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The Markets November 13, 2006
Putnam: Default Option Choice Presents Three Considerations
A new Putnam Investments analysis of the Department of Labor (DoL)-approved default option list suggests plan sponsors could be doing participants a disservice by concentrating too heavily on one driver in selecting their default.
Reported by Fred Schneyer
A new Putnam Investments analysis of the Department of Labor (DoL)-approved default option list suggests plan sponsors could be doing participants a disservice by concentrating too heavily on one driver in selecting their default.
In deciding among a lifecycle or targeted-retirement date fund, a balanced fund, and managed accounts – the three DoL-sanctioned categories of qualified default investment alternatives (QDIAs) (See DoL Releases Default Investment Option Safe Harbor) – Putnam suggested plan sponsors needed to consider:
- wealth accumulation – Wealth accumulation captures the full impact that investment decisions will have on the portfolio, and, therefore, it is an effective measure of DC asset performance.
- wealth preservation – Wealth preservation is critical – particularly as the participant approaches retirement. “Fluctuations in return have little impact early on, but consequential impact near retirement,” the researchers commented.
- loss aversion – A participant’s sensitivity to loss – or loss aversion – is important. “The worst outcome following a loss would be for a participant to opt out of the plan,” Putnam said.
“The default investment choice in a plan has a special attribute,” the report said. “It is the one investment in a defined contribution plan that the trustees, rather than the participant, elect. As such, this investment choice can bring special sensitivities, particularly around outcomes that lose money for participants.”
Plan sponsors should go through that three-pronged analysis, keeping in mind that that the list won’t fit each defined contribution plan the same way, Putnam researchers wrote.
“In designing the investment architecture of a DC plan, trustees must consider the investment implications of each of these differences along with the unique circumstances of the participants in their plan,’ Putnam wrote. “While proposed legislation seeks to increase DC plan participation and savings rates to meet retirement needs, the selection of a default option based on a single variable may not adequately protect against participants’ opting out of the plan, suffering large losses close to retirement, or having low returns early in their careers.”
The Putnam report also presents more information about the three investment option categories and then analyzes each according to the three drivers the report specifies.
“By comparing qualified default investment alternatives within the context of wealth objectives, risk aversion and demographic profiles, our analysis provides an important framework for plan sponsors to use when making their default option decision,” said Amy Walls, managing director of Putnam Investments Strategic Research Team. “The Department of Labor has made tremendous strides in approving options that generate wealth and preserve capital; however, with more than one permissible option, plan sponsors are still left with an important decision that should consider classic risk-reward trade-off analysis.”
The study is HERE