stock. Given the complexity, these participants may be more willing to share this information with a managed account provider. For these reasons, offering managed accounts alongside TDFs may be worth considering.