Which QDIA Is Right for Your 401(k) Investments?

If you’re like many people I've talked to, you haven’t taken a class on retirement planning much less 401(k) investments such as a QDIA (qualified default investment alternative). Yet when you started at your new employer you were given a package by the HR department or chief financial officer telling them about the retirement plan. Some of those plans automatically use a QDIA as an investment choice if you, the participant, don’t make one yourself. Is that a good idea for you?

QDIA Investment History Lesson

When the 401(k) was introduced it had a limited number of choices. The law actually suggests that three types of investments—cash, stocks and bonds—need to be included. These are referred to as asset classes. The choice of three asset classes pulls from some Nobel-Prize-winning economic research that suggested one could develop multiple outcomes by just using these three investments. Think of it as if you’re cooking with salt and pepper. By changing the proportions of salt to pepper you can get different profiles. A two-to-one ratio of salt to pepper tastes different than two-to-one ratio of pepper to salt.

However, technology advancements have allowed companies to add more investment options to the menu of a 401(k). Many people think more choices are better, but research from choice architecture and behavioral economists, such as Richard Thaler at the University of Chicago, shows a different result. They found that more choice actually led to people not making choices. It also sometimes led people to look at all of the choices, say 10, and spread their money out equally among each of the 10 investments. What may appear to be different investments can actually be nearly identical investments with just a different name.  All this confusion led the government to develop a new standard called the qualified default investment alternative. (For related reading, see: 401(k) Flaws You Should Know About.)

Help From a Qualified Default Investment Alternative?

Some plans had people default into some type of cash account if they made no choice. Many people once they make their initial investment choice don’t go back to revisit it. Unfortunately few people have the luxury of only getting the returns that cash has historically given investors. While most people don’t like the ups and downs of the stock market, historically it has gained far more than simply investing in cash. However, it is usually people such as professors of economics or finance, certified financial analysts and others with backgrounds in investing that understand all the factors and the terminology. As nothing stays the same, it’s important that these professionals continue to stay up-to-date with the latest research and empirical evidence. 

To help the employee, the government said a choice that embedded some of the knowledge of investing such as asset allocation and rebalancing could be packaged into something called a qualified default investment alternative. They allowed for three choices, balanced, risk-based or target date strategy. Using our salt-and-pepper analogy, a balanced strategy typically has about 50% bonds and 50% stocks, or a one-to-one ratio of stocks to bonds. The risk-based strategies pull more from Harry Markowitz's Nobel Prize research and allows for varying combinations from all bonds to all stocks with varying increments such as 60% stock to 40% bond or 80% stock to 20% bond. A new concept was added to the mix.

Target-Date Funds

The target date strategy takes this risk-based concept and says from age 22 to age 65 the combination will start out more heavily in stocks—say 100% stocks and no bonds—and as time goes on it will decrease that allocation down to as low as 20% stocks and 80% bonds. The thought is that people with a longer timeframe until they plan to use the money can take on more market risk where those who are closer to retirement should be in a less risky portfolio. While there is a certain logic to the target date strategy, the proof is in the pudding. (For related reading, see: Why You Should Be Wary of Target Date Funds.)

Different investment managers have different ideas on the various combinations of stocks and bonds that could be used to fill your investment menu. Moreover, there is not a universal target date strategy. In fact, some firms believe they should become very conservative at age 65 whereas others believe that should happen closer to 80. However, some people retire at 62 while some are retiring at 70 or later. Some are simply choosing to delay taking Social Security until age 70 but are starting to spend down their assets at age 62. These factors quickly began to argue against the target date strategy being a one-size-fits-most-participants solution. None of the target date strategies recommend any type of saving date strategy nor do they promise any return now or in the future.

Your QDIA Action Plan

Your employer likely has good intentions regarding the choice of your investment menu. You should be receiving a notice informing you of your qualified default investment alternative choices. If your company uses a QDIA, you should find out exactly which one you have. If you don’t have expertise in this area I would recommend you seek out a financial advisor with retirement planning credentials who can help you analyze or do an x-ray of your choice.

I am biased toward risk-based choices and balanced strategies. From a planning perspective, it is easier to match up how much you need to save alongside the historical returns of the asset classes that should be reflected in the choices that are given. That being said, your menu may have choices that will allow a skilled professional to develop a more tailored strategy for you. Under current legal standards, this person must be an investment advisor representative obligated to work in your best interest (fiduciary).

(For more from this author, see: How Tax-Deferred Savings Boost Retirement Income.)

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.