The Smart Path To Personalizing 401(k) Investments, Especially For Baby Boomers

·       The $5 Trillion target date investment industry is evolving toward personalization, but distinguishing risk capacity from risk tolerance is critical for effective implementation. Most “Personalization” mistakenly relies on risk capacity when it should use risk tolerance.

·       Personalized Target Date Accounts (TDAs) aim to improve upon Target Date Funds (TDFs) by tailoring risk to individual participants because investing is personal. There is a better path to achieving this important goal.

·       Rich people with high risk capacity want to stay rich, so they have low risk tolerance. Poor people with low risk capacity might want a shot at not being poor by taking high risk.

·       Non-defaulted (self-directed) participants want to engage, so they should use TDAs. For defaulted participants, the plan’s sponsor should use the TDA structure to create a custom TDF for all as the Qualified Default Investment Alternative (QDIA).

In What Advisors Need to Know About Personalized Target Date Funds, Great Gray  Trust Company praises the movement to Personalized Target Date Accounts (TDAs) that aim to improve upon regular old  one-size-fits-all-set-it-and-forget-it  Target Date Funds (TDFs).

It’s a good article that describes the benefits, but the path to personalization can and should be much smarter, especially for baby boomers because they are in the Retirement Risk Zone near retirement.

Most current TDAs rely on recordkeeper data to make a risk decision. This is a mistake because the wrong data is used. The “beauty” of current TDA approaches is that the defaulted participant does not have to engage. It’s good because defaulted people don’t want to engage. But the problem is that recordkeeper data reveals risk capacity when you really should use risk tolerance.

Risk Tolerance

In 2014 financial expert Michael Kitces published Separating Risk Tolerance From Risk Capacity – Just Because You Can Afford To Take Risk Doesn’t Mean You Should. The investment industry took heed and directed its attention to advancing investment theory that came to be known as Post-Modern Portfolio Theory (PMPT).

Rich people with high risk capacity want to stay rich – they have low risk tolerance. Some poor people with low risk capacity might like to stop being poor – to take high risk. You can only know risk tolerance by asking and therein lies the dilemma: defaulted participants do not want to tell you their tolerance, primarily because they don’t know it.

Separation of Application

Even though defaulted people won’t share their risk tolerance, non-defaulted self-directed participants want to discuss their risk preferences – tolerance. Consequently, TDAs should be driven personally by non-defaulted participants.

On the other hand, plan sponsors should use the TDA structure to design a custom TDF for all defaulted participants as the QDIA (Qualified Default Investment Alternative) . Custom TDFs have caught on a little, but they rely on the glidepath provided by a consultant. Under a TDA approach, the plan sponsor can blend several risk-based glidepaths to conform to the demographics of the workforce, as recommended by the DOL.

Conclusion

The $5 Trillion (with a “T”) TDF Industry is evolving. It can and will get better. Personalization is high on the list of improvements because investing is personal. But we need to be careful in delivering personalization and to recognize the important distinctions between risk capacity (the ability to take risk) and risk tolerance (the willingness to take risks) because most rich people like being rich and some poor people might like to take a chance at getting rich by taking risk.

Participants in 401(k) plans need to know how their savings are being invested. Non-defaulted participants do know because they decide. By contrast, those who default into a QDIA trust their employer to make a right decision for them, but that decision is generally high risk for baby boomers near retirement, with 85% risky assets – 55% equities plus 30% long-term bonds. “Personalization” might change this, but defaulted participants need to look, and to move to safety if necessary.