Default Investment Options Research Articles

Defaults and Consumer Response to Rainy-Day Funds: Evidence from 401(k) Participants during the COVID-19 Pandemic

Defaults improve outcomes for passive savers but may also reduce the effectiveness of policies such as rainy-day emergency savings funds that require active choice. We investigate whether active and passive retirement savers responded to a policy change in the 2020 CARES Act that allowed workers to access retirement savings without penalty to meet COVID-19-related spending needs. Using a large database of 401(k) plan participants, we find that workers in occupations with high subsequent unemployment who actively invest were more likely to call about withdrawing funds from their account than workers in default investment options. Evidence that passive savers are less likely to respond to a policy change suggests a possible negative consequence of defaults that can limit the effectiveness of traditional policy solutions that require active choice. Some form of active choice may be needed to increase engagement in a range of employer-provided services such as financial wellness and participant education among passive savers.

To Target a Date or Not to Target a Date? That is the Question: The Unintended Consequences of Investing for the Long Run

We study how managers of funds created to invest for the long run behave when shielded from liquidity constraints and their investors' short-term needs. Using the universe of US target-date funds (TDFs), we document that asset managers exploit lower investor attention to deliver lower performance. This results in a hypothetical cumulative return loss of 21% for the average investor holding the fund for 50 years. This underperformance is driven by fund families using the TDFs to smoothen the flow shocks of the affiliated open-ended funds. It is also due to higher fees arising from investing in the affiliated expensive share classes. We use the Pension Protection Act of 2006 as an exogenous shock that made TDFs the default investment options within 401(k) retirement plans.

Implications of Money-Back Guarantees for Individual Retirement Accounts: Protection Then and Now

Capital market volatility spurs interest in protecting retirement accounts; one such approach is to require money-back guarantees. Using a lifecycle model where investors have access to stocks, bonds, and tax-qualified retirement accounts, we show that such guarantees alter participant consumption, saving, and investment behavior during times of high interest rates, but impacts are even larger in a low-return environment. We conclude that abandoning guarantees could enhance old-age consumption for over 80% of retirees, particularly lower earners, without harming pre-retirement consumption. Our results are of interest for default investment options in individual retirement accounts such as the Pan-European Personal Pension Products. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

One size fits all? Tailoring retirement plan defaults

Default investment options in retirement plans are a potent influence on member choice, however little is known about how plans set them. We investigate how retirement plan providers choose default investment strategies for passive members. We interview plan executives and survey members during a review of default settings in 2013-14 prompted by a change in the regulation of the Australian retirement system. Passive plan members are different from active members in ways that matter for investment strategy. Passive members are less willing to take financial risks; they are also younger, less wealthy and more often female. Executives say they design defaults with passive members in mind, but they seem to overlook some key factors. For example, plan executives set high risk exposure in default investment strategies. Executives also assume motivations for defaulting that do not match those reported by members. Most plan executives think of passive members as uninterested in their retirement savings but passive members say they trust their plans, and lack skill rather than interest. The heterogeneity, trust and low skill of passive members make opting out of the default less likely and smart defaults more appealing.

Delegation, Trust and Defaulting in Retirement Savings: Perspectives from Plan Executives and Members

We combine survey data from retirement plan members with information from interviews with plan executives to get both perspectives on who accepts the default plan and default investment option and why. We use a natural experiment in default construction where a new regulatory framework required providers to have stipulated default settings in place by early 2014. We find that not all retirement savings plan members who default at the plan choice stage default at the investment choice stage, and vice versa. Only around one third of the sample say they defaulted twice. While some plan executives describe defaulting members as uninterested in their retirement savings, our results highlight that subjective lack of skill combined with trust in the managing agents are the prime motivations for defaulting, rather than low interest. Plan executives set a high risk exposure in default investment strategies to ensure high wealth growth, but defaulting respondents show a lower appetite for risk than active choosers. The heterogeneity and low skill of members make a case for smart defaults.

Are lifecycle funds appropriate as default options in participant-directed retirement plans?

Since the enactment of Pension Protection Act of 2006, lifecycle funds that reduce exposure to stocks with age have rapidly replaced money market funds as the most commonly nominated default investment options for participant-directed retirement plans. We examine their appropriateness in meeting a threshold level of retirement wealth required by plan participants. Using a utility function motivated by prospect theory (Kahneman and Tversky, 1979), we show that whilst lifecycle funds are vastly superior to money market funds (except for very low thresholds), they rank below balanced funds that maintain constant exposure to equities over time. As thresholds increase, lifecycle funds are also dominated by funds that switch assets conditional to prior investment performance. Even in the absence of a minimum threshold wealth level, lifecycle funds do not emerge as the most preferred choice among the investment options considered by our paper.

Asset Allocation Policy, Returns and Expenses of Superannuation Funds: Recent Evidence Based on Default Options

We examine the asset allocation, returns and expenses of superannuation funds whose assets are mainly invested in default investment options. A majority of these funds fail to earn returns commensurate with their asset allocation policy. It appears that much of the variation in returns between these funds is a result of engaging in significant active management of assets. Our results indicate that the returns from active management of retail funds are negatively related to expenses, whereas the relationship is positive for industry funds. We also find strong evidence of economies of scale existing in superannuation funds across different size categories.

Default investment strategies in a defined contribution pension system: a pension risk model application for the chilean case

AbstractIn a defined contribution pension system, one of the main risks faced by members refers to the investment of funds. In this context, we discuss which is the most suitable risk measurement for the affiliates to the pension system. Different life-cycle investment strategies are evaluated under this measure for different types of workers. We point out the importance of designing well-suited default investment options in light of the economic behavior of members, characterized by low financial knowledge, inertia and myopia in decision-making. We calibrate a pension risk model for the Chilean economy, including measures of life-cycle income, human capital risk, investment and annuitization risks. Our results suggest that affiliates can gain (loss) around 0.85 percentage points in terms of average replacement rates in return for an increase (decrease) of 1 percentage point in risk, measured as standard deviation of replacement rates. Using a stochastic dominance analysis, we find that there are no dominated strategies when subsidies from the Solidarity Pillar are excluded. When the Solidarity Pillar is considered, the most appropriate investment strategies for affiliates that receive these subsidies are concentrated on the riskier funds. However, this also means that there could be increased pressure on Government spending in order to grant additional benefits to affiliates. Our model has a wide range of practical applications that go from informing affiliates about the degree of uncertainty associated to their expected replacement rate to a guide to evaluate how different investment strategies affect the expected values of affiliates' pensions and their associated risk.

Superannuation Knowledge and Plan Behaviour

This paper presents new evidence from a national survey of non-retired individuals with superannuation accounts between the ages of 25 and 65. Fielded in June of 2012, the survey responses suggest that Australians often are ill informed about many important features of the superannuation system. This lack of retirement system knowledge is consistent with findings in other countries. Specifically, the survey suggests that Australian respondents are most challenged by questions associated with the access age to their superannuation savings, the risky composition of balanced funds (a popular default investment option), and the tax treatment of superannuation contributions and investments. Regression analysis suggests a relationship between superannuation knowledge and savings behaviour. The results provide motivation for further research in the area and suggest more can be done to educate individuals about the superannuation system.

Rethinking DC Asset Management

The evidence that DC education programs are ineffective and that DC plan members have poor investing skills points to some important questions about the CAP Guidelines that every sponsor of a DC plan may wish to consider: 1. Are DC plan sponsors and members realizing any value from the investment choice and education that the CAP Guidelines require? 2. Is the default investment option appropriate for employees who do not make investment choices? 3. Is there a better way to manage DC assets?

Assessing Default Investment Strategies in Defined Contribution Pension Plans

This paper assesses the relative performance of different investment strategies for different structures of the payout phase. In particular, it looks at whether the specific glide-path of life-cycle investment strategies and the introduction of dynamic features in the design of default investment strategies affect significantly retirement income outcomes. The analysis concludes that there is no “one-size-fits-all” default investment option. Life-cycle and dynamic investment strategies deliver comparable replacement rates adjusted by risk. However, life-cycle strategies that maintain a constant exposure to equities during most of the accumulation period, switching swiftly to bonds in the last decade before retirement, seem to produce better results and are easier to explain. Dynamic management strategies can provide somewhat higher replacement rates for a given level of risk than the more deterministic strategies, at least in the case of pay-outs in the form of variable withdrawals. The length of the contribution period also affects the ranking of the different investment strategies with life-cycle strategies having a stronger positive impact the shorter is the contribution period.

Don't Judge a Superannuation Default Investment Option by Its Name

With the massive decline in savings arising from the Global Financial Crisis (GFC), it is timely to review superannuation fund investment and disclosure strategies in the lead-up to the crisis. Accordingly, this study examines differences among superannuation funds’ default investment options in terms of naming and framing over three years from 2005 to 2007, as presented in product disclosure statements (PDSs). The findings indicate that default options are becoming more alike regardless of their name, and consequently, members may face increasing difficulties in distinguishing between balanced and growth-named default options when comparing them across superannuation funds. Comparability is also likely to be constrained by variations in the framing of default options presented in investment option menus in PDSs. These findings highlight the need for standardisation of default option definitions and disclosures to ensure descriptive accuracy, transparency and comparability.

The appropriateness of default investment options in defined contribution plans: Australian evidence

Abstract For participants in defined contribution (DC) plans who refrain from exercising investment choice, plan contributions are invested following the default investment option of their respective plans. Since default investment options of different plans vary widely in terms of their benchmark asset allocation, the most important determinant of investment performance, participants enrolled in these options face significantly different wealth outcomes at retirement. This paper simulates the terminal wealth outcomes under different static asset allocation strategies to evaluate their relative appeal as default investment choice in DC plans. We find that strategies with low or moderate allocation to stocks are consistently outperformed in terms of upside potential of exceeding the participant's wealth accumulation target at retirement as well as downside risk of falling below that target outcome by aggressive strategies whose allocation to stocks approach 100%. The risk of extremely adverse wealth outcomes for plan participants also does not appear to be very sensitive to asset allocation. Our evidence suggests the appropriateness of strategies heavily tilted towards stocks to be nominated as default investment options in DC plans unless plan providers emphasize predictability of wealth outcomes over adequacy of retirement wealth.

Superannuation: Switching and Roulette Wheels

Abstract: Purpose - To investigate the effects of switching strategies between investment options for Australian superannuation funds. Design/methodology/approach - Outlines the switching arrangements available, refers to relevant research and explains Bauer and Dahlquist's (2001) 'roulette wheel' approach to evaluating switching strategies. Applies it to 1985-2005 monthly returns data for Australian and global investment opportunities including property and blended options. Explains the methodology and considers consistency with other research. Findings - Although Australian equities gave negative returns for 89 of the 252 months, an Australian equity buy-and-hold strategy gave better returns than 63% of possible switching paths. Buy-and-hold was also superior to switching between Australian property and T-bills etc., confirming Sharpe's (1975) idea that investors need a 70% to 80% forecast accuracy for switching to work. Research limitations/implications - Calls for more research on superannuation funds' default investment options and switching effects, including switching at the margin. Originality/value - Provides evidence that buy-and-hold is usually better than switching strategies in the context of Australian superannuation funds.

How Behavioral Finance Can Inform Retirement Plan Design1

Several key lessons for pension design have emerged in the last decade from behavioral economics and finance research. This article analyzes the insights from this literature on how workers decide to save, manage their retirement investments, and draw down their assets in retirement. The aim is to understand how workers and retirees deviate from the rational, well‐informed agents that underpin economic theory, public policy, and often retirement plan design.The evidence suggests that many people save too little, others make poor investment decisions, and still others spend their accumulated assets too quickly in retirement. The “behavioral” reasons for such tendencies include overconfidence, limited self‐control, the overvaluation of the present at the expense of the future, susceptibility to “framing,” and an aversion to realizing losses.By shedding light on why people fail to achieve an ideal outcome on their own, this literature offers practical guidance to plan sponsors and policymakers who must design, regulate, and evaluate the institutions that help provide for economic security in old age. More specifically, the literature suggests that the plan design should be made automatic for the many individuals unwilling to exercise full control over their retirement savings choices. Recommended design features include automatic enrollment, scheduled annual savings increases, and default investment options or managed account programs that represent optimal portfolio choices.