Why Have Balanced Funds Been Given the Short Shrift?

Their performance only matches that of TDFs for a certain age cohort, but there are other circumstances for which they might be considered a good QDIA fit.

Of the qualified default investment alternatives approved by the Department of Labor, target-date funds have grown to be the most popular. According to the 2021 PLANSPONSOR Defined Contribution Survey, 75.6% of respondents overall use a TDF as their default investment for automatic enrollment.

By comparison, only 1% of DC plan sponsors indicated that they use a stable value fund or guaranteed investment contract as the default for automatic enrollment; 2.3% said they use a risk-based asset allocation fund; 3.4% reported they use a professionally managed account; and 5.1% use a balanced fund. Stable value funds are only protected by the QDIA safe harbor for the first 120 days of participation, so those plan sponsors that reported they use a stable value fund as the default might be moving those participants who remain in the plan longer into another QDIA option, such as a TDF.

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The argument against using a stable value fund as a default is that it is much too conservative for retirement savings. Managed accounts haven’t taken off because they’ve been criticized as too costly or because studies have shown participants don’t provide the level of personalized information for them to be of optimum use. But why aren’t balanced funds more common—is it performance, cost, something else or a combination of these factors?

Amy Arnott, a portfolio strategist at Morningstar in Chicago, recently did a comparison of TDFs and balanced funds for an article on the firm’s website, and she updated it to January 31 for PLANSPONSOR.

Arnott explains that the equity allocation of TDFs’ 2030 vintage is about 62%, a bit higher than the average balanced fund, but it’s the closest comparison.

“The performance numbers are pretty close depending on the time period,” she says. “For the past three, five and 10 years, TDFs are slightly ahead, but balanced funds are ahead over the past 15 to 20 years.”

Performance for Balanced Funds Versus TDFs

Balanced funds
TD 2030 funds
3 years
11.10%
11.40%
5 years
8.91%
9.50%
10 years
8.16%
8.74%
15 years
6.44%
6.01%
20 years
6.74%
6.32%
Source: Morningstar Direct data as of 1/31/22

Performance for Balanced Funds Versus TDFs (continued)

Worst 3-month return since inception (%)

Balanced funds
TD 2030 funds
-19.69%
-18.91%
Source: Morningstar Direct data as of 1/31/22

But, Arnott says, plan sponsors might want to consider the risk side as well. “In terms of downside risk, TDFs held up a bit better because of their broader range of asset classes,” she says.

Arnott says another important consideration is expense. “There’s a pretty significant gap there,” she says. “The expense ratio of the average balanced fund is 1%, compared with close to 0.55% for TDFs. And, since fees have been under so much scrutiny, that’s a compelling reason to favor TDFs.”

Arnott notes that TDFs have a few other advantages, including that their broader asset allocation provides greater diversification in one fund, and most TDFs follow a glide path that automatically de-risks portfolios as employees get older.

“If participants are defaulted into a balanced fund, they might have less equity exposure than ideal when they are young or too much when they reach retirement age,” she says. “With TDFs, there’s a dynamic adjustment to risk level changing over time.”

Matthew Eickman, Omaha, Nebraska-based national retirement practice leader at Qualified Plan Advisors, who works as a 3(38) fiduciary investment manager but is also an Employee Retirement Income Security Act attorney, says he’s “come to believe the greatest reason for the wide use of TDFs [as QDIAs] is the financial incentive for companies that make them available.

“That’s been lessened by the lower use of recordkeepers’ proprietary funds but, still, recordkeepers will offer reduced prices if plan sponsors use their proprietary funds,” he continues. “To be fair, they are very transparent about this.”

Eickman says plan sponsors are typically given up to three to five quotes: one for a pure open architecture fund lineup, one for a lower cost if the plan sponsor puts the recordkeeper’s stable value fund in the lineup, one for a lower price if the plan sponsor uses the recordkeeper’s passive TDFs, perhaps an even lower price if the provider’s active TDFs are used, and potentially the best price if the plan sponsor does a re-enrollment into a recordkeeper’s proprietary QDIA.

“I appreciate the transparency of it,” he says. “It puts plan sponsors in a position of knowing what their choices are, but it also explains why there is a preponderance of TDFs as QDIAs.”

Balanced Funds’ Valuable Role

Plans in which participants are automatically enrolled could benefit from having a balanced fund as the QDIA if plan sponsors want to encourage participant engagement, Eickman says.

“Often, auto-enrollment or re-enrollment into a QDIA tends to lead to a disengaged participant population. It’s an incentive for people to not take action,” he says.

Eickman says a plan re-enrollment can be treated with little fanfare, or it can be an event that encourages proactive elections. “We don’t do a re-enrollment without a roadshow or education about ways employees can engage with the plan,” he says.

A balanced fund can work better during a re-enrollment when a plan sponsor says, “‘We’re going to automatically put you in this safe [investment] vehicle where you will be treated like everyone else, but we assume that’s not what you’d like. We’d like you to learn about your options and make an engaged choice,’” Eickman explains.

Research seems to support his theory that auto-enrolling into a fund other than a TDF will lead more participants to make a proactive choice. The TIAA Institute’s “Investment Defaults and Retirement Savings Allocations” study compared the behavior of participants who were defaulted into a money market fund with that of participants who were defaulted into a TDF. The research found the money market default was less “sticky” than the target-date default. Only 2% of participants allocated exclusively to the money market fund six months after joining the plan.

But there are other reasons that might make balanced funds the right TDF for a plan.

“Plan sponsors can look at the costs of funds and look at their participant demographics and determine the right default investment for them, and it could very well be a balanced fund,” Eickman says. “Looking at performance comparisons, if a plan sponsor’s participant population skews older, one can argue a balanced fund would be best. If the population skews younger, it might be that a TDF performs better. The youngest participants have a 20-year run before a ‘60/40’ allocation would be appropriate for them.”

Arnott agrees that a balanced fund could come out on top if the participant demographic skews older. A balanced fund might also be a good choice for a small plan sponsor that isn’t equipped to research funds.

“Balanced funds are more straightforward,” she says. “Plan sponsors have to do a bit of digging for TDFs because of the wide range of equity exposure, as well as asset class exposure.”

Plan sponsors might  also consider putting a balanced fund on the investment menu, but not as the QDIA, Arnott adds. “It’s reasonable to put a balanced fund on the menu for investors looking for a straightforward option that’s easy to understand,” she says.

Eickman says he has found that the growing reliance on QDIAs has led plan sponsors to pay less attention to default investments because of the DOL’s safe harbor, but “when 70% to 75% [of plan investments are] in the default, then that investment needs more attention.

“I really believe that the prevailing thought in the [DC plan] marketplace is that TDFs are an easy choice that plan sponsors don’t have to put much thought into, but good fiduciaries take the time to consider what’s right for participants, taking into account the age demographic of participants and how the plan sponsor wants to present the plan to them,” Eickman continues. “Those considerations should help plan sponsors choose what’s right rather than what’s easy.”

Eickman adds that he and his colleagues have spent a lot of time thinking about the pros and cons of TDFs, managed accounts and balanced funds, and they still struggle with whether there is any one perfect solution.

“We’ve thought about whether a dynamic QDIA has merit,” he says. “The idea that younger participants who do not make a proactive investment decision should have higher equity allocations for a period of time is good so accounts grow as much as they can. Then as people’s lives have more complexity—they have more assets and have to think about competing savings needs—the solution should be more customized for them.”

“TDFs tend to attract a lot of criticism, described as cookie-cutter because they are not tailored to individual investors, and that’s true in a way,” Arnott says. “But we have always thought that for the majority of participants, they are a solid investment option, especially as a QDIA. It’s hard to think of another alternative that would be more compelling.”

QDIA Basics

What plan sponsors need to know about qualified default investment alternative rules and how to select the appropriate one for their employees.

Qualified default investment alternatives provide plan sponsors with a safe harbor for investing retirement plan participants’ contributions in the absence of participant direction. Along with allocating participants’ retirement deferrals, such investment options also ease the employer’s fiduciary liability, according to industry experts.

QDIAs were authorized by the Pension Protection Act of 2006, and final regulations were issued by the Department of Labor in 2007. By easing plan sponsors’ fiduciary liability for defaulting participants’ savings into certain investments, experts say QDIAs removed an impediment to more widespread use of automatic enrollment in defined contribution plans.

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“These options really helped address plan fiduciary concerns about the liability of undirected investment decisions,” explains Joni Tibbetts, vice president for management, retirement and income solutions at Principal Financial Group, in Des Moines, Iowa. “They’re really addressing plan fiduciaries’ concerns about the liability of investment losses, while providing participants [with] investments that may lead to future growth. That’s really the genesis of why they were introduced.”

QDIAs help to maximize participants’ accumulated retirement savings over a career, says David Morehead, vice president at retirement pan adviser OneDigital, in San Diego, California.   

“For employees, it takes what can sometimes feel like guesswork or maybe uninformed decision making out of the equation and allows the professional money manager to allocate their assets on their behalf with a lot of thought and research behind the decisions being made there,” Morehead explains.

He says QDIAs benefit plan sponsors as well. “The fiduciary liability protection that comes with QDIA compliance makes employers tremendously more comfortable putting employees in an investment option that entails a little bit of risk but is likely the best investment option for them long term,” he says.

Rules of the Road

The DOL’s Employee Benefits Security Administration is in charge of executing Congress’ PPA legislation for QDIAs, effecting the rules and regulations, and providing ongoing oversight. 

Plan sponsors can select from a menu of approved QDIAs, according to EBSA. That includes:

  • A product with a mix of investments that takes into account the individual’s age or retirement date (an example of such a product could be a lifecycle [risk-based] or targeted-retirement-date fund);
  • An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date (an example of such a service could be a professionally managed account);
  • A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (an example of such a product could be a balanced fund); and
  • A capital preservation product for only the first 120 days of participation (an option for plan sponsors wishing to simplify administration if workers opt out of participation before incurring an additional tax).

 

Plan sponsors must also conform to several conditions under the rules to obtain safe harbor relief from fiduciary liability for investment outcomes:

  • Assets must be invested in a “qualified default investment alternative” as defined in the regulation;
  • Participants and beneficiaries must have been given an opportunity to provide investment direction but have not done so;
  • A notice generally must be furnished to participants and beneficiaries in advance of the first investment in the QDIA and annually thereafter. The rule describes the information that must be included in the notice;
  • Material, such as investment prospectuses, provided to the plan for the QDIA must be furnished to participants and beneficiaries;
  • Participants and beneficiaries must have the opportunity to direct investments out of a QDIA as frequently as from other plan investments, but at least quarterly;
  • The rule limits the fees that can be imposed on a participant who opts out of participation in the plan or who decides to direct their investments; and
  • The plan must offer a “broad range of investment alternatives” as defined in the DOL’s regulation under Section 404(c) of the Employee Retirement Income Security Act.

 

Morehead reaffirms that disclosure requirements are key for plan sponsors. “Otherwise, [the QDIA selected] loses basically all of the benefits for the plan sponsor,” he says.

Some funds won’t qualify as a QDIA, Morehead adds, including funds without fixed-income exposures, for example. “That knocks the fund out from being a QDIA right there,” he says.

“The main requirement for a QDIA is generally that it not be exclusively in one particular kind of investment,” explains Andrew Oringer, a partner in Dechert’s ERISA and executive compensation group in New York City.

QDIA Trends

Since the introduction of QDIAs, target-date funds, which assign an asset allocation to participants based on their age, have become the most popular choice. According to the 2021 PLANSPONSOR Defined Contribution Survey, 75.6% of respondents overall use a TDF as their default investment for automatic enrollment.

By comparison, only 1% of DC plan sponsors indicated that they use a stable value fund or guaranteed investment contract as the default for automatic enrollment; 2.3% said they use a risk-based asset allocation fund; 3.4% reported they use a professionally managed account; and 5.1% use a balanced fund.

The vast majority, nearly 99% of OneDigital’s plan sponsor clients, use an age-based QDIA, Morehead says.

“More recently, they’ve also been looking at managed accounts, but I’d say an age-based option is generally the starting point,” he adds.

While “a broad array of possible QDIAs,” are available to plan sponsors, “what we have seen in the market is fairly clear, trending to the use of target-date funds,” Oringer says.

A Cerulli and Associates study with the SPARK [Society of Professional Asset Managers and Recordkeepers] Institute shows that 71% of plan sponsors use a TDF, 9% use a managed account and 5% use a dynamic QDIA.

Dynamic QDIAs are investment options that start a participant off in one investment product or solution, such as a target-date fund, and automatically transition the participant—upon reaching a certain threshold including account balance or age—into another retirement-focused product.

QDIA Selection

The right QDIA for a plan sponsor depends on the demographics of the employer’s workforce, its plan design and its investment philosophy, sources explain. Another important consideration is the level of investment sophistication of the workforce, Tibbets says.

“An employer can consider factors such as participant ages, compensation levels, plan contribution rates, automatic enrollment percentages, turnover and distribution activity,” she says.

For example, some plan sponsors may use managed accounts to maximize participants’ retirement readiness because these funds can offer greater personalization of investment options and tailored advice, Tibbetts explains.

“Most of the QDIA options are designed for the plan generally at the plan level, but managed account options are really customized at that individual participant’s needs,” she says. “The employer, of course, needs to evaluate the cost of the performance of each option, but it’s really key for the plan fiduciary to understand the differences in these options, the asset classes and how this really might change over time, because it’s really important that a fiduciary selects the best option upfront.”

Morehead performs demographic analysis with the plan sponsor, with several questions, to select a few fund managers that offer target-date or managed account funds to find the best fit, he says. Morehead says he will talk with the plan sponsor about its investment philosophy and fund composition, and he will educate the investment committee on nuances between selections.

The firm’s analysis also includes U.S. Census data, the average age at the company and median age. Additionally, it will consider whether the plan sponsor prefers active or passive asset management, and tactical or strategic investment management, Morehead adds.  

“Income is another big demographic factor that we look at, as well as number of participants with an outstanding loan. We also look at the percentage of terminated participants that take a distribution versus leave their money in the plan,” he says. “A couple of other really prominent ones that I also like to look at are presence of a self-directed brokerage account [and] other retirement plans that the plan sponsor may be offering.”

Morehead explains that, typically, higher average income translates into higher participation and savings rates. “When we have high, consistent investments from participants, this affords us more ability to assume a higher level of market risk in our TDF recommendation based on this positive behavior,” he says. “If we have lower income, participation and savings rates, this will typically lend toward a more conservative strategy being more important.”

The number of participants with an outstanding loan and the percentage of terminated participants that take a distribution versus leave money in the plan help establish a time horizon when making investment recommendations to plan sponsors, Morehead adds. 

“The presence of an SDBA will help guide our recommendations when it comes to the number of asset classes and the overall investment strategy—for example, active versus passive, or tactical versus strategic,” he says.

In addition, Morehead says, if participants have access to a defined benefit pension plan, it allows them to take more risk in DC plan investments. “That’s a really good foundation which would then allow them to have a little bit riskier investment allocation for potentially higher returns, better growth,” he says.

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