Evaluating managed account performance: Understanding the differences

Evaluating the performance of Qualified Default Investment Alternative (QDIA) solutions–such as target date funds and managed accounts–has been a challenge long acknowledged by plan sponsors and their consultants. Each QDIA is different. Differences in the methodologies drive core design aspects, such as the glide path, asset allocation advice and underlying asset classes. So when it comes to creating a meaningful evaluation, how do you compare these apples and oranges?

The problem with traditional evaluation methods

To put it bluntly, traditional evaluation methods are a poor fit for target date funds or managed accounts. Such methods typically include the following:

Benchmark-relative performance: How the fund has performed versus its benchmark
Peer-relative performance: How the fund has performed versus other funds with the same benchmark or objective

Why the poor fit? Because comparing target date funds or managed accounts in this way would be like performing an analysis that commingles peers with different investment styles (e.g.; growth and value), which could lead to improper attribution of performance. The performance differences would likely be driven by the market’s current valuation of an investment style rather than by the skill of the solution’s investment team or process.

While reporting and rating systems attempt to create appropriate peer groups for target date funds through the categorization of funds according to vintage–or to the anticipated year of retirement–comparison of funds within these peer groups is challenging due to the differences in the funds’ glide paths or de-risking methodologies and to the underlying asset class composition. The customized asset allocations generated by managed accounts only amplifies the challenge of comparing these solutions to other QDIA options.

Using an outcome-oriented framework to evaluate QDIAs

Since the traditional relative performance method provides limited insight into the quality of uniquely constructed QDIA solutions, we believe plan sponsors should consider additional frameworks to ensure they are fulfilling their responsibility of evaluating their QDIA on a consistent and recurring basis to meet the interests of participants. After all, participants don’t care how well the fund performed over a five-year period relative to a benchmark. They care if they have enough money to meet their specific, individual retirement needs.

That's why one best-practices framework we see as instrumental is a comparison of expected outcomes for the participants who depend on the plan. An appropriate outcome to serve as a basis for this comparison is expected income replacement as a percentage of the participant’s final salary. This outcome provides participants with the ability to accurately budget for retirement expenses and understand the reality of their individual situation.

Asset allocation and goal-targeting

We believe best-in-class managed accounts programs harness participant data to calculate an income replacement goal for each individual participant and then, based on a participant’s ability to achieve this objective, provide an asset allocation specifically targeting the goal for that individual. This allocation is then adjusted on an ongoing basis as individual circumstances change.

It goes without saying that when it comes to meeting these goals, participants’ progress will vary: they’ll either be behind, on-track or ahead.

Behind participants:
The goal with this group–which comprises the majority of U.S. retirement plan participants–should be to get participants back on track. We believe a higher allocation to growth or risky assets could help improve outcomes for these participants or increasing the likelihood of meeting their income replacement goal. An increased savings rate would also have the potential to improve outcomes, but in the absence of engagement by the participant, this may be unattainable.
On-track participants:
This group consists of participants projected to meet their income objectives with a relatively high probability. These are typically participants who have been, and are continuing to, diligently save for retirement. In this case, we believe a more conservative allocation to growth or risk assets is optimal.
Ahead participants:
Participants in this group have adequately reached their goal of meeting an appropriate level of retirement income. Oftentimes, these participants have significant other sources of income, such as a defined-benefit (DB) plan, and the defined-contribution (DC) plan is supplemental. We believe participants can afford more risk and should receive a relatively higher allocation to growth assets in order to help maximize their wealth, as a secondary objective.

But what if an on-track participant falls behind, as circumstances evolve? We also think it’s instrumental to re-evaluate each participant's asset allocation and reallocate as necessary on a quarterly basis. This helps ensure that as circumstances change, either due to participant-directed changes (such as an increase in savings rate), or due to market conditions, participants still have an appropriate allocation –specific to their personal circumstances.

Evaluating an income replacement objective solution

An income replacement-focused solution has a goal of getting and keeping participants on track to replace a percentage or amount of income. The asset allocation for each participant specifically targets this income replacement goal. For these types of solutions, it is most appropriate to perform a forward-looking analysis of how different types of participants are projected to do compared to alternative QDIAs such as target date funds. Since there is a spectrum of being on-track, a forward-looking comparison to an alternative QDIA, such as a target date fund, can be unwieldy based on the volume of unique circumstances being solved for in a customized way. We believe that organizing participants by age cohort and then by how on-track they are makes the comparison more manageable.

Traditional methods: Trailing total return comparison

We recognize that employing traditional evaluation methods may still bring about a sense of comfort. Therefore, we believe that if you must look at trailing total returns, it’s important to do so through the appropriate lens: the overall position your participant base is in. Are most behind, on-track or ahead? How participants are tracking to their retirement income goals strikes us as the most meaningful measurement. Therefore, it should direct the asset allocation participants receive.

With that in mind, one way to look at historical performance is to show the average returns for different age cohorts and compare them to the returns they would have experienced in an average target date fund, or any other target date fund series that would be a reasonable alternative. For example, participants who were born between 1963-1967 would be defaulted into a 2030 target date fund, so it would be prudent to compare the average participant for that age group to the returns realized by the average 2030 target date fund.

Remember that we believe the most appropriate investment solution for individuals who are behind is to allocate more of their wealth to growth (higher risk) assets. During strong markets where growth outperforms capital preservation, participants will likely benefit more versus solutions with less risk. Alternatively, when market conditions are poor, results for these behind participants will likely struggle relative to a target date fund that may have less risk.

Therefore, trailing return results may be heavily influenced by the latest market environment, especially over short time periods. This is why we caution against using this metric, as the evaluation method doesn’t provide clarity regarding the progress toward participant objectives. Over long time periods, the policy of allocating more to growth assets for participants who are behind can lead to improved retirement outcomes.

Bottom line

We contend that sponsors should focus on two things: How participants are tracking to meet their income objectives, and the steps that can be taken to improve the likelihood of meeting those objectives. This is particularly important for the behind participants who represent most of the DC savers today. Offering a QDIA solution that addresses the unique circumstances of participants–at an individual level–and is designed to improve outcomes is more vital than ever.

Evaluating these solutions can be difficult, but using an outcome-oriented framework can be an impactful way of demonstrating the potential improvement in retirement income for participants, whether they are behind, on-track or ahead. Many managed account solutions also offer the opportunity for participants to engage further, leading to potentially larger improvement in retirement outcomes.

Lastly, targeted campaigns around saving more and encouraging participants to engage in their personal finances can have a big impact. If done effectively, participant readiness will improve, more participants will be on track and their individual asset allocations will adapt appropriately until they reach retirement.