Personalization by Default

By: Todd Levy, AIFA, QKA

Say what you will about modern technology; one indisputable benefit is the personalization impact technology has on our daily lives. When we leave work and get in our cars Spotify recommends the perfect playlist to decompress from a day of endless tasks, Waze navigates us home avoiding traffic and the stress of guessing the best route, along the way Ring notifies us that DoorDash has delivered dinner and our Amazon packages have arrived. After arriving home and eating dinner, Netflix recommends a curated selection of evening entertainment. With all these personalized conveniences in our lives, why does our 401(k) plan seem so antiquated and impersonal? 

The Pension Protection Act(PPA)

Let’s examine further. In 2006, legislation was passed that has led to over $3 trillion of 401(k) assets flowing into target-date funds, which are professionally managed to target a certain retirement year. Among other regulations, the Pension Protection Act of 2006 (PPA) opened the door to personalization in two significant ways. First, plan sponsors were given the ability to automatically enroll employees in their company 401(k) plans, and second, to select certain types of investments on their behalf (Qualified Default Investment Alternatives, or QDIAs).  Plan sponsors willing to adhere to strictly- defined implementation and ongoing monitoring guidelines set forth by the Department of Labor (DOL) were afforded safe harbor protection from investment outcomes within accounts of plan participants.  

Why Were New Regulations Passed?

The DOL believed that more could – and should – be done to promote retirement readiness for 401(k) plan participants. Step one was to reverse-engineer retirement savings; allowing plan sponsors to automatically enroll plan participants into 401(k) plans and gradually – over time – increase their annual salary deferral contribution amounts.  Most employees want to save for retirement, however, requiring individuals to participate causes inertia to limit employee enrollment to as low as 30% in some 401(k) plans. When inertia is used to influence better saving habits and participants are automatically enrolled in 401k(k) plans, long-term participation rates typically remain as high as 80-90%. 

Personalization in 401(k) Plans

The first iteration of personalization in 401(k) plans began as a result of PPA regulations. The new rules provided a safety net for plan fiduciaries investing participant balances in certain types of default investment alternatives in the absence of participant investment direction. These default investments, today known as Qualified Default Investment Alternatives (QDIA), must meet one of the following: 

• A product with a mix of investments that considers the individual’s age or retirement date (e.g., a life cycle or target-retirement-date fund).  
• A product with a mix of investments that considers the characteristics of the group of employees, rather than of each individual (e.g., a balanced fund).  
• An investment-management service that allocates a participant’s contributions among existing plan options to provide an asset mix that considers the individual’s age, target retirement date, or life expectancy (e.g., a professionally managed account).  
• A capital-preservation investment product designed to preserve principal and provide a reasonable rate of return, but only for a period of 120 days after the date of a participant’s first elective contribution under Section 414(w)(2)(B) of the Internal Revenue Code (“Code”). Note, however, that at the end of the 120-day period, the product would cease to be a QDIA, and to continue to obtain relief under the regulation, the fiduciary would have to redirect such investment into another QDIA before the end of the 120-day period. This category provides a nearly risk-free option that will preserve principal during the limited period when an employee is most likely to opt-out of participation and request a return of his or her contributions. 

Target Date Funds

Of the four options, Target Date Funds (TDFs) gathered the most assets and have been adopted by the highest percentage of 401(k) plan sponsors as the QDIA of choice. Since 2006, TDFs have become the “easy button” for plan sponsors and plan advisors. Based on the participant’s age, payroll deductions are professionally invested in a single fund that diversifies account values across various types of equity and fixed income securities. Furthermore, the TDF adjusts the account balance to become more conservative every five years as individuals approach their estimated retirement date (typically between the ages of 65-67).  This “set it and forget it” capability allowed plan participants and plan sponsors to focus on saving goals while delegating the investment burden to professional TDF managers.  

On the surface, this was an attractive option for investors who never wanted the burden of managing their investments throughout their working careers. Looking deeper, the automation of TDFs falls short of today’s personalization expectations. As mentioned, TDFs are a single-factor investment solution. The one factor that drives all investment decision-making is age, and not specific ages but approximate ages in five-year increments.  Should all 40-year-old plan participants be invested the same?  Imagine if all 40-year-olds got the same Netflix or Spotify recommendations? Or Waze directions?  Maybe single-factor (age) investing can be improved or – better yet – personalized? 

For now, let’s assume a plan participant saves effectively (ideally at least 10% of pay per year), the TDF manages their investments properly over a 40-year working career, and then they plan to retire. The biggest concern most retirees face is how much money they spend in retirement without running out of money. TDFs are helpful during the accumulation phase of retirement savings, however, they do not offer personalized guidance during the spending phase of retirement (decumulation).  Is it appropriate to think all 65-year-old participants need the same amount of monthly income in retirement? What if they retire earlier or later than age 65? Is it possible that single-factor TDFs are not the ideal solution for investing during retirement either?  

Better Outcomes with Personalization

If automation is good, personalization is even better. The good news is that your 401(k) already knows a lot about your individual uniqueness. Your 401(k) knows your actual age, your income, the amount you are saving in your plan, your employer’s contribution to your plan, your current account value, and if your employer offers a defined benefit plan or other retirement savings plan. Furthermore, your 401(k) can easily account for your projected Social Security benefit to determine the remaining amount your retirement savings must provide. If your 401(k) plan took all these factors into account and could create a specific portfolio of investments for you within the plan and then automatically refresh this data on a quarterly basis and adjust your investment allocation accordingly, doesn’t this sound more like the 401(k) version of the Netflix experience that we should expect with something as important as our retirement savings?  

Finally, let’s assume you spend $5,000 per month in the final working years of your working career. What if your 401(k) automatically knew you were eligible to receive $2,000 per month from Social Security and was able to divert a portion of your 401(k) account into an investment account that would be guaranteed to pay you the additional $3,000 per month throughout your retirement years.  Would you feel more comfortable making the decision to retire if you knew your monthly income of $5,000 would be sustained for the rest of your life? Does this sound personal? Do you think employees and employers would feel better about their 401(k) plans if investments and retirement income projections were more personalized? 

Good News!

Under the DOL regulations established in 2006, plan sponsors can elect a Managed Account solution as the 401(k) plan’s QDIA offering. While these options have been available for quite some time, the technology linking the plan’s investments to the source of the personalized data (recordkeeping system) has been cost-prohibitive, unavailable, or both.  Even more exciting is 1) the technical challenges have been solved, 2) the costs of personalization have come down to levels comparable to traditional age-based TDF, and 3) guaranteed income solutions are now available inside 401(k) plans.  

How Can We Help?

As your partner on the road to retirement, TRPC is committed to continuing to evolve our retirement plan technology platform; driving quantifiable retirement solutions to plan sponsors and participants.  In the coming calendar quarters, we will be rolling out a suite of personalized QDIA Managed Account solutions to include individualized investment management services aimed to help savers accumulate a sufficient retirement nest egg and guaranteed income alternatives to make sure participants can live a long and dignified life in retirement without the fear of running out of money. For more information please contact TRPC Sales at 888-673-5440, option 4.