Winter 2007

Managed Accounts vs. Lifestyle or Lifecycle Funds

By Tim Chapman, President, PMFM, Inc.

The recently passed Pension Protection Act (PPA) has focused a lot of attention on investment advice and default options in ERISA plans. The PPA legislation provides a safe harbor for plan fiduciaries investing participant assets in certain types of default investment alternatives when participants do not make their own investment elections. The default options being considered by most plan sponsors are Lifestyle funds (risk-based allocation); Lifecycle funds (age-based allocations); or individually managed accounts. While 457 Plans do not fall under ERISA, the debate over which of these options best meets the needs of plan participants in 401k and 403b plans is certainly of interest in the 457 marketplace too.

Any of the choices listed above can help plan participants reach their retirement goals if used properly, but none of the three choices are perfect. Let's look at what is good and bad about each option.

Lifestyle and Lifecycle funds are "single" fund solutions. For years our industry has preached the importance of diversification, which to most participants means owning more than one fund. Risk-based and age-based funds are well diversified of course, but the challenge is communicating that to participants. When a participant does not see any activity in their account and only sees one fund on their account statement, they tend to question the value being added and wonder they are not more diversified. Participants also tend to judge the Lifestyle or Lifecycle fund performance relative to all the other funds offered in their retirement plan. Properly diversified portfolios will often underperform the more aggressive asset classes, particularly in strong bull markets like the late 90's. Many participants will succumb to the lure of "greener grass" based on short-term performance, or at the very least will add a few more funds to their portfolio thereby undermining the intended overall asset allocation.

Virtually all risk-based or age-based funds are managed using strategic asset allocation. Changes are made to the underlying allocation to rebalance, to replace an investment manager within an asset class for performance or style drift, or to gradually reduce equity exposure as the participant nears retirement. Even though the general philosophy governing these funds is the same, there can be tremendous differences in the actual make-up of the portfolios. For example, when given the same inputs - age, expected retirement date, risk tolerance, etc. - there can be very disparate results in the equity/fixed income mix from one portfolio to the next. One of the greatest concerns of defaulting participants into such options is the very real probability of the participant experiencing a large investment loss in severe bear market conditions such as the 2000-02 period.

For these reasons, the critical factor to success using Lifestyle or Lifecycle funds is the participants understanding of them. Meeting that challenge require excellent communication and education programs, and most importantly, a workforce that wants to be educated on these issues.

Individually managed accounts overcome these problems because participants see more than one fund in their account, plus they see the activity on an ongoing basis as the portfolio allocation changes. Managers using a tactical asset allocation philosophy might also be able to add value in bear market conditions by limiting downside risk in the portfolio. The biggest disadvantage of individually managed accounts is the cost. While Lifestyle or Lifecycle funds tend to be very inexpensive options, managed accounts might cost 1% per year or more. These costs are typically paid by the participant through deductions form their account so they do not add to the overall cost of the plan for participants not choosing to have their account managed.

One other advantage to managed accounts is the opportunity for one-on-one interaction between the plan participant and a financial professional. Study after study has shown that most participants prefer the investment advice be delivered face to face. Not only does this enhance their understanding and appreciation of the employer's plan, it also enhances their chances of success in reaching their retirement goals. The financial advisor can bring outside assets into the planning process, help the participant set realistic goals, and encourage greater deferral percentages when needed. The success of many managed account offerings suggests that participants are very willing to pay more in fees to get more personalized service and have the peace of mind in knowing their retirement decisions are being made by a professional.

Regardless of which option a plan sponsor chooses - Lifestyle fund, Lifecycle fund, of Managed Accounts - offering these vehicles to plan participants, along with automatic enrollment and automatic defaults, will hopefully result in more Americans being on track to retire with dignity and live out their Golden Years without running out of money.

Tim Chapman is President of PMFM, Inc., a registered investment advisory firm located in Athens, Georgia. PMFM offers investment advice and managed accounts to the retirement industry through their 410kToolbox, 403bToolbox, and 457Toolbox services. In 2004, Defined Contribution News named Chapman "Advice Provider of the Year" in the 401k market.