When a Default Investment May Be the Worst Choice for Your 401(k)

NEW YORK (MainStreet) -- Employers are increasingly offering to put your 401(k) investments on autopilot, and, for the most part, that’s a good thing. Workers without the time, knowledge or desire to manage their investments often hijack their own best efforts. Automatic enrollment and default investments seem to be the best short-term solution to fix a broken retirement savings system. But there is a hitch: one of those go-to investments offered by your employer may be a poor choice.

Plan sponsors are allowed by the Department of Labor to offer one of three default investments:

  • Life-cycle or target date funds, mutual funds with an investment allocation based on the age or risk appetite of the worker
  • Balanced funds that hold a fixed mix of investments that never changes
  • Managed accounts that provide a “custom” investment strategy

These “do-it-for-me” options are offered to participants who opt out of managing their own investments.

Managed accounts comprised more than $100 billion worth of defined contribution plan assets by the end of 2012, according to the Government Accounting Office. They have become increasingly popular for participants looking for a more personalized investment experience.

Advocates contend that managed accounts help reduce volatility and that the customized allocations and frequent rebalancing outperform target date or balanced funds. In a study conducted by the GAO, several managed account providers even claimed that participants tended to save more for retirement, compared to those who were not enrolled in the service.

But the GAO found managed accounts were prone to charge higher fees than target date and balanced funds.

“Paying higher additional fees to a provider for a managed account service offers no guarantee of higher rates of return compared to other providers or compared to the reported rates of return earned by participants who invest in other professionally managed allocations or who self-direct investments in their 401(k) accounts,” the GAO report said.

“Because of these additional fees, 401(k) plan participants who do not receive higher investment returns from the managed account services risk losing money over time,” the agency concluded.

The study found managed account providers charge additional 401(k) fees ranging from $8 to $100 on every $10,000 in a participant’s account. That results in a wide range of costs, based on a participant’s account balance – some paying a low annual fee while others are penalized with “substantial” charges.

In addition, the government study found participants generally didn’t receive performance and benchmarking reports for their managed accounts. With high fees and no performance accountability “plan sponsors may be unable to select a provider who offers an effective service for a reasonable fee,” the GAO concluded.

While noting the positive aspects of managed accounts, global consulting service Towers Watson also finds fault with the prevailing fee structure of the service.

“We acknowledge that the range of additional services offered in addition to asset allocation… should have added costs associated with them," the firm notes in a recent report. "Still, we believe that the managed account industry needs to lower fees before we would expect meaningful adoption of managed accounts.”


The consultancy offers a possible workaround: younger workers could utilize target date funds at the beginning of their careers and then transition to managed accounts as they “develop more complex circumstances approaching retirement.” That way, they would effectively reduce their cost of investment management.

While the industry works to sort out the fees and performance reporting deficiencies of managed accounts, there is good news. A Towers Watson study of defined contribution plans found that most sponsors utilize target date funds as their default option, “because they are simple, cost effective and dynamic in that the asset allocation changes over time, de-risking as retirement approaches.”

Until managed accounts can become more affordable, allocation funds still seem to be an effective solution for the hands-off 401(k) investor.

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