Managed Accounts, TDFs and Questions About ‘Alpha’

One of the most common approaches to valuing managed account services is to compare historical investment performance with a target-date fund or similar benchmark; Empower Retirement argues there is a better approach that involves considering “an alpha-equivalent measure.”

Explaining the vision behind the latest white paper from Empower Retirement, researchers note that there has, so far, been a lack of standardized methods for “valuing managed accounts” within the defined contribution (DC) retirement plan arena.

The white paper, aptly titled “Made to measure: Evaluating the impact of a retirement managed account,” delineates the menu of features that may be offered through a managed account investment option in a DC plan. And just as important as this delineation, the firm finds that a “robust retirement managed account” provides 55 to 92 basis points (bps) of added value for unengaged participants and 152 to 258 bps for engaged participants.

As the researchers explain, managed accounts are frequently compared with target-date funds or other professionally managed investment solutions.

“This approach has merits, but the comparisons often fail to consider the difference between the two options,” the paper notes. “Managed accounts can either be used as a qualified default investment alternative [QDIA] or be affirmatively elected by a participant. The level of participant engagement can result in significant differences in value to the participant.”

Researchers point to another lasting source of confusion: “While some managed accounts products include near and in-retirement planning features, others are more focused on accumulating assets and outperforming the applicable benchmarks. Other managed account products have been tightly integrated with recordkeeping systems, allowing for significant data sharing and automation of advice, while some are only loosely integrated.”

The result is that consumers of institutional financial services are broadly left unsure of the relative merits of managed accounts versus target-date funds or other investment vehicles and strategies—and how to go about picking a product once they take up the goal of adding managed accounts either as the QDIA or as a stand-alone option.

Defining managed accounts

Seeking to set something of a better baseline for the discussion of managed accounts moving forward, Empower Retirement suggests the industry should adopt the term “retirement managed account,” or RMA for short. This designation is intended to avoid confusion with a similar product typically offered by individual wealth or financial advisers and termed a separately managed account (SMA) or a unified managed account (UMA).

For a solution to meet Empower’s definition of an RMA it first must provide participant-level 3(38) service and protection, meaning a registered investment adviser (RIA) must offer the product, with the RIA acting as a fiduciary to participants. In some instances this is the RMA product provider’s RIA, as is the case with Financial Engines Advisors or Morningstar. In other cases, an RIA associated with a recordkeeper or adviser offers the product, as is the case with Empower’s own managed accounts.

The second necessary characteristic of an RMA, according to the white paper, is that it must deliver “ongoing personalized discretionary investment management. … On a periodic and continuous basis, the solution must consider attributes of the participant, such as current age, retirement age, account balance, pension and/or risk tolerance, and have the authority and automation to update the investment mix to match participant attributes.” On the user experience side, and third, the RMA must include a means for a participant to understand the data being used, a way to adjust that data and an explanation concerning the investment decisions made. “This is typically done online through a proprietary user interface,” researchers note.

Finally, the RMA should be tied to call center support, Empower argues, suggesting participants “must be given the opportunity to talk to someone who can explain the investment decisions made in the RMA.” This typically requires call center support personnel to be investment adviser representatives with the RIA offering the RMA, Empower suggests.

Important to note, researchers suggest there are some DC industry products that are similar to a managed account but fail to meet the above definition of an RMA.

“For example, custom models, which are models typically created by plan advisers using funds in the plan lineup, are excluded from our definition of an RMA,” Empower Retirement reports.

Measuring performance

With this groundwork laid, researchers note that one of the most common approaches to valuing an RMA service is to compare historical investment performance with a target-date fund or similar benchmark.

“While we believe all RMA providers should provide historical performance, we don’t believe this is the most appropriate way to explain and account for the overall value of an RMA to an investor for this reason: The three main drivers of investment risk and, therefore, long-term performance are not directed by the RMA,” researchers argue. “In short, because the major drivers of risk are largely out of the RMA’s control, we don’t believe RMA value should be measured by historical performance. There is some evidence that RMAs outperform target-date funds, but we believe the long-run historical performance of an RMA will be generally aligned with target-date fund performance.”

Then why should participants pay additional fees for RMAs if they won’t make up the fee difference in performance? On Empower Retirement’s analysis, the “true value of an RMA lies in three sources of value: Personalization, financial planning features and ability to mitigate negative behavioral tendencies of the account holder.”

Researchers go on to posit that the best way to understand the value of an RMA is to understand its features and then estimate the value of those features. They assign value differently based on two factors. First is “engaged versus unengaged employees.” Some RMA features apply automatically—rebalancing investments allocation, for example—while others may require participant interaction, such as more tax-efficient drawdown. Naturally, automated features have the same value for all participants; those that require participant engagement have value only for those who are engaged. This should bear directly on the managed account decision, researchers suggest.

The second factor called out by researchers is “proximity to retirement.” For features with different values depending on the life stage of the participant (, a drawdown strategy is more helpful for a participant closer to retirement) researchers propose naturally differentiated values based on proximity to retirement.

More on the mechanics of this effort is available in the body of the white paper, but the conclusion drawn is that, to compare features and the value of an RMA to fees, it is best to use “an alpha-equivalent measure.”

“For example, if an RMA participant avoids negative investment behavior that would have otherwise cost them 50 bps in returns per year, we count it as 50 bps of excess returns, or alpha equivalent,” researchers explain. The paper goes on to offer up specific features found in RMAs—as well as a proposed way to value each one by life stage and engagement versus automation.

These features are personalized investment allocation; savings rate advice; Roth versus pre-tax savings advice; Social Security claiming advice; dynamic withdrawal advice; personalized allocations to guaranteed retirement income products; tax-efficient withdrawal strategy; mitigating negative behavioral tendencies; and in-person one-on-one support.

The broad conclusion from researchers is that RMAs differ significantly from other default investment options like target-date funds or balanced funds in three key areas: more personalized investment management, financial planning and the ability to mitigate negative behavioral tendencies.

“All these features have value,” the paper notes. “Assuming the value exceeds the cost of the service, RMAs should be considered as default investment options relative to target date funds.”

Find the full white paper here.