The value of managed account advice

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1 The value of managed account advice Vanguard Research September 2018 Cynthia A. Pagliaro According to our research, most participants who adopted managed account advice realized value in some form. For them, advice led to higher projected retirement wealth through increased expected returns and savings. For a smaller group, advice led to reduced risk exposure, resulting in lower expected returns and projected retirement wealth but better diversified portfolios. By using managed account advice, 7 in 10 participants increased their projected ten-year retirement wealth by an average of 23%, net of investment and advice fees. This increase can be attributed to higher expected returns due to increased equity exposure and, for a subset, increased savings rates. Among participants, 54% made an active savings decision when they adopted managed account advice. The majority in this group chose to increase their savings rate by an average of 3 percentage points. For participants with concentrated single-stock positions of 20% or more of their account balance, company stock risk was substantially reduced through a managed account service. The average allocation to company stock fell from 52% to 9%. A managed account advisory service can help improve outcomes for defined contribution plan participants. The benefit will depend on the fee charged for the service relative to improvements in investment allocations and savings behavior. Plan sponsors should consider offering professional advice programs as a complement to other professionally managed vehicles, such as target-date funds. Because of the powerful effect of savings increases on wealth outcomes, managed account providers should also more actively promote increased saving.

2 Background A managed account program is a form of investment advice offered to defined contribution (DC) plan participants for an additional fee. In this paper we assess the relative value of such an advisory service based on its impact on portfolio allocations and savings levels and, more importantly, on the investment management and advice fees paid by the participant. Under a managed account program, a plan sponsor typically selects a third-party advisor 1 to provide independent advice to participants. In most cases, a managed account service is offered to participants on a voluntary basis, rather than as a default, often because of the service s additional fee. The advisor will use a plan s existing investment lineup to create a broadly diversified portfolio consistent with a participant s time horizon, risk tolerance, and other factors. Managed account services are a form of robo-advice for DC plans, where much of the portfolio allocation and management process is provided in an automated, technology-based environment. Vanguard Managed Account Program In this paper we evaluate one managed account service, the Vanguard Managed Account Program (VMAP ). Under VMAP, Vanguard Advisors, Inc. (VAI) acts as investment advisor and fiduciary for the program. Financial Engines serves as sub-advisor, using its proprietary methodology to make investment recommendations to participants. At the end of 2017 (the last year included in this study), 30% of Vanguard recordkept plans used the service. A total of 55% of participants in those plans had access to this service and 7% used the service. 2 Participants who sign up for the service cede all investment control to the third-party advisor. These participants authorize the advisor to set their portfolios asset allocations, choose investments, and monitor and rebalance their portfolios, all on a continuing basis. Enrollees are encouraged to personalize their experience by specifying their planned retirement age, risk tolerance, and/or other asset holdings. The incremental advice fee is charged as basis points against account assets. It s important to note that our findings are closely tied to the service and pricing features of VMAP, including its current fee structure, which typically begins at 0.40% on the first $100,000 in assets under management. Managed account advice with lower fees can let participants keep more of their investment return than advice with higher fees. About this study In this research, we consider the impact of advice on all the components that affect retirement wealth, including savings, portfolio expected returns and risk, and investment and advisory fees. 3 The participants in this study are from Vanguard recordkept plans that offer managed account services as a part of their DC retirement plan offering. Our sample includes approximately 50,000 participants who adopted the service between 2014 and 2017, representing 27% of all participants enrolled in VMAP at the end of To be included in the sample, participants had to have designated an elected deferral rate both six months prior to and six months after joining the service. On average, the participants in this study are 45 years old and have a job tenure of around 11 years at the time of managed account enrollment (Figure 1). Their average annual base compensation over the four-year period of our study is around $76,000 and 59% are male. 4 One of the objectives of a managed advisory service is to address concentrated company stock positions in participant accounts. In our analysis, we split the sample into two groups based on whether participants have concentrated company stock positions, defined as having 20% or more of account wealth in a single employer stock. Ninety-one percent of participants have less than 20% of company stock in their portfolios, while 9% of participants have a concentrated position of 20% or more of holdings in employer stock. We analyze these two groups separately. 2 1 Plan sponsors have well-established fiduciary duties under the Employee Retirement Income Security Act (ERISA) when appointing a third-party advisor. While a plan sponsor may be engaging a third party to take on the fiduciary responsibility of delivering investment advice to plan participants, the plan sponsor fiduciary ultimately still has fiduciary responsibility to prudently select and monitor the investment advisor. 2 See How America Saves 2018, Vanguard. 3 Recordkeeping fees are unaffected by managed account advice adoption and therefore are excluded from our analysis. 4 Because enrollment was restricted to the period between 2014 and 2017, these participants are slightly younger and less tenured than the population of all managed account participants in Vanguard-administered plans.

3 Figure 1. Demographic characteristics Participants who adopted managed account service Defining value Managed account participants All Managed account participants (<20% company stock) Managed account participants (>=20% company stock) Percent of sample 91% 9% Age (average) Tenure at service adoption (average) Average annual base compensation $75,794 $75,464 $79,045 Male (%) 59% 58% 64% Note: Characteristics at time of service adoption. The value of managed account advice can take several forms (Figure 2). One measure of value is an increase in expected retirement wealth, net of investment and advice fees. This increase typically arises from an increase in portfolio equity exposure or from higher contribution rates resulting from the advice service. Value may also come from a reduction in investment risk. Managed account advice may move a participant portfolio to a lower-risk allocation based on the participant s circumstances, such as age and risk tolerance. However, reducing the participant s risk exposure, while potentially psychologically valuable, will result in lower projected retirement wealth because of lower expected returns and the additional cost of the advisory service. Value can also arise from another form of diversification eliminating single-company stock risk in a portfolio. 5 Singlestock holdings raise portfolio risk substantially and investors are generally not compensated for assuming single-stock risk. For plan sponsors concerned about the fiduciary risk associated with offering company stock, managed account services may be a way of encouraging diversification of participant accounts. There are other, more subjective, ways that participants realize value through the use of a professional advisory offering. One is personalization. The service allows users to personalize their experience by selecting their expected retirement age and risk level, and allows them to include outside assets in the overall asset allocation evaluation. In our sample, around half of all participants personalized the service in some manner. Another possible benefit is the enhanced sense of security associated with using a financial advisor. While we don t evaluate personalization and subjective measures in this study, these should be considered when gauging the value of a managed account service. The value of advice must be weighed against the potential cost of a managed account service. One component of the cost is the fee itself. Another is the change in the costs of the underlying investments held by the participant as a result of the advisory process. Those costs can be higher or lower depending on the recommendations of the advisor. Figure 2. Components of value Increase in retirement wealth Decrease in risk exposure Decrease in stock-specific risk Ability to personalize advice Increase in subjective satisfaction 5 In this analysis, we don t quantify the actual reduction in risk, we just show the change in company stock allocation. 3

4 Overview of changes For a given participant, the impact of managed account advice comes from an interplay of several factors: savings behavior, portfolio composition, and fees. Independently, each of these elements is influenced by the managed account service (Figure 3): Nearly half of all participants increased their savings rates, 8% decreased them, and the remainder maintained contribution rates at the same level. A nearly equal percentage of participants experienced either an increase or decrease in equity exposure. Sixty-eight percent of participants saw their expected rate of return rise, and 20% saw expected returns fall as portfolio risk was reduced to an age-appropriate level. Many participants saw the average cost of their fund holdings rise as the advisor added international and some active strategies to portfolios. But 43% saw a reduction in average fund fees as the advisor shifted participants to lower-fee, better-performing options, particularly index funds and lower-cost active funds. All participants incurred a separate fee for advice. In some cases, the fee for advice was actually offset by the reduction in expense ratios due to portfolio reallocation. On average, expense ratios were reduced by 0.02% for all participants. This reduction, attributed to portfolio reallocation to lower-priced funds, offset approximately 7% of the fee for advice. Figure 3. Behavioral effects Another way to examine these effects is to look at participant behaviors before and after service adoption. As a result of the managed account advice, more participants were deferring more than 9% of their salary to their DC accounts; international equity diversification improved (at the expense of cash and employer stock); and expected returns improved (Figure 4). While average expense ratios decreased slightly, the percentage of participants paying less than 10 basis points decreased. This is because of the higher percentage of portfolios that previously were invested in low-cost target-date funds. The reallocation of assets to higher-cost funds will increase a participant s total expense ratio. The value of managed account advice To summarize the interplay of these effects, we use the change in participants projected ten-year real retirement wealth as a benchmark for evaluating advice. This allows us to observe the true effect of managed accounts, independent of the participant s starting account balance or asset allocation. Our analytical approach to project ten-year real retirement wealth is based on changes in contributions, returns, and fees paid. For each managed account participant, two projected ten-year retirement wealth calculations are computed. The first is based on contribution, investment, and fee parameters six months before service adoption and the second is based on the same parameters six months after service adoption. The difference in these projections is used to determine the relative change in projected ten-year retirement wealth. (See Appendix A for a more detailed discussion of the methodology.) All participants who adopted managed account service Deferral Total (savings) equity Expected Expense VMAP rates exposure returns ratios fees Increase 46% 47% 68% 53% 100% Decrease No change Total 100% 100% 100% 100% 100% 4

5 Figure 4. Changes before and after advice adoption All participants who adopted managed account service Before advice adoption After advice adoption Before advice adoption After advice adoption a. Personal savings rates c. Expected real returns (net of fees) 31% Less than 6% 22% Less than 6% 44% Less than 5% 22% Less than 5% 36% 6 to 9% 36% 6 to 9% 56% 5 to 7% 78% 5 to 7% 33% More than 9% 42% More than 9% b. Asset allocation (distribution of average portfolio) d. Expense ratios 64% U.S. equity 5% International equity 54% U.S. equity 24% International equity 44% Less than 0.10% 25% 0.10 to 0.20% 20% Less than 0.10% 56% 0.10 to 0.20% 17% Bond 8% Cash 20% Bond 1% Cash 11% 0.20 to 0.30% 8% 0.30 to 0.40% 15% 0.20 to 0.30% 6% 0.30 to 0.40% 6% Company stock 1% Company stock 5% 0.40 to 0.50% 7% Greater than 5.0% 1% 0.40 to 0.50% 2% Greater than 5.0% 5

6 On average, the use of managed accounts led to a substantial increase in retirement wealth. Managed account participants experienced a relative increase of 14% in projected retirement wealth (Figure 5). To illustrate the variation of effects across different participant circumstances, we divide the group into ten equal groups, or deciles, based on the change in retirement wealth. Participants in Decile 10 had the largest increase in net retirement wealth; participants in Decile 1 had the largest decrease. The change in projected ten-year wealth is a sum of the individual components. For example, in Decile 8, the change in retirement wealth due to managed account advice is 16%. This figure is calculated as follows: 8% is from higher contributions, 11% is from higher expected returns, 0.13% is from an increase due to the advisor s use of funds with lower expense ratios, and 2.74% is the reduction due to managed account advice fees paid over a decade. Participants in the top seven deciles (Deciles 10 through 4) experienced a net increase in retirement wealth after investment and advice fees as a result of the managed account service. Much of this increase was driven by higher expected real returns, but increases in annual contributions also contributed to the growth in wealth. The participants in Deciles 3 and 2 experienced little or no change. Participants in the bottom decile, Decile 1, experienced the largest decrease in wealth, largely because of a decrease in contributions. Figure 5. Managed account advice and retirement wealth Managed account participants with less than 20% in company stock Expected real returns computed using 10,000 Vanguard Capital Markets Model (VCMM) simulations for the average participant in each decile Increase wealth Decrease wealth Decile Annual contributions Expected real return Expense ratio Advice fee Change in projected 10-year retirement wealth 10 59% 29% 0.38% 3.93% 84% Average 14% Note: The values in this table represent the relative difference after service adoption. IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of June 30, Results from the model may vary with each use and over time. For more information, please see the last page of this research paper. 6

7 The managed account participants in Decile 10 are younger and have the lowest starting account balances (Figure 6, top panel). They realize the largest increase in projected retirement wealth in part because of the effects of higher contributions on a lower starting balance. Participants in other deciles have higher starting balances, so even if contributions increase, the change has a smaller effect. On average, participants in the top six deciles increased their contributions, with the top decile increasing the most (Figure 6, bottom panel). Participants in the bottom decile decreased their contributions, on average three percentage points, falling from 11% to 8% on average. This combination of lower savings and a higher advisory fee leads to the sharp drop in projected retirement wealth. Across all deciles, adoption of managed accounts ties equity exposure more closely to age. The youngest adopters have the highest exposure and the oldest adopters have the lowest. Managed account services address the more extreme asset allocation choices made by participants who constructed their own portfolios initially. Figure 6. Demographic and financial characteristics A. Demographics, income, and account balances At time of service adoption Decile Change in retirement wealth Average Age Percent male Average Tenure Average base pay ( ) Average account balance 10 84% 41 53% 5 $68,301 $16, ,377 55, ,119 73, ,093 96, , , , , , , ,372 87, , , , ,085 B. Savings and investment characteristics Before and after service adoption Change in retirement Decile wealth Personal deferral rate Expected real returns Equity allocation Equity allocation U.S. Equity allocation international 10 84% 5 to 11% 4.9 to 5.9% 66 to 82% 63 to 57% 3 to 25% to to to to 55 3 to to to to to 54 3 to to to to to 54 4 to to to to to 53 5 to to to to to 53 6 to to to 56 4 to to to to 58 4 to to to to 53 8 to to to to to 50 9 to 23 7

8 Impact on company stock A total of 9% of the managed account participants in this study held concentrated positions in company stock. One of the benefits of a managed account service is that it reduces single-stock risk. Before adopting managed account advice, nearly half of participants in this sample of the study held more than 50% of their accounts in company stock (Figure 7). One in 6 participants held more than 80%. After participants adopted the advice service, allocations to company stock were reduced to only 9% on average. A majority of all participants held 10% or less of their retirement account assets in company stock. On average, this group of participants increased their projected retirement wealth by 8% using managed account advice (Figure 8). Compared with participants with less or no company stock, the overall magnitude of the change in wealth was lower across all deciles. More participants experienced modest changes. Most of the benefit of advice for this group was through a reduction in diversifiable single-stock risk. After managed account adoption, participant portfolios were better diversified (Figure 9). Equity holdings in particular were better diversified, reflecting a reallocation of concentrated company stock holdings to both U.S. and international funds. In addition, bond allocations were increased and cash holdings were decreased. Implications Managed account advice services can significantly improve the projected retirement wealth outcomes for the vast majority of participants who use them. They continue to be an effective tool to improve retirement preparedness. The primary benefit to the participant comes from higher expected returns due to the reallocation of investment portfolios. In most cases, these higher returns more than offset the fee paid for the advice. Managed account advice also led to reduced risk for 2 in 10 participants. Risk is typically reduced to a more ageappropriate level. However, reduced risk exposure also leads to a reduction in expected return and projected retirement wealth. The additional advice fee further reduces wealth. It is possible to argue that this shift to Figure 7. Change in company stock exposure Managed account participants with 20% or more in company stock 100% Axis label if needed % Average company stock holding: Before managed accounts: 52% After managed accounts: 9% 24% 19% 11% 14% 12% 8% 7% 9% 2% 2% 3% 5% 0% 0% 2% 1% 1% 0% 3% 0% 0% 0 to to to to to to to to to to % Percentage of portfolio allocated to company stock Pre-service adoption Post-service adoption 8

9 Figure 8. Advice, retirement wealth, and company stock Managed account participants with 20% or more in company stock Increase wealth Decrease wealth Decile Annual contributions Expected real return Expense ratio Advice fee Change in projected 10-year retirement wealth 10 41% 18% 0.52% 3.48% 56% 9 12% 10% 0.20% 2.83% 19% 8 6% 7% 0.21% 2.61% 10% 7 5% 6% 0.13% 2.51% 8% 6 2% 4% 0.18% 2.46% 4% 5 0% 3% 0.02% 2.39% 1% 4 0% 3% 0.23% 2.41% 0% 3 0% 2% 0.27% 2.22% 1% 2 0% 1% 0.26% 2.27% 3% 1 7% 2% 0.37% 2.17% 12% Average 8% Note: The values in this table represent the relative difference after service adoption. Sources: Vanguard, 2018, using VCMM projections. Figure 9. Advice and company stock allocations Managed account participants with 20% or more in company stock Before advice adoption After advice adoption a lower risk level does not constitute adequate value and that participants should make portfolio changes without relying on another party. However, given the prevalence of inertia in retirement decision-making, we believe that participants are highly unlikely to adjust portfolio risk levels on their own without a managed account, target-date fund, or similar rebalancing service. For all participants, managed account advice eliminated extreme equity allocations and improved international and fixed income diversification. These are the broad benefits of professional diversification of assets. 31% U.S. equity 3% International equity 9% Bond 5% Cash 45% U.S. equity 25% International equity 19% Bond 2% Cash 52% Company stock 9% Company stock One way to further enhance value from managed account advice would be to strengthen savings advice. Higher contribution rates did improve retirement outcomes and more than offset the incremental costs of advice in onethird of our sample. Extending this effect to a broader universe would further enhance the value of advice. 9

10 References Aon Hewitt and Financial Engines, Help in Defined Contribution Plans: 2006 Through Available at Blanchett, David, The Impact of Expert Guidance on Participant Savings and Investment Behaviors. Available at GAO (United States Government Accountability Office), (k) Plans: Improvements Can Be Made to Better Protect Participants in Managed Accounts. Available at Vanguard, How America Saves 2018: Vanguard 2017 Defined Contribution Plan Data. Vanguard Center for Investment Research. Available at institutional.vanguard.com Appendix A. The analytical approach Projected ten-year retirement wealth was calculated using a participant s elected deferral rates, portfolio, and investment parameters six months before and after managed account enrollment. Assumptions: A participant s base pay is averaged over the four-year study period. In some cases, base pay was not available in all years so the average is based on the available data. Base pay is assumed to grow 1% annually over the ten-year period. Annual dollar contributions are calculated by multiplying an adopter s elected deferral rate by his or her average base pay. Contributions are assumed to remain constant over ten years and are capped at $20,000 per year. This cap represents a reasonable single estimate of 402g deferral limits and catch-up limits from 2014 to 2017 and impacts less than 5% of the sample. Expense ratios were extracted from Vanguard s internal financial reporting system and reflect the year of service adoption in most cases. In other cases, the most current expense ratios were used. Missing expense ratios were populated with the average of all values within a specific fund classification. Expected ten-year real returns were estimated using the Vanguard Capital Markets Model (VCMM). The values reported in Figures 5 and 8 represent the result of 10,000 return simulations for the average participant in each decile. Equation: The change in projected retirement wealth reflects the percent increase or decrease in ending projected account balance using managed accounts relative to the projected ending account balance had enrollment not occurred. Expressed as an equation: Change in projected 10yr retirement wealth = ((Projected 10yr ending balance) Post Projected 10yr ending balance) Pre ) Projected 10 yr account balance Pre 10

11 Appendix B. Expected growth Achieving higher expected returns generally requires an investor to take more risk. Describing higher expected returns as more desirable without acknowledging that more risk-taking is required to achieve them overstates their actual value. Even if expected returns remained constant, the increased risk would reduce the long-term growth of the portfolio. More volatile returns mean that the cumulative effect of compounding is reduced. An alternate method to estimate portfolio returns and account for the risk-return trade-off is to calculate expected growth. The formula for expected growth is: Expected growth = Expected return - ½ (portfolio variance) The term ½ (portfolio variance) can be viewed as a risk penalty. Expected return is penalized for any increase in the risk profile of the portfolio. As result, an increase in any expected return due to managed account adoption needs to account for any increased risk in the portfolio. The change in projected ten-year retirement wealth using this method for the bifurcated sample is shown in Figure 10. On average, the projected wealth for participants with less than 20% in company stock increases by 16%. The rate for participants with concentrated company stock holdings was smaller, at only 7%. Figure 10. Net values using expected growth rates A. Managed account participants with less than 20% in company stock Change in projected Decile 10-year retirement wealth % Average 16 B. Managed account participants with 20% or more in company stock Change in projected Decile 10-year retirement wealth 10 74% Average 7 11

12 Connect with Vanguard > vanguard.com IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time. The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based. The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time. For more information about Vanguard funds, visit vanguard.com or call to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing. All investing is subject to risk, including the possible loss of the money you invest. Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the work force. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the target-date fund is not guaranteed at any time, including on or after the target date. The Vanguard Group has partnered with Financial Engines Advisors LLC to provide subadvisory services to the Vanguard Managed Account Program and Personal Online Advisor. Financial Engines Advisors LLC is an independent, federally registered investment advisor that does not sell investments or receive commission for the investments it recommends. Advice is provided by Vanguard Advisers, Inc. (VAI), a federally registered investment advisor and an affiliate of The Vanguard Group, Inc. (Vanguard). Eligibility restrictions may apply. Vanguard is owned by the Vanguard funds, which are distributed by Vanguard Marketing Corporation, a registered broker-dealer affiliated with VAI and Vanguard. Neither Vanguard, Financial Engines, nor their respective affiliates guarantee future results. Vanguard Research P.O. Box 2600 Valley Forge, PA The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. VMAPRES