Impacts on 401(k) Lineups…a few little surprises may be hiding in your retirement plan.

Written by Steve Scott

There may be a few little surprises that are hiding in your retirement plan. More than 15 years after the passage of the Pension Protection Act of 2006, Qualified Default Investment Alternatives (QDIA) and target-date funds are now a core offering for many plan sponsors. While target date innovation may have slowed down in recent years, interesting things are happening elsewhere in the world of QDIAs.

Since the Great Recession in 2008 – 2009, we saw interest rates at historical low points.  Around the same time we had the Pension Protection Act (PPA) pass and one of the many changes this brought to the retirement plan industry was revamping the definition of a “safe harbor” within a Plan’s Qualified Default Investment Alternative (QDIA).  These two changes have created a very different environment over the past 13 years. Both of which may be tested and challenged in the coming months/years.

So what is the “So What” of those two seemingly unconnected and generally positive policy shifts from more than a decade ago?  The answer is Stable Value and Target Date Funds.  Both of these had light utilization prior to 2008 and both are now in almost every plan we see, with target date funds capturing more than 70% of all the inflows coming into the 401(k) space.  That is billions and billions of dollars.

Let’s talk Stable Value Funds

While modern lineups vary between fund offerings, most 401(k) plans tend to offer between 15 to 30-ish funds options.  It is important to remember that per ERISA you only actually need to offer three options to meet the diversification requirements, everything else is a best practice, not a requirement.  Those offerings are stocks, bonds and a cash equivalent.

I started my career in this business in 1995 at State Street Global Advisors (SSGA) working with some of the largest funds in America, and in fact one of them (Boeing) was the largest 401(k) Plan in America at that time.  While we were all fighting for more fund coverage and creative options to capture the massive increased cash flows from the average American caused by one of the best stock markets in US history and the 401(k) revolution.  The one that was always there, was money market.  Boring and safe with modest returns, there was never a plan you saw that did not offer a money market.

When my career took me to Chicago and the smaller plan market in 2002, I started to find that insurance companies had put in these fixed and Guaranteed Income Contracts (GICs) into 401(k) plans.  I remember at that time it made no sense to me to have a complex insurance product with so many liquidity restrictions in a company benefits plan. So while most plans were still using money markets I started to experience a business or organization trying to move the plan only to find out there was a hidden cost or liquidity event often referred to as a Put against these monies.  In almost every case this was followed by a phone call of frustration by the sponsor. 

Fast forward to 2022 and we find ourselves going through an increasing interest rate environment for the first time in almost a decade and a half.  It is this sort of environment that causes these liquidity restrictions too often kick in and shock sponsors with costs or complications they were unaware of.  Now factor in that during this previous period where interest rates were so low for so long that a vast majority of plans look to Stable Value Funds as an enhanced money market due to the fact that money markets were often net negative we factored in other 401(k) fees.

So unlike the insurance product solutions I spoke of earlier that I believe were more of revenue and pricing game, now we had a massive trend to a product that also has these liquidity options but this time was done for good reason.  But does anyone remember that all these Stable Value Funds may have a lot more challenges and related issues as people go to make benefit changes in this coming period. 

The Explosion of Target Date Funds

Secondly, and likely the most significant change to the industry over the past 20 years, is the explosion of target date funds. I no longer need to explain target date funds even to newer investors very often as they have become part of our common investment vernacular.  And they have also become the default fund in almost every plan I have seen during the past 10 years and it has actually become a massive red flag if a plan does not have a TDF as their QDIA.

This point is not to beat up target date funds.  I stand by it being a prudent place for many investors and research by respected institutions such as Boston Research Group has suggested many times that their performance vs. do-it-yourself 401(k) investors is often superior.  But so much of the communication and business idea around target date funds has been to make it easier and easier and more and more automated.  This has created a unique situation I cannot draw a parallel to, where a majority of investors have their money in a fund that many do not really understand.

Market Influences in 2022 Impact 401(k) Lineups

What is different and why is this relevant now you ask?  Because even with the strong market performance in 2021, we saw a significant uptick in volatility with 141 trading days seeing movement by more than 1% in the S&P 500.  In our 2022 Market Outlook we highlighted that and suggested that perhaps this trend would last for a bit as we go through a transitory period. 

Now factor in that we saw the longest bull market in US history coming out of the Great Recession and a renewed emphasis on fiduciary and investment due diligence.  As a result, target date funds with higher equity positions, usually caused by being a “through not to” strategy, meaning you manage the participants money through their life expectancy, typically performed better and were selected and promoted.  So we not only saw a massive increase in TDFs since 2009, we also saw a massive increase to through strategies and we saw an industry chasing performance keep nudging that equity exposure higher.  To the point that today many of the top target date funds being used in America, which again are capturing more than 70% of all 401(k) inflows, have equity exposures around or greater than 50% even at normal retirement age of 65.

Simple Facts Causing Complex Decision Making

These two independent policy changes of lowering interest rates and giving great fiduciary protections to TDFs are both coming to a headwind at the same time.  These are complicated matters that were caused by people actually following prudent fund selection in many ways.  So this time, for a change, no one really did anything wrong.  But the simple facts are:

  • A significantly higher percentage of conversions in the next few years may have a fund with an unknown charge or liquidity issue.
  • Between the aging Baby Boomer generation and the Great Resignation, we are seeing historic numbers of people transition from asset accumulators to asset distributors. This causes a significant increase to volatility sensitivity.
  • Because of the strong equity returns of 2009 – 2021, we find a vast majority of the monies in plans today on auto-pilot investments where the equity exposure may be much higher than the underlying participants are aware of.

Yes, this is a long and complicated explanation.  But I guess that is my point.  These two changes that occurred 13-ish years ago is going to create increased complexity for sponsors.  You want to ensure you have thought it through and that you have the right consultative support team to make what is likely more complicated and challenging decisions than we have had to deal with in a long time.