Earlier this year 401(k)Specialist published my article entitled Truly Managed Accounts are Not QDIAs: Opinion in which I argue that the word “managed” cannot be true when the investor does not talk to you, as is the case for defaulted participants in QDIAs. In this new article, I bring us back to an important discussion that we have been having for more than a decade, namely the distinction between risk “capacity” and risk “tolerance.”
Investment experts have long understood the distinction between the ability to take risk—capacity—and the willingness to take risk—tolerance.
For example, 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.
Personalized investment providers (PIPs) use capacity data as the risk indicator, which is a big mistake because most rich people (with high capacity) want to stay rich (so low tolerance), and many poor people (low capacity) want to take gambles (high tolerance) in order to stop being poor—risk tolerance differs from risk capacity and cannot be inferred from data.
Determining risk capacity and risk tolerance
Capacity decreases as horizon shortens and increases with wealth. PIPs use the following recordkeeper data to determine capacity. Defaulted people do not engage, so no communication—just data.
- Investment Horizon: Current Age and Target Retirement Age
- Wealth: Account Balance, Salary, Contribution Rate and Marital Status
Data does not tell us risk tolerance.
By contrast, tolerance is emotional and situational, and changes over time, so it can’t be gleaned from data. Data cannot reveal life events, like the birth of a baby, buying a house, marriage, etc. The investor needs to tell us their willingness to take risk. Tolerance is the key to effective management, but because defaulted participants will not engage, we can’t know their tolerance.
Some say that participants do not know their risk tolerance. That’s why behavioral scientists have developed risk tolerance questionnaires, but defaulted people will not complete these. Early questionnaires were discredited for failing to accurately capture risk tolerance, so behavioral scientists stepped in to perfect the results. The important fact is that there are ways to elicit a risk tolerance decision from people who want to engage.
The Big Mistake
PIPs provide Qualified Default Investment Accounts (QDIAs) under the Pension Protection Act of 2006 that designates managed accounts as QDIAs, but the common interpretation of the Act is wrong because you cannot “manage” assets for someone who will not talk to you. You can manage assets for self-directed participants, but they do not default, so it’s not a QDIA.
The meaning of “managed” is the Catch22 in managed account QDIAs. A related Catch22 is that rich people do not default, so the capacity meter registers “Low” for all people in a QDIA, obviating the need for capacity scaling.
No one has questioned this mistake, until now. Changing the name to “Risk Capacity Accounts” (RCAs) would be much more accurate. Would regulators designate an RCA to be a QDIA? Perhaps. Risk Capacity is personalized, but it’s not the right risk measure for effective risk management.
Similarly, personalized target date accounts (PTDAs) have recently come to market as QDIAs. These are simply traditional managed accounts that explicitly tell investors that investment horizon is baked into the risk decision. They too use risk capacity, rather than risk tolerance, and they too are not actually managed when applied to defaulted participants. PTDAs are confusing in that the target date part qualifies as a QDIA but the ”managed account” part is not actually managed because you cannot manage assets for someone who will not talk to you.
NOT a Big Mistake
Because self-directed participants want to engage and will tell us their risk tolerance, PTDAs and managed accounts should be widely used by them. These accounts are not QDIAs. A third of the $4 trillion in TDFs is from self-directed participants.
A Master PTDA should be used for all defaulted participants as the QDIA, where the plan sponsor chooses a target date and risk level for all. This is a big improvement over target date funds that generally have very high risk glidepaths and use only proprietary investments. No investment firm is best in all asset classes.
Everybody wins, especially participants.
Conclusion
Plan participants benefit from personalization that is actually managed, but that cannot happen for defaulted participants because they will not engage, so the QDIA needs to be a “Master” personalized account. This is a big improvement over typical TDFs.
Self-directed participants can and should receive true personalization.
Most of us have forgotten the distinction between risk capacity and risk tolerance, and that has allowed “managed” accounts to stand as QDIAs even though they are not actually “managed.” Participants in managed accounts need to be concerned, especially Baby Boomers because they are in the Retirement Risk Zone when losses can ruin the rest of life. As Michael Kitces said, “Just because you can afford to take a level of risk doesn’t mean you should.” Baby Boomers should not maximize risk at this time in their lives.
Target date funds (TDFs) do meet the description in the 2006 Act, so they are valid QDIAs, but recently PIPs have tried to extend TDFs to PTDAs as a QDIA, but that simply doesn’t work.
It’s time to end the confusion, and to do what is right and better for retirement savings participants. It’s the right thing for fiduciaries to do.
SEE ALSO:
• Risk Capacity Used in PTDAs is Much More Dangerous Than Risk Tolerance
• Surz Releases Book Championing Better, Safer TDFs