The Markets January 9, 2020

Keeping Defaulted Participants on the Right Path

Roughly 80% of participants initially accept target-date funds when they are offered as the default investment, although acceptance declines to approximately 70% after five years of participation.
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Art by James Yang


Morningstar has published a detailed new white paper titled “Made to Stick: The Drivers of Default Investment Acceptance in Defined Contribution Plans.”

Written by David Blanchett, head of retirement research for Morningstar Investment Management, and Daniel Bruns, vice president, product strategy, Morningstar Investment Management, the paper analyzes the survey responses of some 46,439 participants across 175 plans using 18 different target-date series.

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According to the analysis, approximately 80% of participants initially accept target-date funds (TDFs) when they are offered as the default investment, although acceptance declines to approximately 70% after five years of participation in the DC plan. Seeking to better understand this pattern, the white paper explores four key attributes associated with a plan’s default investment to gauge their impact on “default stickiness.” These are the expense ratio, the size of the sponsoring target-date fund company (which is assumed to be a proxy for general brand awareness), the relative risk of the respective target-date vintage (i.e., equity allocation versus all other funds in the same Morningstar Category), and relative performance of the target-date fund.

“While we find that certain target-date attributes do have a relation to default investment acceptance, they tend to be less important than certain demographic variables, such as income and balance,” Blanchett tells PLANADVISER. In other words, examining the characteristics of the plan population will tell one much more about the likely use of default target-date fund investments versus examining the specific characteristics of the default fund itself.

Blanchett notes the findings do show that default investment acceptance increases marginally for target-date funds with lower expense ratios, lower levels of equity risk, and higher relative performance, with expense ratio having the largest effect among the three.  

According to the white paper, the average expense ratios across the 19 series was 46 bps and the plan-weighted average was 31 bps. The plan-weighted average is lower than the overall average given the relative low cost of series such as the Vanguard target-date series, the paper explains, which had an average 14 bps expense ratio. T. Rowe Price was the most expensive widely used target-date series, with an average expense ratio of 67 bps.

“Target-date funds are professionally managed multi-asset portfolios that are likely to result in better investment outcomes than if an average participant was to self-direct his or her own portfolio,” Blanchett says. “The goal should be to get as many participants in the default investment as possible, and to keep them there, so it’s really important to understand who is choosing to use them and who is not.”

In terms of practical takeaways, Blanchett says that participant age has an “interesting effect” on default acceptance rates.

“Older people are less likely to accept a default investment, but it’s not simply because they are older,” he explains. “Almost the entire effect comes about because older participants tend to have higher balances and higher incomes than those who are younger. When you control for age, income and balance, default acceptance is pretty much the same for all ages.”

In this sense, Blanchett says, the research really shows that it’s important to understand the underlying drivers of behavior.

“If you just think, oh, default acceptance just diminishes with age, you’re missing the deeper point,” he warns. “If you have a plan with an older population that has lower income and lower balances, the patterns of behavior could be totally different than a plan where you have mainly high-balance, high-income older employees.”

The lesson here is that plan sponsors must carefully analyze their participant demographics in making decisions about default investments, Blanchett says, adding that the paper’s conclusions also make him think about the importance of re-enrollment. This may be the best tool plans have to keep people invested in the default fund. 

“Re-enrollment is a powerful tool for keeping more people in professionally managed default investments,” Blanchett says. “It’s always been strange to me that we have people annually reconsider their health care choices, but we have no similar mechanism on the retirement planning side. I think these findings underscore the importance of regular re-enrollments as a way to keep more people in high-quality, professionally managed investment portfolios.”

TDFs Drive Different Investing Behaviors

The TIAA Institute published a related research paper in 2019, dubbed “The effect of default target-date funds on retirement savings allocations.” In short, the paper finds that, while the use of one TDF versus another TDF does not strongly impact default acceptance, participants are more likely to exit other types of default investments, such as money market funds.

According to the TIAA Institute, prior to the adoption of target-date defaults, most retirement plans used money market fund defaults, and participants who joined plans with a money market default largely switched away from the default fund.

“[After leaving the default,] these participants had substantial variation in the equity exposure for their contributions and … allocated contributions to a median of three funds,” the TIAA Institute analysis says. “Women had less equity exposure than men and contributed to more funds, and participants contributed to more funds if the plan offered more funds.”

The TIAA Institute analysis shows those who joined a plan with target-date defaults behaved differently, with more than two-thirds investing in a single fund, with both sexes holding more in equity. The analysis further shows women in plans with a TDF default invest in fewer funds and carry the same average equity exposure as men, and with the size effect of the menu becoming insignificant.

“Our results for target-date funds are partially in accord with the existing literature on defaults,” the analysis concludes. “With target-date defaults, roughly two-thirds of new participants contribute only to a single fund, and they therefore allocate contributions in accordance with the equity percentage of that fund. Those who joined plans prior to the adoption of target-date defaults, when money market funds were the most common default, hold more funds and there is more cross-participant variation in equity contributions, with average equity contributions significantly below those of target date default participants.”

The TIAA Institute explains there are gender effects at play here, with women contributing significantly more to equity after target-date defaults became the norm than before. In fact, male-female disparities in equity percentage have largely vanished with target-date defaults. Also important to note, according to the analysis, is that the availability of target-date funds within a plan seems less important than whether these funds are the default investment. This is evident in the relatively sparse use of target-date funds in 2012 by participants who joined plans before they were a default, TIAA Institute says.

Compliance December 30, 2019

What Might the SECURE Act Mean for Lifetime Income?

Giving retirement plan sponsors legal protections when they offer lifetime income products doesn’t change the fact that investors generally have low opinions of annuities.
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Art by Giulia Sagramola


Among the many important provisions included in the Setting Every Community Up for Retirement Enhancement (SECURE) Act is the establishment of legal protections for plan sponsors offering lifetime income products on their defined contribution (DC) plan menus.

The annuity industry advocated strongly for this new “safe harbor,” as have some advisers and plan sponsors. Their argument was that plan sponsors often hesitate to offer lifetime income products within DC plans due to concerns that an insurer might not be able to meet its financial obligations at some point in the future. Given the fiduciary duty under which plan sponsors operate, they fear this could result in the employer being held liable for paying an outstanding annuity, and possibly being sued by plan participants.

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Experts say the SECURE Act safe harbor will go a long way toward assuaging these fears, but they also note the question remains whether plan participants will embrace annuities. Indeed, some DC plans already offer various forms of annuities, none of which have proven to be popular.

Annuity Misconceptions Are Hard to Undue

Sheryl Moore, president and CEO of Moore Market Intelligence and Wink Inc., says participant’s hesitancy about annuities is in large part tied to the traditional media’s negative perception of annuities, which is itself tied to a lack of quality sourcing and the inherent challenge of conveying information about complex financial instruments in short pieces of content.

“As you know, the way stocks and mutual funds are sold on Wall Street works is that the sales person is either paid a flat fee or is paid an annual amount based on the assets, based on the AUM,” Moore says. “Annuities are different. The key difference is that most annuities are sold by commission, and the vast majority of annuities are paid one single commission at the time the product is sold.”

According to Moore, members of the public and financial professionals look at this simple fact about how compensation is organized and draw the false conclusion that annuities as a whole are not consumer friendly.

“A lot of registered investment advisers and broker/dealers take the position that annuities aren’t consumer friendly because they pay a commission of maybe 5%, while a mutual fund only takes 1% of AUM annually,” Moore says. “In reality, if you hold that mutual fund for 10 or 20 years, you will end up paying a lot more in fees to the mutual fund company than you would have paid as part of the initial 5% commission.”

Moore says there have been some attempts by the annuity industry to get around this problem, for example by trying to popularize trail commissions, where the salesperson gets a lesser amount or even $0 up front, but then they get an annual payment based on the account value of the contract for the life of the contract.

“This may be a better approach, but communicating this kind of information gets very technical, and again the media doesn’t really focus on these things,” Moore explains. “Many reporters are happy to hear from the stock and mutual fund salesmen, who talk about annuities not being consumer friendly relative to the stocks and mutual funds they sell.”

Sri Reddy, Principal’s senior vice president of retirement and income solutions, says that in his experience, the No. 1 thing people get wrong about annuities is to say that annuity customers are investors.

“They are in fact savers who we are helping to invest so they can address inflation and participate in the growth of the economy,” Reddy says. “This distinction is significant. It means that our customers display very different behaviors versus what Wall Street or academics say is the optimal course for investors. Annuity purchasers are people looking for peace of mind. They want to participant in gain without losing big. They also don’t want choppiness.”

Another entrenched misunderstanding that will need to be addressed is that annuitization is an all-or-nothing game.

“It is really not that at all,” Reddy says. “ That’s not an outcome that anyone in our organization would promote.”

What Might Does SECURE Act Mean for Lifetime Income?

Contemplating these issues as they relate to the SECURE Act’s passage, Yaqub Ahmed, head of defined contribution and insurance/sub-advisory for Franklin Templeton Investments, and Drew Carrington, head of institutional defined contribution at Franklin Templeton, say advisers are in a great position to help solve some of these perception challenges.

“With the SECURE Act, we may start to see more plan sponsors moving into this area where beforehand they were reluctant,” Carrington says. “When we ask plan sponsors, we hear consistently that an enhanced safe harbor would encourage them to offer lifetime income solutions. Now we have that safe harbor, and we will have to see whether there will be real movement or activity in these areas. We’re looking forward to rolling up our sleeves and getting busy.”

Ahmed recommends that, as advisers talk to people about lifetime income, it’s going to be important to help them think about their full financial picture. Also important will be helping people make sense of the mandatory lifetime income projections that are to be included in certain plan statements being sent to participants now that the SECURE Act has become law.

“Something we need to be aware of is the potential for sticker shock,” Ahmed says. “Participants may feel that they have generated a significant lump sum, but when they see that amount translated into a lifetime monthly income stream, they can be discouraged. We need to provide them with actionable steps to take and help them improve their financial outlook.”

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