Updating TDFs to Provide Better Retirement Income

Three ideas for a qualified default investment alternative (QDIA) design that will better serve participants ready to retire.

While target-date funds (TDFs) as qualified default investment alternatives (QDIAs) serve the needs of many retirement plan participants, Jason Shapiro, director, investments, Willis Towers Watson, argues that a new QDIA design is needed to serve defined contribution (DC) plan participants who are ready to move into retirement.

In a blog post, “How to evolve default options for retirees in DC plans,” Shapiro notes that some DC plan participants may stay in their plan after retirement and rely on TDFs’ asset allocation for retirement income for possibly 30 years or even more. He says that what matters more than whether a TDF has a “to” versus “through” glidepath is what the relevant risk level is at various points in participants’ life cycles.

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Shapiro mentioned the “hybrid” QDIA, already adopted by a few plan sponsors, in which plan participants are defaulted into a TDF and then moved into a managed account when a certain trigger is met, such as age.

In a previous discussion with PLANSPONSOR, Holly Verdeyen, senior director, defined contribution strategy at Russell Investments in Chicago, said participants may be moved to a managed account based on age or what she calls “funded status,” which is the amount of income replacement in retirement the participant’s account balance would provide.

“TDFs and balanced funds tend to keep static allocations until participants are in their late 30s or early 40s. Then, derisking occurs,” Verdeyen said. She noted that an age trigger would probably be 10 to 15 years prior to retirement, and a funded status or account balance trigger would be when someone is approaching fully funded status based on their retirement income need. “A managed account can preserve that funded status better than a TDF,” she contended.

According to Verdeyen, a properly structured managed account will be able to adapt to changing participant circumstances and market conditions; if market conditions lower a participant’s funded status, a managed account could adjust for that. Likewise, if market conditions improve a participant’s funded status, a managed account could derisk, like a pension plan, to preserve the higher funded status. “A TDF will keep rolling on its glidepath, but a managed account could change with market conditions,” she said.

As for participant circumstances, Verdeyen noted that if a participant gets a raise, which would help his or her funded status, a managed account portfolio could be adjusted. The same is true if the participant stopped contributing to the plan, hurting his or her funded status.

Diversifying the TDF

Another idea put forth by Shapiro for designing TDFs for participants at retirement is to provide “a more efficient investment design, going beyond stocks and bonds to a more diversified portfolio that includes less liquid assets.”

He noted that for a previous study, he and a colleague partnered with the Georgetown University Center for Retirement Initiatives to explore possible evolutions for TDF asset allocations. Through stochastic modeling of portfolios containing a diversified combination of direct real estate, private equity and hedge funds, they found that, versus a baseline scenario, expected risk was considerably reduced, and median expected retirement income increased by 17%. The proxy TDF was heavy in public equities throughout, while the diversified glide path allocated decreasing proportions to public equities in the later years, replacing them with more diversified assets.

Results of a study published by Neuberger Berman research partner the Defined Contribution Alternatives Association (DCALTA), in collaboration with the Institute for Private Capital (IPC), suggest that including private equity investments in balanced funds and TDFs both improves performance and has diversification benefits that lower overall portfolio risk.

The researchers sought to understand the properties of a portfolio strategy that provides an investor exposure to more private funds early in the investment lifecycle but then shifts to increasingly lower-risk and more liquid assets over time. In particular, they simulate the impact of including private market funds into target-date funds (TDFs) that typically have a defined change in asset allocation over several decades.

The analysis found average returns of the TDF portfolio are higher than for the all-public benchmark and the calibrated portfolio outperforms in 82% of the 1,000 simulations.

“Unwrapped” TDFs

Shapiro also puts forth the idea of an “unwrapped” TDF—a hybrid combining traditional model portfolios and custom TDFS. He explains that a plan sponsor or adviser develops a series of model portfolios that suit the demographics and behaviors of its employee base, and they are assigned spots on a glide path, according to their risk levels and any other objectives (e.g. ability to generate income).

The DC plan recordkeeper allocates the model portfolios to participants’ accounts at certain triggers, such as age, and is responsible for rebalancing.

Shapiro says the model portfolios are invested in the plan’s core investment menu to benefit from asset scale. Non-core investments could be added as well, to create more diversified exposures.

A more detailed explanation can be found in a Willis Towers Watson report about QDIA evolutions.

In conclusion, Shapiro says, “A separate—and accelerated—evolutionary track is needed for retirement income solutions in DC plans. This is where customization is most crucial, as participants’ retirement needs vary widely due to differences in asset levels, spending needs and preferences. A QDIA designed to provide sustainable income can work much like a target-date fund or managed account, offering components for guaranteed income, dynamic spending and coordination that manages tax liabilities and Social Security benefits.”

What U.S. Retirement Plans Should Know About GDPR

It’s not just multinational employers that need to understand and potentially comply with the European Union’s strict data privacy laws.

During a recent conversation with PLANSPONSOR, Peg Knox, chief operating officer of the Defined Contribution Institutional Investment Association (DCIIA), highlighted the growing importance of data privacy laws in the operation of U.S. retirement plans.

Knox says DCIIA is focused on this topic for a few reasons, including the fact that the European Union has now fully implemented the General Data Protection Regulation (GDPR). She also warns that the California Consumer Privacy Act (CCPA) goes into effect January 1, 2020—another sweeping data privacy regulation that includes many similar protections and provisions to GDPR.

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“It may not be obvious at first, but these regulations can be potentially very significant for U.S. plan sponsors,” Knox says. “Even for plans that feel they are not at this stage subject to either regulation directly, doing a review of GDPR and CCPA may be helpful in considering how to respond as similar regulations possibly take effect in the U.S. at the federal or state levels.”

To this end, DCIIA recently published a detailed white paper that can help plan sponsors and their service providers understand and comply with both GDPR and CCPA. According to DCIIA’s analysis, GDPR marks the most significant change to European data privacy and security in more than 20 years.

“It regulates market practices for businesses operating within the EU and protects specific elements of the personal information of individuals residing in both the EU and the European Economic Area (EEA),” the paper explains. “In doing so, the GDPR has tightened existing EU privacy rules, added new rights for covered individuals, and provided a series of enforcement tools and penalties. The GDPR also enables the EU to hold all organizations engaging with any EU resident accountable for regulation violations, whether or not the firm is located within the EU.”

According to DCIIA, GDPR necessitates a particular, and in many cases new, way for organizations to interact with individual customers.

“For example, if a firm does business online or maintains a website, GDPR regulates whether, how and to what extent a firm may collect individual personal information; a firm may track or record individual website use, such as through cookies; a firm may utilize such information, and with what limitations,” the white paper says. “The GDPR applies regardless of whether the services are paid for or are free. … Since penalties for non-compliance are significant, affected organizations will want to be able to demonstrate effective processes, controls and compliance.”

According to DCIIA, one main upshot of GDPR in practical business operations is that “opt-out” practices have been replaced with affirmative “opt-in” ones or written individual agreements as one way to establish a legal reason to process data. There are also other legal grounds under which data can be processed, such as a legitimate business reason, a contractual obligation or a legal obligation.

Also important to understand is the GDPR’s requirements when a data breach occurs. As DCIIA explains, GDPR is specific about how to handle data breaches.

“If your organization is a data controller, either the firm or its EU representative must notify the appropriate national supervisory authority within 72 hours of identifying a data breach, unless the individuals affected are unlikely to be harmed,” the paper explains. “If your firm is a data processor, it should immediately notify the data controller of the data breach. The information should include a breach description, the number of individuals and records impacted, potential consequences, and a resolution recommendation.”

What Does This All Mean For U.S. Plans?

While the GDPR does not directly address U.S. benefit plans, DCIIA says, it should be of particular interest to defined contribution (DC) plan sponsors and their service providers because they hold personal information for each plan participant.

“A U.S. retirement plan sponsor with EU residents in its plan will fall under the scope of the GDPR, if the plan’s website allows EU residents to access plan services,” DCIIA explains. “Within our industry, the trustees and fiduciaries for retirement plans would be considered the data controllers, and the data processors would be the service providers working with the retirement plan.”

In the case of a benefit plan that is processing data, DCIIA says, opt-in consent for data storage and processing may be attained at the time the plan participant signs up for the plan. If a firm is acting as a third-party service provider, DCIIA says, the firm should ensure that the client organization has obtained written consent from its employees for their personal data to be passed to a third party.

“Service providers processing special data categories will be required to have an additional legal authority for such collection,” the paper warns.

DCIIA recommends that plan sponsors and service providers work with their ERISA counsel on these matters.

“The GDPR is complex, with many nuances,” the paper says. “Your ERISA counsel can help you work through the maze that is the GDPR and how it may apply to your organization’s specific circumstances. Consider the extent to which you may need to include GDPR-specific compliance procedures as an element in service-provider selection and oversight.”

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