Why Your 401(K) Has a Default Investment Option and How It Helps You
Updated: Nov 7
A common question that I get from 401(k) participants is, “Why is my money automatically invested in this fund?” The follow up question usually is, “Should I choose a different one?” In this post, I will explain some important things to know about the first question and explain when the answer to the second question is “yes.”
Qualified Default Investment Alternative (QDIA)
In 2006, the Pension Protection Act introduced the concept of a qualified default investment alternative (QDIA). This is the investment chosen when an employee does not actively make their own investment choices within a retirement plan. It’s the default option that your money is put into if you don’t make a choice.
Each year, your employer will send out an annual notice declaring the plan’s QDIA.
There are 3 options that qualify as QDIAs, and your plan should have one of the following as the QDIA:
An investment service that allocates money among the investment options based on the individual’s age or retirement date.
A fund that considers the individual's age or retirement date.
A fund that considers the characteristics of the group as a whole with respect to risk and time horizon.
Lastly, a plan could choose a preservation fund like a stable value fund as the QDIA, but it can only be used for the first 120 days of participation in the plan, so this type of QDIA must include one of the choices above as well.
The QDIA provides liability protection to the employer that administers the retirement plan, but it also provides some advantages to employees.
Avoiding the horrors of 2008
For those who experienced investing during the Great Financial Crisis, there may still be some residual trauma. I regularly hear horror stories about retirement accounts being wiped out. It’s important to understand what happened then and how the QDIA will help investors avoid a repeat of this.
Since QDIAs had only been introduced in 2006, by the time 2008 came around there was still very low adoption of target date funds. Only 7 percent of 401(k) assets in 2007 were held in target-date funds. Without an automatic risk-adjusted allocation, it seems that many investors were taking on too much risk when the GFC hit. This problem was acutely felt by investors that were close to retirement. Studies show that 1 in 4 investors between ages 55 to 65 had more than 90% of their account balance in stocks and 2 in 5 had over 70%.
If some of these investors that were close to retirement in 2008 were invested in a target-date fund, it is safe to assume that they would have had a reduced allocation to stocks and mitigated some of the losses they experienced.
Source: Fidelity Institutional Asset Management
This chart shows Bond performance in dark blue in the years when stock performance has been negative. As you can see, in 2008 bonds were a good hedge against the losses in the stock market.
What about younger investors?
During the GFC, the largest losses were in the accounts with the largest account balances. These accounts are typically the older workers who are nearer to retirement. Younger investors with smaller account balances had a different experience. In fact, accounts with less than $10k in 2008 experienced 40% growth on average because the regular contributions outpaced investment losses.
These results show a great example of why a younger investor should consider taking on more risk in their allocation and utilize dollar-cost averaging by contributing to their plan through market downturns.
When to choose different options
It’s important to ask questions and understand the characteristics of what you are invested in. Each target-date fund manager has a specific approach to the way that they allocate money. As you accumulate more money in your retirement plan account, it may be wise to allocate to funds that match your specific objectives. Here are a few things to consider:
Target date funds typically have a mandated ratio of U.S. to international investments. While diversification is important for long-term growth, one may want to consider their own allocation if they have a shorter time horizon.
Target date funds typically have a mandated exposure to bonds of various types and maturities. As one approaches retirement, they may want to consider a tailored approach to bond risks and income.
If your plan QDIA is invested based on the group, you may be in a balanced fund. If you are a young investor, you may want to take on more risk in your allocation for growth opportunities.
It is wise to check the internal cost of the QDIA funds. Sometimes, funds can have high expense ratios that diminish long-term returns.
What to know
Investing in your plan’s QDIA is typically a good option for most investors. If you have a long time-horizon before retirement and a smaller account balance, these options will typically provide a well-diversified portfolio that will allow your account to capture market returns and grow over time.
As your account grows, you may want to consider a tailored allocation that considers your personal risk tolerance, time horizon and financial plan.
You should always understand your plan’s QDIA. Make sure to ask your advisor to explain the QDIA and help you understand what you are invested in.
Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.