Role of Target-Date Funds Within Hybrid-Defined Contribution Plans

Target-date funds (TDFs) have become incredibly popular in defined contribution plans, such as 401(k)s, due to their combination of low cost and risk-adjusting asset allocations.

While TDFs work out well as qualified default investments in these plans, they still lack a personal touch when it comes to an individual investor’s needs and objectives. This article explores how a TDF in combination with an individually managed account might produce superior risk-adjusted returns.

Click here to help better understand the importance of how your TDF’s allocation changes over time.

The Role of QDIAs With Defined Contribution Plans

In a defined contribution retirement plan, the amount invested is known, but the future benefit is uncertain. Common-defined contribution plans include the 401(k) and 403(b) plans, as well as traditional and Roth IRAs. When enrollees in these plans are uncertain of where to put their money or don’t choose an investment option on their own, a qualified default investment alternative (QDIA) is selected on their behalf.

The Pension Protection Act of 2006 stipulates that a QDIA can be a target-date fund, balanced or individually managed account, although TDFs are the most popular choice by far. This is mainly due to TDFs changing their asset allocations to become more conservative as retirement approaches, but consideration must be given to the fact that investor assets must be managed not just to retirement, but through retirement.

To learn more about how customized target-date funds can be advantageous, click here.

How to Construct Your Own Hybrid QDIA

One solution that helps to solve these dilemmas is to use a combination of investment options. One drawback of using a TDF in isolation is that once it reaches the target-date, the asset allocation generally remains static from that point forward. This is the point in life when investors most need individualized solutions. Healthcare concerns, retirement plans, cash needs, risk tolerances and other factors all impact how one’s post-retirement portfolio should be allocated. A TDF alone might not address these concerns, but a TDF combined with a managed account could.

This type of setup could take a few different forms. It could be age-based, where an investor could use a TDF in the early years and switch over, either partially or totally, to a managed account once a certain age is reached. It could also be asset-based, where once an account has accumulated enough assets to meet anticipated retirement needs, a managed account would be used to help keep things on track from there. It’s the combination of a low-cost, risk-appropriate investment option with individualized attention that could reap the greatest benefits.

To learn more about target-date funds, in general, check out our Target-Date Funds section.

Considerations for a Target-Date Fund/Managed Account Combination

With a hybrid QDIA, the greatest benefit is the combination of a low-cost, risk-appropriate investment option with individualized attention. A customized savings and planning program could not only help with making sure that personal investment goals are achieved, but it can also help in adjusting the portfolio to account for current economic and market conditions.

In addition, the hybrid QDIA can be used successfully by investors at any point in the life cycle. Early stage investors get invested in a low-cost, broadly diversified portfolio. Near-retirees can use the managed account aspect to ensure that their accumulated wealth will meet their retirement needs. Retirees received individualized attention to make sure that all personal financial needs are being addressed.

One challenge of setting up a hybrid QDIA is that, for most, it won’t be a viable option as managed accounts have been adopted by fewer than 10% of plan sponsors. Investor engagement will be key in the success of any hybrid QDIA. If a lack of engagement is what led to selecting a TDF in the first place, investors might fail to leverage the full advantages of an individually managed account.

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The Bottom Line

Target-date funds alone are great as long-term investment options, but using them in combination with a managed account to provide more individual attention might be a better option for some investors. The managed account, while likely coming with a greater cost, is better able to address personal goals and objectives in a way that a TDF alone cannot. Once in retirement, individuals have widely differing circumstances that need to be considered, and using some type of managed account might be the best way to address those situations.