Why Have Balanced Funds Been Given the Short Shrift?

Their performance only matches that of TDFs for a certain age cohort, but there are other circumstances for which they might be considered a good QDIA fit.

Of the qualified default investment alternatives approved by the Department of Labor, target-date funds have grown to be the most popular. According to the 2021 PLANSPONSOR Defined Contribution Survey, 75.6% of respondents overall use a TDF as their default investment for automatic enrollment.

By comparison, only 1% of DC plan sponsors indicated that they use a stable value fund or guaranteed investment contract as the default for automatic enrollment; 2.3% said they use a risk-based asset allocation fund; 3.4% reported they use a professionally managed account; and 5.1% use a balanced fund. Stable value funds are only protected by the QDIA safe harbor for the first 120 days of participation, so those plan sponsors that reported they use a stable value fund as the default might be moving those participants who remain in the plan longer into another QDIA option, such as a TDF.

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The argument against using a stable value fund as a default is that it is much too conservative for retirement savings. Managed accounts haven’t taken off because they’ve been criticized as too costly or because studies have shown participants don’t provide the level of personalized information for them to be of optimum use. But why aren’t balanced funds more common—is it performance, cost, something else or a combination of these factors?

Amy Arnott, a portfolio strategist at Morningstar in Chicago, recently did a comparison of TDFs and balanced funds for an article on the firm’s website, and she updated it to January 31 for PLANSPONSOR.

Arnott explains that the equity allocation of TDFs’ 2030 vintage is about 62%, a bit higher than the average balanced fund, but it’s the closest comparison.

“The performance numbers are pretty close depending on the time period,” she says. “For the past three, five and 10 years, TDFs are slightly ahead, but balanced funds are ahead over the past 15 to 20 years.”

Performance for Balanced Funds Versus TDFs

Balanced funds
TD 2030 funds
3 years
5 years
10 years
15 years
20 years
Source: Morningstar Direct data as of 1/31/22

Performance for Balanced Funds Versus TDFs (continued)

Worst 3-month return since inception (%)

Balanced funds
TD 2030 funds
Source: Morningstar Direct data as of 1/31/22

But, Arnott says, plan sponsors might want to consider the risk side as well. “In terms of downside risk, TDFs held up a bit better because of their broader range of asset classes,” she says.

Arnott says another important consideration is expense. “There’s a pretty significant gap there,” she says. “The expense ratio of the average balanced fund is 1%, compared with close to 0.55% for TDFs. And, since fees have been under so much scrutiny, that’s a compelling reason to favor TDFs.”

Arnott notes that TDFs have a few other advantages, including that their broader asset allocation provides greater diversification in one fund, and most TDFs follow a glide path that automatically de-risks portfolios as employees get older.

“If participants are defaulted into a balanced fund, they might have less equity exposure than ideal when they are young or too much when they reach retirement age,” she says. “With TDFs, there’s a dynamic adjustment to risk level changing over time.”

Matthew Eickman, Omaha, Nebraska-based national retirement practice leader at Qualified Plan Advisors, who works as a 3(38) fiduciary investment manager but is also an Employee Retirement Income Security Act attorney, says he’s “come to believe the greatest reason for the wide use of TDFs [as QDIAs] is the financial incentive for companies that make them available.

“That’s been lessened by the lower use of recordkeepers’ proprietary funds but, still, recordkeepers will offer reduced prices if plan sponsors use their proprietary funds,” he continues. “To be fair, they are very transparent about this.”

Eickman says plan sponsors are typically given up to three to five quotes: one for a pure open architecture fund lineup, one for a lower cost if the plan sponsor puts the recordkeeper’s stable value fund in the lineup, one for a lower price if the plan sponsor uses the recordkeeper’s passive TDFs, perhaps an even lower price if the provider’s active TDFs are used, and potentially the best price if the plan sponsor does a re-enrollment into a recordkeeper’s proprietary QDIA.

“I appreciate the transparency of it,” he says. “It puts plan sponsors in a position of knowing what their choices are, but it also explains why there is a preponderance of TDFs as QDIAs.”

Balanced Funds’ Valuable Role

Plans in which participants are automatically enrolled could benefit from having a balanced fund as the QDIA if plan sponsors want to encourage participant engagement, Eickman says.

“Often, auto-enrollment or re-enrollment into a QDIA tends to lead to a disengaged participant population. It’s an incentive for people to not take action,” he says.

Eickman says a plan re-enrollment can be treated with little fanfare, or it can be an event that encourages proactive elections. “We don’t do a re-enrollment without a roadshow or education about ways employees can engage with the plan,” he says.

A balanced fund can work better during a re-enrollment when a plan sponsor says, “‘We’re going to automatically put you in this safe [investment] vehicle where you will be treated like everyone else, but we assume that’s not what you’d like. We’d like you to learn about your options and make an engaged choice,’” Eickman explains.

Research seems to support his theory that auto-enrolling into a fund other than a TDF will lead more participants to make a proactive choice. The TIAA Institute’s “Investment Defaults and Retirement Savings Allocations” study compared the behavior of participants who were defaulted into a money market fund with that of participants who were defaulted into a TDF. The research found the money market default was less “sticky” than the target-date default. Only 2% of participants allocated exclusively to the money market fund six months after joining the plan.

But there are other reasons that might make balanced funds the right TDF for a plan.

“Plan sponsors can look at the costs of funds and look at their participant demographics and determine the right default investment for them, and it could very well be a balanced fund,” Eickman says. “Looking at performance comparisons, if a plan sponsor’s participant population skews older, one can argue a balanced fund would be best. If the population skews younger, it might be that a TDF performs better. The youngest participants have a 20-year run before a ‘60/40’ allocation would be appropriate for them.”

Arnott agrees that a balanced fund could come out on top if the participant demographic skews older. A balanced fund might also be a good choice for a small plan sponsor that isn’t equipped to research funds.

“Balanced funds are more straightforward,” she says. “Plan sponsors have to do a bit of digging for TDFs because of the wide range of equity exposure, as well as asset class exposure.”

Plan sponsors might  also consider putting a balanced fund on the investment menu, but not as the QDIA, Arnott adds. “It’s reasonable to put a balanced fund on the menu for investors looking for a straightforward option that’s easy to understand,” she says.

Eickman says he has found that the growing reliance on QDIAs has led plan sponsors to pay less attention to default investments because of the DOL’s safe harbor, but “when 70% to 75% [of plan investments are] in the default, then that investment needs more attention.

“I really believe that the prevailing thought in the [DC plan] marketplace is that TDFs are an easy choice that plan sponsors don’t have to put much thought into, but good fiduciaries take the time to consider what’s right for participants, taking into account the age demographic of participants and how the plan sponsor wants to present the plan to them,” Eickman continues. “Those considerations should help plan sponsors choose what’s right rather than what’s easy.”

Eickman adds that he and his colleagues have spent a lot of time thinking about the pros and cons of TDFs, managed accounts and balanced funds, and they still struggle with whether there is any one perfect solution.

“We’ve thought about whether a dynamic QDIA has merit,” he says. “The idea that younger participants who do not make a proactive investment decision should have higher equity allocations for a period of time is good so accounts grow as much as they can. Then as people’s lives have more complexity—they have more assets and have to think about competing savings needs—the solution should be more customized for them.”

“TDFs tend to attract a lot of criticism, described as cookie-cutter because they are not tailored to individual investors, and that’s true in a way,” Arnott says. “But we have always thought that for the majority of participants, they are a solid investment option, especially as a QDIA. It’s hard to think of another alternative that would be more compelling.”