Investing May 6, 2020

QDIAs the Best Place for Participant Assets During Downturns

QDIAs keep DC plan participants on a path for growth, but the current market volatility plants seeds of new ideas about their construction going forward.
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Most defined contribution (DC) plan participants invested in a qualified default investment alternative (QDIA) refrained from trading in the first quarter, despite the tremendous decline in the market and subsequent volatility, David Blanchett, head of retirement research at Morningstar Investment Management, told attendees of the “Managing Through the Crisis: The State of QDIAs” webinar sponsored by the Defined Contribution Institutional Investment Association (DCIIA), The Retirement Advisor University, the SPARK [Society of Professional Asset Managers and Recordkeepers] Institute and The Plan Sponsor University.

Only 2% of those invested in a managed account made a trade and only 2.1% of those invested in a target-date fund (TDF) made a trade, Blanchett said. By comparison, 17% of participants who self-direct their investments made a change, and 22.7% of those invested in more than one TDF vintage made a change, he noted.

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“You don’t want them trading because this hurts them in terms of long-term performance,” Blanchett said.

Speaking to PLANSPONSOR, Doug McIntosh, vice president of investments at Prudential Retirement, says participants have so far fared better during the COVID-19 crisis than in the Great Recession of 2008 because of the increased use of TDFs as the QDIA. In 2008, 60% of plans used TDFs as the QDIA; today, that number has risen to 97%, he says.

In addition, “today, TDFs have generally taken down risk for those closest to retirement,” McIntosh says.

“The glide paths have gotten more conservative,” he adds. “As well, there are a broader set of asset classes being utilized, such as TIPS [Treasury inflation-protected securities] and private real estate, to minimize equity volatility and inflation.”

During the webinar, Liana Magner, partner, U.S. defined contribution and financial wellness leader, Mercer, said the scaled back equity exposure in TDFs has made a difference: In 2008, they suffered a 14% decline, whereas in the first quarter of 2020, they went down by 10.4%. “This is mostly because they have less exposure to growth,” she said. “Long-term bonds have helped as well.”

However, McIntosh says he believes TDFs need to become even more conservative, noting that some 2025 TDFs lost 20% to 25% of their value in the first quarter of 2020. “If I am only five years out from retirement, that is a concern,” he says.

Magner said the key question is how the COVID-19 crisis will affect the TDF marketplace. “Will they take on more downside protection?” she asked. “Will there be more focus on retirement income? Will there be more use of custom funds? It will take some time for the investment managers to become more strategic, but we do expect a reinvention phase.”

The Setting Every Community Up for Retirement Enhancement (SECURE) Act encourages plans to offer guaranteed income solutions, McIntosh notes. He says he believes that should be part of the QDIA.

Sharon Scanlon, senior vice president, head of CX, Individual Life & Annuity Ops and Retirement Plan Services, Lincoln Financial Group, told webinar attendees that investors in her company’s products also refrained from trading during the first quarter.

Moving Away From TDFs

Joe DeNoyior, president of HUB |Washington Financial Group said, “One of the most important challenges plan sponsors face is determining the appropriate QDIA for their workforce.” He explained that the 2008 crisis showed that not all TDFs are created equal—some can mitigate volatility, some are tactical—and TDFs have become more sophisticated. “We think sponsors should expand their due diligence. Plan sponsors need to scrutinize their default options looking at their demographics and taking a view through participants’ eyes,” he said.

DeNoyior noted that in the past five years, more of HUB | Washington Financial Group’s clients have been considering managed accounts. DeNoyior expects more sponsors will adopt them, particularly as the expanded use of automatic enrollment and automatic escalation has resulted in higher balances.

“They can provide for different risk tolerance and tend to have stickier assets,” he said. “Once the dust settles from this crisis, we think plan sponsors will be more inclined to use managed accounts as the QDIA, or at least offer it in their plan.”

McIntosh says he expects managed accounts, as well as TDFs, will increasingly pair actively managed fixed income with low-cost passive asset management.

Investing May 4, 2020

Current Volatility Shows Weaknesses in TDFs

Lessons about diversification—especially for those nearest retirement—not learned during the Great Recession will be a focus for plan sponsors and TDF providers now.
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Art by Lorenzo Gritti

During this period of pronounced volatility caused by the coronavirus pandemic, target-date fund (TDF) returns can vary widely due to different glide paths, says Jason Shapiro, director, investments, at Willis Towers Watson.

“For those who are young, the consensus is that they need growth through equity exposure,” Shapiro says. “So, for those funds from the fifth to the 95th percentile, their returns have ranged from negative 17% to negative 23% in the first quarter.” The broad equity markets were down 21%.

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Returns for TDFs for those retiring near 2025 have ranged from negative 5% to negative 14%. The funds returning negative 5% are the “to retirement funds,” which fully de-risk at the point of retirement, Shapiro notes. The funds returning negative 14% are the “through retirement” TDFs, which have much higher equity exposures.

“The point is, these funds are designed to do very different things,” Shapiro continues. “Those two objectives—protection and growth for another 30 years—go head to head. Sponsors need to be cognizant of the very large dispersion in the universe, which is really stark in such a volatile market.”

While many believed that TDF managers made a point to diversify their portfolios following the Great Recession in 2008/2009, that actually did not happen, Shapiro contends. “We haven’t seen the TDF universe change substantially.”

He says he believes TDF managers need to do a much better job of diversifying their holdings beyond equities and fixed income into real estate, commodities, high-yield emerging markets and other credits. “Off-the-shelf glide paths have not evolved to provide protection,” Shapiro says. “They should also include retirement income provisions.”

Because TDFs have not really evolved, he believes retirement plan sponsors need to scrutinize their holdings and glide paths.

Bransby Whitton, executive vice president and product strategist at PIMCO, agrees with Shapiro that TDFs’ supposed “diversification in the first quarter failed. TDF vintages most appropriate for a 60-year-old declined by as much as 25%, whereas the S&P 500 was down 30%. The declines were the most pronounced for the ‘through retirement’ TDFs.”

Whitton says even though the “through retirement” TDFs are meant to protect investors for another 20 to 30 years, “ultimately, for the age 60 and older cohort, these funds have too much risk.”

Like Shapiro, Whitton says that following the Great Recession and TDFs’ poor performance, “the TDF industry impressed upon investors the need for diversification. Up until the first quarter of this year, we had no reason to doubt these messages. The is a real wake-up call for those who believed they were in a fund with a diversified glide path. Changes were not made.”

Whitton says he believes TDFs need to be better diversified. “We argue that when you think about diversifying the glide path, you need to look beyond core bonds to other sources in the fixed income market,” he says. “We think Treasuries and TIPS [Treasury Inflation-Protected Securities] can make sense.”

Rick Fulford, head of PIMCO’s defined contribution (DC) business, expects the dismal returns of TDFs in the first quarter will prompt retirement plan sponsors “to take a much closer look at the risk in their target-date funds, particularly for those near retirement. More than ever, plan sponsors are interested in retaining retirees in their plans. They need to deliver for that cohort.”

For the past 14 years, PIMCO has conducted its annual Defined Contribution Consulting Survey to ask plan sponsors about their top priorities, Fulford notes. “Their No. 1 priority this year was reviewing their target-date funds—and that was before this downturn. They’ll learn that their TDFs probably had more risk than they knew. They will likely be asking if their TDFs’ glide paths are sufficiently diversified—across asset classes, regions and sectors, and whether there is too much U.S. bias or equity risk. They should also be asking their TDF provider if volatility management is a high priority, especially for those near or in retirement.”

Jake Gilliam, head multi-asset strategist at Charles Schwab, says the TDFs his firm offers are well-diversified, particularly for those near or in retirement. “Since the crisis of 2008, we have increased the diversification in our funds, into such things as TIPS, global real estate and various types of fixed income,” Gilliam says. “Diversification has played a strong role in limiting volatility.”

Gilliam says this has encouraged near-retirees and retirees to remain invested. He says plan sponsors will have “detailed questions for those target-date funds that did not hold up so well.”

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