If you’re like many people I talked to you haven’t taken a class on retirement planning much less 401(k) investments such as a QDIA (qualified default investment alternative). Yet when they started at their new employer there are given a package by their HR departments or chief financial officer telling them about the retirement plan. Some of those plans start to use QDIA as an investment choice if you the participant don’t make one yourself. Is that a good idea for you?
A QDIA investment history lesson
When the 401(k) was introduced it had a limited number of choices. The law actually suggests that three types of investments cash, stocks and bonds need to be included. These are referred to as asset classes. The choice of three asset classes pulls from some Nobel Prize winning economic research that suggested one could develop multiple outcomes by just using these three investments. Think of it as if you’re cooking with salt and pepper. By changing the proportions of salt to pepper you can get various different profiles. A two to one ratio of salt to pepper taste different than 82 to 1 ratio of pepper to salt. However, many firms and technology enhancements allow more investments to be added to the investment menu and a 401(k). Many people think that more choice is better than less choice. However, research from choice architecture and behavioral economists such as Richard Thaler at the University of Chicago show a different result. His research and others found that more choice actually leads to people not making choices. It also sometimes leads people to look at all of the choices say 10 and spread their money out equally among each of the 10 investments. What may appear to be different investments can actually be nearly identical investments with just a different name. All this confusion lead the government to develop a new standard called the qualified default investment alternative.
Help from a qualified default investment alternative?
Some plans had people default into some type of cash account if they made no choice. Many people once they make their initial investment choice don’t go back to revisit it. Unfortunately few people have the luxury of only getting the returns that cash has historically given investors. While most people don’t like the ups and downs of the stock market historically it has gained far more than simply investing in cash. However, it is usually people such as professors of economics or finance, Certified Financial Analysts and others with backgrounds in investing that understand all the factors and the terminology. As nothing stays the same, it’s important that these professionals continue to stay up-to-date with the latest and research and empirical evidence. To help the investor, the employee, the government said that a choice that embedded some of the knowledge of investing such as asset allocation and rebalancing could be packaged into something called a qualified default investment alternative. They allowed for three choices one with referred to as balanced, a risk-based or a target date strategy. Using our salt-and-pepper analogy a balance strategy typically has about 50% bonds and 50% stocks, or a one-to-one ratio of stocks to bonds. The risk-based strategies pull more from Harry Markowitz Nobel prize research and allows for varying combinations from all bonds to all stock with varying increments such as 60% stock to 40% bond and 80% stock to 20% bond. A new concept was added to the mix. The target date strategy takes this risk-based concept and says from an age of 22 to an age of 65 the combinations will start out more heavily in stocks say 100% stock and no bonds and as time goes on will decrease that allocation down to typically as low as 20% stock and 80% bond. The thought being is that people with a longer timeframe until they plan to use the money can take on more market risk where those who are closer to retirement should be in a less risky portfolio. While there is a certain logic to the target date strategy, the proof is in the pudding.
Different investment managers have different ideas on the various combinations of stocks and bonds that could be used to fill your investment menu. Moreover, there is not a universal target date strategy. In fact, some firms believe that they should become very conservative at age 65 whereas others believe that should be closer to age 80. However, some people are retire at age 62 where some are retiring at age 70 or later. Some are simply choosing to delay taking Social Security until age 70 but are starting to spend down their assets at age 62. These factors quickly began to argue against the target date strategy being a one size fits most participants solution. None of the target date strategies recommend any type of saving date strategy nor do they promise any return now or in the future.
Your QDIA Action Plan
Your employer likely has good intentions regarding the choice of your investment menu. You should be receiving a notice informing you of your qualified default investment alternative choices. If your firm uses a QDIA, you should find out exactly which one you have. I would recommend that if you don’t have expertise in this area that you seek out a financial advisor with retirement planning credentials that can help you analyze or do an x-ray of your choice. I am biased towards risk-based choices and balance strategies. From a planning perspective it is easier to match up how much you need to save alongside the historical returns of the asset classes that should be reflected in the choice that are given. That being said, your menu may have choices that will allow a skilled professional to develop a more tailored strategy for you. Under current legal standards this person must be an investment advisor representative obligated to work in your best interest (fiduciary).
If you’re ready to start the conversation assessment of your risk comfort level which you can find here.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.