The devil may be in the default option


Originally published on Pensions & Investments

By Mark Dixon and Susan Shoemaker

Participants in 401(k) plans often feel stymied about picking an investment mix when planning for retirement. After all, the choices are bewildering, and who has the time to investigate?

That’s one reason the qualified default investment alternative used by plan sponsors is so important. But in order to provide the highest level of protection to fiduciaries, the default option should be appropriately analyzed, selected and monitored.

Increasingly, sponsors are signing up for managed accounts, rather than target-date funds or diversified balanced funds, as the default option.

Managed accounts, if implemented and used properly, can help participants make investment decisions and compute how much to save. This is generally a good thing. But most managed accounts have fees associated with them, typically ranging from 0.4% to 1% annually (on top of the cost of the underlying investment options within the plan).

Plan sponsors need to determine if these fees are reasonable for the services provided. Who is getting paid for the managed account service: The administrator? The investment adviser? The Department of Labor requires that plan sponsors need to determine if the fees collected by each party are reasonable for the services provided. And when it comes to a QDIA, given that many participants who are “defaulted” into the option are not truly engaged in the retirement planning process, are the fees paid to a managed account reasonable if the participant is not engaged? Over 20 years, that’s a lot of money in other people’s pockets.

It is one thing when a participant consciously signs up for the service and signs a separate contract indicating they understand the fees, etc. But it is likely another thing when a participant is defaulted into these accounts. There are two annual pieces of information that should contain fee information as well as a breakdown of fees on quarterly statements.

According to Sarah Fowles, an ERISA attorney with Quarles & Brady, “The fact of these disclosures should emphasize to plan sponsors that they need to evaluate the reasonableness of these fees since the fees should be disclosed repeatedly to plan participants through the year.”

A managed account QDIA could create more risk for plan sponsors since the fees could be substantially more than other plan investment alternatives.

In addition, without input from the participant, many managed accounts primarily rely on a participant’s age. (Sound like a target-date fund?) If the participant is not engaged, and is not providing additional information such as outside assets, personal risk tolerance, etc., some managed account options could allocate a relatively high amount of a 60-year-old participant’s savings to equities. Part of the due diligence process of hiring a managed account provider should include documenting the minimum and maximum equity allocations given a participant’s age that is defaulted into a managed account.

To be fair, many participants fail to inquire about or provide basic information to providers, such as risk tolerance, outside savings and spousal income. That means participants are likely getting an inaccurate assessment from the managed account provider while paying an additional fee for that assessment.

Then there is a potential conflict of interest. Many managed account providers have a vested interest in keeping participants in the 401(k) or 403(b) plan after they depart the company because they typically collect fees on the managed accounts. It might be a financial disincentive to suggest the participant pursue out-of-plan options if they are making a substantial amount for managed account services.

To complicate matters, because managed accounts provide a service rather than an investment option, it is difficult for plan sponsors to monitor performance, which should be done at least annually. Unfortunately, because of the complexity of managed accounts, most sponsors don’t have the expertise in-house to do the due diligence on them. Providers sell them; participants pay for them. The sponsors are simply the conduits to that relationship. But technically, the plan sponsor is making the fiduciary decision to offer the accounts, and have the fiduciary responsibility for that decision. It’s one thing to offer the accounts to participants, still another to make them the default option.

There are other QDIA options that plan sponsors should consider, such as diversified balance funds and target-date funds. While they don’t take into account outside assets, risk tolerance, etc., and rely primarily on the age of the participant or the demographics of the plan, there is typically not an additional fee to the participants. This would be especially important for those participants who are otherwise not engaged in the process.

Our advice: If sponsors decide to use managed accounts as the default option, at least make sure the fees are reasonable for a participant who is defaulted, and that the default asset allocation is reasonable based on minimal inputs. Unlike performance, fees can be controlled.

Plan sponsors should also consider the risk of being sued if they default participants into high-fee, inappropriate asset allocation, poor-performing managed accounts. Especially if they might have trouble monitoring performance on an ongoing basis. The potential liability is very real. Preferably, plan sponsors should make sure they have an independent adviser that is helping them select a QDIA that is most appropriately suited for their participants. One size does not fit all.

Mark Dixon and Susan Shoemaker are partners of Plante Moran Financial Advisors. Mr. Dixon leads the institutional investment consulting practice; Ms. Shoemaker leads the qualified plans practice.