The Marriage of QDIAs and Managed Volatility in US DC Plans
Probably the best way to connect US defined contribution (DC) plan participants with the angst-reducing benefits of managing volatility is through a plan’s qualified default investment alternative (QDIA)—especially if the QDIA is a target-date fund.
That’s because target-date funds, in essence, take a strategic viewpoint on the appropriate level of risky assets at any given point along the lifecycle. Managing volatility is a way to enhance investors’ experience by modifying the impact on participants when the risk of extreme losses is elevated.
But DC plan sponsors sometimes have three “perception hurdles” when seeking to incorporate an approach to managing volatility in their plans’ QDIAs: concerns over potentially higher costs, fiduciary liability and implementation issues. But these are perceived hurdles—not, in our opinion, substantial ones.
One approach to dynamically adjusting the asset allocation of a target-date fund in response to extreme market conditions is to simply adjust the allocation to each underlying asset class. This, however, could result in many expensive transactions and could be disruptive to the underlying components.
We advocate a simpler and more efficient strategy of adding a volatility-modifying component to the target-date fund’s glide path, primarily sourced from the stock allocation in the glide path. When volatility is unusually high and the portfolio manager believes that investors are not adequately compensated for portfolio risk, this volatility-management component can move from its base 100% equity position all the way to 100% bond/cash exposure.
An asset-allocation portfolio with this component could underweight the strategic equity exposure by as much as 20%. In this way, the portfolio manager can adjust for changes in expected risk-adjusted returns while helping to keep the strategic asset allocation of the glide path from changing materially in a normal market—thereby remaining consistent with the fund’s long-term investment objectives, not exposing participants to a significant opportunity cost in a rising equity market and keeping the target-date fund competitively priced.
As to any concerns over fiduciary liability, we believe that a volatility-modifying component in a target-date fund could potentially strengthen a fiduciary’s adherence to ERISA’s “prudent expert” rule. In fact, we would argue that such a target-date customization would mesh well with one of this year’s tips issued by the Department of Labor (DOL) to guide DC plan sponsors when selecting a target-date fund: the DOL stated that plan sponsors should inquire about whether a custom or nonproprietary target-date fund would be a better fit for their plans than a prepackaged, off-the-shelf strategy.
Customization can help diversify investment-provider exposure, and it allows for incorporation of a plan’s best-in-class fund options from the core menu or even the company’s pension plan. Customization also lets fiduciaries review all the target-date fund component investments individually and replace any underperformers without causing any hiccups to the target-date fund or to the participant experience.
But the most important hurdle for plan sponsors involves how they implement a strategy that manages volatility. If an enhanced risk-based fund or a target-date fund with some method for managing volatility is simply added to the plan’s fund lineup, there’s little likelihood that participants will make much use of it—primarily due to inertia. Instead, it’s more effective to incorporate a volatility-modifying strategy into the plans’ QDIA. If a DC plan already has a customized target-date fund as its QDIA, a volatility-managed component can be added seamlessly: there’s no need for any action on the part of participants, and the plan could just describe that change to the QDIA in a communication to participants.
Furthermore, if the desire of the sponsor is to increase the percentage of assets that are professionally managed in a multi-asset-class portfolio, then a re-enrollment—defaulting participants who don’t make affirmative investment elections into the QDIA—should be implemented in concert with automatic enrollment.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
“Target date” in a fund’s name refers to the approximate year when a participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as participants near retirement. Investments in target-date funds are not guaranteed against loss of principal at any time, and account values can be more or less than the original amount invested¾including at the time of the fund’s target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.
Daniel J. Loewy is CIO and Co-Head of Multi-Asset Solutions at AllianceBernstein.