Managed accounts look attractive to 401(k) advisers, but how do you measure performance?

For 401(k) advisers, managed accounts are a tough nut to crack.

On one hand, many advisers believe managed accounts will compete with target date funds as the most popular type of default investment option in 401(k) plans as soon as they become a bit more cost-competitive. After all, the prospect of an asset allocation tailored to individual plan participants sounds enticing.

But benchmarking is an area that could present a snag for advisers.

“It’s a conundrum and it’s an issue,” said Matt Gulseth, partner at Channel Financial, which oversees about $1.1 billion in defined contribution plan assets. “Frankly, I’m not sure how to address it.”

The customization that makes managed accounts alluring to some plan advisers is what creates this headache. The products essentially offer robo-advice services to 401(k) participants, developing individual portfolios using algorithms that are based on specific data inputs such as a participant’s age, salary, contribution rate and risk tolerance.

Prudently monitoring a target date fund is already a difficult task for 401(k) advisers. Due to the unique nature of TDFs, advisers can’t monitor them in the same way as other 401(k) investments, that is, by using a stated benchmark, such as the S&P 500, to determine if a fund has over or underperformed.

Managed accounts present an even greater challenge, advisers say, because they’re essentially target date funds with a wide dispersion of glide paths accounting for all plan participants.

“We spend all this time benchmarking target-date providers, and managed-account providers kind of have a free pass right now, partly because it’s hard to benchmark,” Mr. Gulseth said.

Yet, benchmarking is an important function of being an investment fiduciary; as with other investments, advisers must determine if the managed account is the right one for the plan and its participants.

The challenge is all the more acute given the industry’s anticipation that they will become more popular in 401(k)s. Providers such as Fidelity Investments and Empower Retirement have recently made a concerted push to garner more participant assets in their managed-account products.

“This is where the industry continues to struggle,” Philip Chao, principal and chief investment officer at Chao & Co., said of monitoring managed accounts. “I don’t think people are doing it,” but are instead “relying on some kind of scorecard or somebody else to tell them this is worthy or not.”

Mr. Chao, whose firm oversees about $1.25 billion in DC assets, doesn’t currently use managed accounts with 401(k) clients, primarily due to product cost. He believes the best way to monitor would be to construct a benchmark for every participant’s account, a difficult and heavily technology-assisted proposition, he explained.

Imagine a participant has a 94%/3%/3% asset allocation, to stocks, bonds and cash, respectively; measuring these allocations against respective market indices for these asset classes would yield a rough measure of overperformance or underperformance on an absolute or risk-adjusted basis.

“That would be the ideal,” Mr. Chao said. “If someone is going to individualize your investments, all in the name of tailoring the risk and return to you, wouldn’t you want a benchmark that’s individualized and tailored to you?”

Wei Hu, vice president of financial research at Financial Engines, the largest provider of 401(k) managed accounts, doesn’t believe advisers necessarily need to conduct such a granular analysis.

“There are a variety of ways plan sponsors [and advisers] have approached this,” he said. “So I wouldn’t say managed-account services have gotten a free pass.”

He’s seen advisers benchmark managed accounts against the in-plan target-date funds, and sometimes against the broader universe of TDFs to understand where participants would fall among this range of risk and return.

The firm, which managed $144.4 billion as of March 31, will provide the raw data necessary for advisers to facilitate whatever benchmarking comparison they feel is appropriate, Mr. Hu said.

(More: Financial Engines’ acquisition of The Mutual Fund Store a turning point in robo debate)

Competing managed-account services are offered by firms such as Morningstar, Fidelity Investments, GuidedChoice and Stadion Money Management.

Beyond managed-account performance, though, there are additional challenges.

“I think one problem is most providers that offer managed accounts only have one solution available,” David Blanchett, head of retirement research at Morningstar Investment Management, said.

Essentially, record-keeping platforms to date offer limited choice. That leads to an obvious question: if an adviser determines a service is underperforming, what should the adviser do?

“From a practical standpoint, can you really exert your monitoring criteria and take action?” Mr. Chao asked. “And if there’s only one other choice, what do you do, when the other may not be any better?”