Default Investment Research Articles

Save more with less: The impact of employer defaults and match rates on retirement saving

AbstractEmployers control two primary levers that can motivate retirement savings among defined contribution plan participants—default savings rates and match rates. Setting a higher default savings rate can increase plan contributions among passive savers who accept the default. A higher match rate incentivizes active savers to increase contributions. This study uses a large sample of defined contribution participants to estimate the interaction between employer match and default rates on savings outcomes among new participants. Selecting a higher default rate has the largest impact on employee savings rates. Plans with low default savings rates that match a high percentage of employee earnings induce higher‐income participants to actively move away from the low default savings rate, resulting in a wider savings gap between higher‐ and lower‐income employees. When employees are defaulted in at a higher rate, fewer move away from the default savings rate and the default investment choice (e.g., a target‐date fund). A higher default savings rate results in higher and more equal savings rates among employees, and higher acceptance of professionally managed defaults investments.

The Appropriate Age for Transition to Managed Accounts in a Qualified Default Framework: It Might Be Earlier than You Think

In this article, we review evidence of retirement under-saving and potential solutions, as well as empirical evidence regarding investor reaction to negative market returns. We present new corroborating evidence from fund flows around the recent volatile market events in 2020 that indicates a rising loss aversion, just as asset levels become significant with investors approaching retirement. We surmise that recent trading activity implies an aggregate investor preference for target-date fund (TDF) portfolios within a 20-year time horizon of retirement, with a volatility profile that is potentially too conservative for requisite savings in later years, due to concomitant lower portfolio return potential combined with the aggregate under-saving problem. This mismatch in investor preferences is compounded by a reactionary tactical investor trading strategy that essentially buys high and sells low. We propose that the rising investor loss-aversion problem can be mitigated by including guaranteed retirement income products in the asset mix in a defined contribution qualified default investment alternative setting to provide for the desired downside risk protection against extreme events, or else by shifting investors from a TDF to a managed account (MA) setting in later years to accomplish the same goal, or by utilizing both approaches in tandem. Given the evidence of MA utilization in increasing aggregate savings rates, reducing portfolio risk levels and its potential to meaningfully address the serious measured return drag from investor return-chasing behavior, the potential benefits can outweigh the higher average fee burden for managed advice in many cases. The question then becomes at what age do the benefits outweigh the potential costs, on average. Based upon the recent empirical evidence of TDF flow data from 2020 and data on average account balances, we propose that the appropriate age for automatic transition to managed accounts could be as early as 40.

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.

Target Date Funds, Drawdown Risk, and Central Bank Intervention: Evidence during the COVID-19 Pandemic

Target Date Funds (TDFs) have become the default investment choice in retirement accounts for most households. Later-dated TDFs (e.g., further away from the present day) allocate a more significant percentage of each dollar invested into equities relative to fixed income. As the TDF moves closer to the designated retirement date, the TDF embarks on its’ glide path. We study the impact of the COVID-19 Pandemic and Federal Reserve intervention on the max drawdowns experienced by TDFs during 2020. Later-dated funds experienced more significant drawdowns relative to near-dated funds. Moving out one target date fund increased the drawdown by approximately 1.90%. Approximately 80% of TDFs experienced their max drawdown on 23 March 2020. The max drawdowns of the TDFs are then studied in the following three sub-periods: (1) before the first Federal Reserve Intervention (2 March 2020), (2) after the first intervention and before the second intervention (16 March 2020), and (3) the period after the second intervention. TDFs experienced the greatest drawdowns after the first intervention by the Federal Reserve (approximately 19%) relative to the other two periods (approximately 7%). Fees associated with the TDFs tend not to influence the drawdowns except for the near-dated funds, where the low-fee funds performed better. Finally, near-dated funds recovered from their max drawdowns around September 2020, whereas later-dated funds did not fully recover until December 2020.

Practical Applications of Do Advisors Improve 401(k) Plans?

In <b><i>Do Advisors Improve 401(k) Plans?</i></b> from the Spring 2021 issue of <b><i>The Journal of Retirement</i></b>, author <b>David Blanchett</b> of <b>PGIM DC Solutions</b> examines the impact that advisors can have on the management and performance of 401(k) plans. Whereas previous research has focused on investment-related outcomes, Blanchett takes a more holistic approach, exploring differences between advised and non-advised plans across a variety of domains. Blanchett begins with a high-level description of the role advisors play in the administration of 401(k) plans before identifying a base dataset of 401(k) plans. The ensuing analysis examines the base dataset in terms of the impact that advisors have on default investment availability and usage, plan governance, the adoption of automatic enrollment, the inclusion of employer securities, and fund diversity, before performing a more traditional investment analysis. Although the results of the analysis are not conclusive for larger 401(k) plans, Blanchett’s research suggests that advisors can add real value, especially for smaller 401(k) plans.

Smart defaults: Determining the number of default funds in a pension scheme

We propose a new methodology for the smart design of the default investment fund(s) in occupational defined contribution pension schemes based on the observable characteristics of scheme members. Using a unique dataset of member risk attitudes and characteristics from a survey of a large UK pension scheme, we apply factor analysis to identify single factors for risk aversion, risk capacity and ethical investment preferences, and then apply cluster analysis to these factors to identify two distinct groups of members across age cohorts. We find membership of these clusters depends on a number of personal characteristics, with the principal differentiating feature being that one group had previously engaged with the pension scheme, while the other had not. These identified characteristics can be utilised in the design of smart default funds, including appropriate engagement strategies.

Improving on Defaults: Helping Pension Participants Manage Financial Market Risk in Target Date Funds

The central issue of this paper is analysis and resulting proposals to help unsophisticated pension participants achieve pension portfolios that match their level of risk aversion when there is a large amount of unexplained heterogeneity in risk aversion. Target date funds are commonly used as the default investment in defined contribution plans in the U.S., UK and other countries. These funds recognize that individuals usually should hold less risky investment portfolios as their expected retirement date approaches because their ability to bear financial market risk declines as the time horizon decreases. However, these funds do not account for differences in risk aversion among people with the same target date. Empirical studies find large amounts of unexplained heterogeneity in risk aversion. Target date funds cannot deal with this issue simply by sorting people into demographic groupings, other than age, that are known to affect risk aversion, such as gender. Financial education can help people do a better job of managing financial market risk in their pension portfolios, but we argue that it is unreasonable to expect millions of pension participants to attain advanced levels of financial literacy. This paper considers three innovations in target date funds that can help individual pension participants do a better job of managing financial market risk. The analysis can be applied to other situations where defaults are used for investing pension participants’ portfolios. The paper suggests new lines of research relating to individual differences in risk aversion.

Do Advisors Improve 401(k) Plans?

Research on the impact of 401(k) plan advisors has focused predominately on the investment menu or participant-level allocation decisions. This research takes a more holistic perspective and reviews the differences between advised plans across a variety of domains with the use of data from 5500 Employee Benefits Security Administration filings from 2016. Advised plans with assets from $1 million to $50 million were clearly performing “better” than those without, and the advisor impact generally declined as plan assets increased. Although this research suggests advisors are adding value, correlation is not causation, and additional research on the actual impact of 401(k) advisors is warranted. <b>TOPICS:</b>Retirement, manager selection, performance measurement <b>Key Findings</b> ▪ Operating a “best-in-class” 401(k) requires a level of knowledge that many plan sponsors may not have; therefore, hiring an advisor or consultant is one way a plan sponsor can attempt to run a more effective 401(k) plan. ▪ Existing research on the potential impact of 401(k) advisors has generally focused on investment-related outcomes; this paper takes a more holistic approach, exploring differences in advised plans by default investment availability and usage, plan governance, the adoption of automatic enrollment, the inclusion of employer securities, and fund diversity, in addition to the more typical investment-related analysis. ▪ The analysis suggests that 401(k) plans with advisors, especially smaller plans, are much “better” than those without. The marginal impact of the plan advisor declined, though, as assets increased for most domains considered. While correlation isn’t causation, overall, this research suggests plan advisors do improve 401(k) plans.

Nudges in SRI: The Power of the Default Option

AbstractWe introduce nudges in order to incite investors to choose Socially Responsible Investment (SRI) funds instead of traditional funds. We have set up two online experiments with a total of 713 US retail investors, using three types of nudges to elicit their effects on investors’ SRI investments level: making SRI the default investment, introducing a SRI explanation message, and priming ethical values by displaying shocking images. Making SRI the default option is the most efficient nudge to influence investors towards SRI. Its effect is twofold. First, around 50% of investors do not opt-out of the default allocation. Second, even investors who opt-out of the default allocation invest more in SRI than those in the control group, an effect that appears driven by anchoring. Although investors subjected to both priming and message content marginally increase their SRI investment, priming or message content in isolation appears to have a non-significant influence. For choice architects who want to steer retail investors towards SRI funds, making them the default option appears to be the most powerful nudge.

How good are default investment policies in defined contribution pension plans?

AbstractDefined contribution (DC) pension plans have been gaining ground in the last 10–20 years as the preferred system for many countries and other agencies, both private and public. The central question for a DC plan is how to invest in order to reach the participant's retirement goals. Given the financial illiteracy of the general population, it is common to offer a default policy for members who do not actively make investment choices. Using data from the Chilean system, we discuss an investment model with fixed contribution rates and compare the results with the existing default policy under multiple objectives. Our results indicate that the Chilean default policy has good overall performance, but specific closed-loop policies have a higher probability of achieving desired retirement goals and can reduce the expected shortfall at retirement.

Measuring The Value of LP Fund-Selection Skill: A Fair Comparison Framework

An LP must make many choices when investing in private markets: How to invest uncalled capital? How many funds to invest in each vintage? How to pace commitments? Is there a class of funds where skill matters more than others? We answer these questions using our fair comparison framework, which also allows a comparison across public and private assets. We find that a careful selection of choices such as the default investment for uncalled and uncommitted capital, the level of diversification across both funds and vintages, and of course the choice of private market strategy (e.g., buyout, venture, or real estate) has a meaningful impact on the risk-adjusted returns of a private asset portfolio. While fund-selection skill improved private asset performance, the benefit from skill was uneven across the different private markets. Somewhat counterintuitively, venture funds’ (especially early stage) risk-adjusted performance may not improve the most from LP fund-selection skill. While mean returns improved, volatility persisted. Based on a fair comparison, we find that LPs may benefit the most from the skillful identification of good performing mezzanine and real estate funds. We also find that venture investments had the lowest risk-adjusted returns because of their high underlying risk, but they may still offer a better investment opportunity than public markets (manager alpha included), with or without skill.

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.

How Good Are Default Investment Policies in Defined Contribution Pension Plans?

Defined contribution (DC) pension plans have been gaining ground in the last 10-20 years as the preferred system for many countries and other agencies, both private and public. The central question for a DC plan is how to invest in order to reach the participant's retirement goals. Given the financial illiteracy of the general population, it is common to offer a default policy for members who do not actively make investment choices. Using data from the Chilean system, we discuss an investment model with fixed contribution rates and compare the results with the default policy under multiple objectives. Our results indicate that the Chilean default policy has a good overall performance, but specific closed-loop policies have a higher probability of achieving desired retirement goals and can reduce the expected shortfall at retirement.

Defaulting Retirement Distributions Out of Defined-Contribution Plans: A Role for Managed-Payout Target-Date Portfolios

Default features in defined-contribution plans are designed to improve the retirement security of plan participants. To date, these have focused on the challenge of saving, ignoring the more complex challenge of dissaving. Automatic default provisions for drawing down participant account balances after retirement could be beneficial. Conceptually, the objective is to reframe the Zeitgeist of defined-contribution plans from that of savings plans closer to that of income continuation plans with pension-like features. This could be accommodated though a managed payout feature designed into the plan’s default investment strategy.

The Evolution of Private Sector Retirement Income From Defined-Benefit Pensions to Target-Date 401(k) Plans

Traditional employer-sponsored defined-benefit pension plans in the private sector that provided lifetime benefits have declined precipitously since 1985. They have been largely replaced by Section 401(k) plans in which investment control, market risk and longevity risk have been transferred from the employer to the participant. Most participants opted for the low-yielding money market plan default option, which proved inadequate for providing viable retirement income. The Pension Reform Act of 2006 made two important changes to 401(k) plans: (1) allowed automatic enrollment and (2) allowed target-date funds as a “qualified default investment alternative.” This article examines the evolution from defined-benefit pensions to target-date funds and the closely related collective investment trusts.

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.

ED03.04 Trumping Big Tobacco

I never would have imagined my work as a doctor would take me to corporate boardrooms across the globe, from Melbourne to London, Paris, New York and more. But then I never would have imagined I would be invested in the tobacco industry either. In my early time as a doctor, I did a placement on the lung cancer ward of the Peter MacCallum Cancer Centre in Melbourne. Despite being able to offer the very best medicine available, the majority of my patients died, many of them in their 50’s and 60’s, some as young as 40. It was shocking to bear witness to the true impact of tobacco. Whilst the treatment and care of patients is paramount, we must deal with the source of the problem — tobacco and the companies that manufacturer it. Once I discovered that through my compulsory pension fund, I was invested in and actually owned a part of a several tobacco companies, I couldn’t just do nothing — I had to take action. In my quest to disentangle the Australian pension sector from tobacco I’ve become well informed about tobacco and the extent of the tobacco epidemic, as it is referred to by the World Health Organisation. The numbers astound me. Six million deaths per year are attributed to tobacco and we are on track for one billion tobacco related deaths this century. Many, including investors (both individual mums and dads as well as big financial institutions), aren’t actually aware of the extent of their tobacco exposure. Tobacco stocks are generally picked up in standard products. Often, tobacco companies have not been selected specifically for investment, but they are wrapped up within default investment products, so they still find a way into your portfolio. I founded Tobacco Free Portfolios to collaboratively engage with leaders of the finance sector to encourage tobacco free investment. Finance executives have been alarmed also, at the scale of the tobacco problem and have deeply considered the role they can play in addressing this pressing global issue. One by one, they have acted and are now proud to lead organizations that are tobacco free. There are now 35 tobacco free pension funds in Australia — just over 40% of all funds. Many more will soon follow. Each tobacco free announcement is met with resounding public support. Tobacco Free Portfolios recently took a global step and we were delighted to work with the global insurance giant AXA who announced a tobacco free decision in May 2016, divesting $1.8B Euro of tobacco assets. More organizations are soon to follow suit. That is the way of the future. Affiliations with the tobacco industry are no longer wanted. There are very few individuals or organizations that actively seek to be a part of the tobacco industry. The associations are often so deep and longstanding that it can seem overwhelming – but they must be addressed and they must be undone. Momentum for tobacco-free investment continues to grow steadily and I can confidently say that the conversation in Australian has largely moved from ‘should we go tobacco-free?’ to ‘how can we go tobacco-free?’ This is a pleasing development and a terrific case study, however, there is still much to do to accelerate action across the globe. The good news is that conversations I have in Vienna, Paris, Singapore, London and New York are received with exactly the same concern as the conversations I have in Melbourne, Sydney and Canberra. The devastating impact of tobacco is felt everywhere on Earth. Tobacco is everyone’s problem, not just the doctors that provide the care and treatment. We should all feel obliged to do something about it and all those with investments, including those through compulsory pension schemes have a role to play. It’s up to us to keep tobacco control on the agenda and in public dialogue. A tobacco free future that will allow our children and the generations to come to enjoy long and healthy lives should be our shared hope. If you are interested in supporting this work, please come along to the Tobacco Free Portfolios workshop on the morning of Wednesday 7th December. Further details available at www.tobaccofreeportfolios.org Cross sector collaboration, tobacco, Tobacco Control, advocacy

The IRA Investor Profile: Traditional IRA Investorss Activity, 2007-2014

Using data from year-end 2007 through year-end 2014, this report analyzes data on traditional IRA investors drawn from The IRA Investor Database to gain insight into how traditional IRA investors fared during and after the financial crisis. After setting the scene in terms of financial developments and regulatory changes affecting traditional IRAs, chapter 1 analyzes the contribution, rollover, and withdrawal activity among 4.9 million consistent traditional IRA investors (those with accounts at the end of each year from 2007 through 2014). In addition, this chapter explores changes in asset allocation and account balances among consistent traditional IRA investors. The remaining chapters of the report primarily focus on a snapshot of traditional IRA investors at year-end 2014. Chapter 2 discusses how contribution activity varied by investor age in 2014, exploring which traditional IRA investors had contributions and how many of them contributed at the limit. Chapter 3 notes that the vast majority of new traditional IRAs opened in 2014 were opened with rollovers, and examines rollover activity by investor age. Chapter 4 explores withdrawal activity, which varies significantly with investor age and in reaction to rules governing withdrawals. Few traditional IRA investors younger than 60 take withdrawals; traditional IRA investors taking withdrawals tend to be older and often take out the required minimum distribution (RMD) amount. Chapter 5 reports variation in traditional IRA balances by investor age. Chapter 6 compares snapshots of the asset allocation of traditional IRA balances among cross sections of traditional IRA investors at year-end 2007 and year-end 2014. Because some of the variation in asset allocation appears to be related to traditional IRA balance size, the asset allocation of balances of $5,000 or less are compared with the asset allocation of balances of more than $5,000. Smaller balances often have high allocations to money market funds or other cash instruments, which in part may reflect default investment rules for certain rollovers.

OPTIMAL SAVINGS FOR RETIREMENT: THE ROLE OF INDIVIDUAL ACCOUNTS

We employ a life-cycle model with income risk to analyze how tax-deferred individual accounts affect households' savings for retirement. We consider voluntary accounts as opposed to mandatory accounts with minimum contribution rates. We contrast add-on accounts with carve-out accounts that partly replace social security contributions. Quantitative results suggest that making add-on accounts mandatory has adverse welfare effects across income groups. Carve-out accounts generate positive welfare effects across all income groups, but gains are lower for low income earners. Default investment rules in individual accounts have a modest impact on welfare.