There’s a movement underway to personalize target date investing based on age and wealth. Age is baked into target date glidepaths. Wealth is the new improvement.
The accepted answer for age is that we should take low risk in the Risk Zone spanning the 5 years before and after retirement. This is what academics recommend, although the typical TDF is much riskier at its target date than academic theory.
The standard answer for wealth is that the rich can afford more risk. Which brings up the question of who defaults their investment decision? The rich or the poor? As reported below, Perplexity AI says it’s the poor who default. They cannot afford to take investment risks, so the wealth aspect also argues for very low risk, especially in the Risk Zone.
In other words, both age and wealth argue for a very low risk near retirement, so why bother with personalization since the right answer for most in QDIAs is very low risk?
Smart Personalization
The fact is that we all have our individual needs and wants that cannot be inferred from age and wealth, especially in the Risk Zone. But defaulted participants will not tell you their preferences, so smart personalization is for self-directed participants because they do want to engage. Personalization for self-directed people is not a QDIA. These non-defaulted people tend to be rich.
Smart personalization also gives plan sponsors the flexibility they need to comply with DOL guidance to match their TDF to workforce demographics. Fiduciaries know how to use personalization for the best interests of defaulted participants as a group rather than trying to make individual decisions as is the case with most personalized target date products.
Age and wealth argue for a QDIA that is “personalized” to be very safe at the target date, but there are plans where the demographic supports more risk, namely wealthy participants.
Put simply, personalization gives fiduciaries and self-directed participants the wherewithal to manage their own unique target date accounts. The QDIA application is a customized one-size-fits-all. That’s a big deal, and an innovation in target date investing. TDFs had not evolved in the past 16 years, until now.
The following summarizes Perplexity AI’s response about the poor being the prominent participants in QDIAs.
Most Defaulted Participants are Poor According to Perplexity AI
Lower-income employees are more likely to default their investment decisions in 401(k) plans compared to higher-income employees. Here are the key points:
- Lower-income employees tend to stick with default contribution rates and investment options more often, even when these defaults may not be optimal for their financial situation.
- Employees who remained at the default 12% contribution rate in one study had an average income approximately one-third lower than those who opted out of the default.
- Financial literacy has an income and wealth gradient, with lower-income individuals generally having less financial knowledge. This can lead to them freezing and remaining at the default status quo.
- Younger employees and those with smaller account balances (who tend to be lower-income) are more likely to rely on default allocations.
- The use of default asset allocations is more common among relatively less experienced employees with modest funding in their employer’s account.
- Higher-income individuals are generally more proactive in making allocation choices and less likely to use the default allocation, partly due to their greater sophistication and expertise.
The tendency for lower-income employees to default their investment decisions has important implications for policy and plan design. Employers and policymakers should consider setting defaults that are more beneficial for lower-income individuals, as they are more likely to stick with these options.
Additionally, efforts to improve financial literacy and encourage active decision-making among lower-income employees could help them make more optimal choices for their retirement savings.
SEE ALSO:
• Personalized Target Date Accounts Provide Ability to Manage Risk Preferences
• Custom Target Date Funds Need Personalization