Personalization is the current hot topic in 401(k) investments because investing is personal. I have written about the practicalities of personalized target date accounts (PTDAs) as a Qualified Default Investment Alternative (QDIA) in the following:
- Personalized Target Date Accounts Provide Ability to Manage Risk Preferences
- Smart Personalized 401(k) Investments
- The Yin and Yang of Personalized 401(k) Investments
- Benchmarking Personalized Target Date Accounts
The problem is that PTDA providers have confused risk capacity with risk tolerance. Capacity can be estimated from recordkeeper data, but tolerance cannot. Capacity is the ability to take risks. Tolerance is the willingness to take risks—it’s emotional. Behavioral scientists tell us that we are risk averse, so we do not want to maximize risk. Capacity is maximum risk.
PTDA providers should stop ‘managing’ QDIAs
I contend that personalization only works for self-directed participants because they want to engage so they will tell us their risk tolerance, but this is not a QDIA.
Defaulted participants do not want to engage, so we can’t know their risk tolerance, which is critical for sound personalization. Also, defaulted participants are financially naïve, so they don’t know their risk tolerance, even if they did engage.
But I have received pushbacks that say recordkeeper data can actually provide enough information to personalize, especially since PTDA providers are actually using this data currently to “manage” QDIAs. I say they’re wrong, and that PTDA providers should stop managing QDIAs. Or put another way, fiduciaries should not buy PTDA QDIAs.
Let’s take a close look at the data that PTDAs are using. Without communication, these datapoints are used to guess an appropriate asset allocation for people they don’t know. Here are the datapoints that AI identifies as sufficient for personalization (hat tip to Nevin Adams):
Minimum Set of 5 Core Data Points
These support risk tolerance estimation, asset allocation, savings trajectory, and retirement income modeling:
- Age/Date of Birth
➤ Determines investment time horizon, retirement age assumptions, glide path. - Current Account Balance
➤ Determines initial wealth base, calibrates expected future accumulation. - Annual Salary/Compensation
➤ Anchors future contribution projections and replacement rate needs. - Contribution Rate (Employee+Employer)
➤ Directly informs the savings trajectory and ability to meet future income needs. - Target Retirement Age/Date (or inferred from plan default)
➤ Defines endpoint of accumulation phase; affects asset glide path and withdrawal assumptions.
Optional but Valuable Additional Inputs (to reach 8+ data points)
- Marital Status / Spousal Income
➤ Affects household planning, Social Security strategy, and income goals. - Outside Assets / Other Retirement Accounts
➤ Offers a more complete view of household financial capital. - Risk Tolerance or Behavioral Profile (via questionnaire or inferred)
➤ Allows dynamic asset allocation within
All of these data points, except No. 8, are about risk capacity.
Numbers 1 and 5 provide investment horizon to retirement; risk capacity declines as retirement nears because we will rely on that money to carry us through retirement years when there are no paychecks.
Numbers 2, 3, 4, 6 and 7 are wealth data points; the presumption is that the wealthy can afford risk, which means their risk capacity is high. But risk capacity is not the same as risk tolerance. Money is personal and emotional, and so is risk tolerance.
The data point that matters most
Datapoint No. 8—Risk Tolerance—is not optional. It’s imperative, but unknowable for defaulted participants because defaulted participants will not complete questionnaires, and wealth is a proxy for risk capacity but not for risk tolerance. Just because you’re rich doesn’t mean you’re a risk taker—rich people want to stay rich. Also, wealthy people don’t default.
Self-directed (non-defaulted) participants do engage and will complete questionnaires but that is not a QDIA.
Personalizing QDIAs
Instead of confusing risk capacity with risk tolerance/aversion, safety is the answer for those who default because they are financially naïve and in need of protection. It’s like our Duty of Care to protect our young children from foreseeable harm. Also, academic lifetime investing theory argues for safety near retirement.
In other words, personalization is not the answer for defaulted people; safety is the answer. A “Master PTDA” for all defaulted participants can be the QDIA. This Master PTDA is the ultimate custom TDF. For most plans, this Master PTDA should protect those near retirement, despite the fact that most TDFs do not protect near retirement even though they should.
Conclusion
PTDAs are coming to market as QDIAs but you cannot “manage” assets for people who will not talk to you.
Listing “Risk Tolerance” as an optional datapoint is what is called an “AI Hallucination” because Risk Tolerance is the lynchpin for personalization. Some investors are rare risk takers, but most are not—most are risk averse. Wealth is not a guide for determining risk tolerance; it’s a qualifier, a limiter.
Wealth is a risk capacity (financial ability) datapoint, but not a risk tolerance (emotional comfort) datapoint. Capacity limits tolerance—don’t take more risk than you can afford. PTDA providers are taking ALL the risk you can afford in their QDIAs. It’s a high-risk guess/gamble.
We cannot infer emotional comfort from data. Participants need to tell us. Self-directed (non-defaulted) participants can and do make a risk tolerance decision. How do they know their risk tolerance? It’s personal.
SEE ALSO:
• Benchmarking Personalized Target Date Accounts
Ron Surz is president of PPCA Inc and its DBA Target Date Solutions (TDS), co-host of the Baby Boomer Investing Show (BBIS), and author of the book "Baby Boomer Investing in the Perilous Decade of the 2020s." TDS licenses target-date fund usage of Ron’s patented Safe Landing Glide Path® (SLGP) that actually protects beneficiaries as they approach retirement. Individual investors can follow the SLGP at Age Sage, an educational interactive website. The BBIS educates baby boomers on the risks and rewards in contemporary investing, and Ron’s book is a tour of these shows.
Ron can be reached at Ron@TargetDateSolutions.com.