A Retirement Plan’s Default Investment Is Not for Every Employee

The retirement plan sponsor’s choice of a default investment should not reflect the full distribution of employee investor types, but rather those who would select it, a research report suggests.

Research provided through the TIAA Institute and written by Chester S. Spatt, Pamela R. and Kenneth B. Dunn professor of finance, Tepper School of Business at Carnegie Mellon University, suggests an interesting concept: The retirement plan sponsor’s choice of a default investment should not reflect the full distribution of employee investor types, but rather those who would select it and avoid the costs of implementing a customized investment portfolio.

The research questions under what circumstances an employee would be willing to rely then upon the default portfolio and concludes that if the employee’s risk aversion is relatively low or high compared with the risk of the default portfolio, he would choose to implement his own customized investment portfolio. The research points out that the risk aversion of the employee depends on certain factors, such as the amount the employee is investing in the plan.

Spatt points out that the decision of how to invest retirement plan savings is, to a degree, a long-term decision (even though it can be easily changed), so the decision may be very significant for someone with a small current balance (who recently started employment, for example) due to the future cumulative effects. Yet, it is expected that younger individuals—who would have smaller balances and less investing experience—would be more likely to rely on default allocations.

Applying the suggestion that the selection of the default portfolio by the plan sponsor should reflect only those employees who will use the default, the conclusions highlight that the plan sponsor should be especially focused on setting the default for those with relatively modest funds and those who are relatively less sophisticated, the research report says.

Thoughts about TDFs

Spatt concedes that for a variety of reasons, including the investing time horizon, a retirement plan participant’s investment allocation would depend upon his age. However, he points out that target-date funds (TDFs) as the default investment may not line up with particular preferences of an individual. His anticipated retirement age could be earlier or later than that of the TDF selected, and the nature of the investment horizon that he anticipates—including whether he wants to leave assets to his heirs—may not match with the TDF allocation near retirement. “In this sense,” Spatt says, “the investor’s age would potentially influence whether the individual chooses to make his own determination rather than relying upon the default portfolio.”

Disadvantages of default investments

According to Spatt, using a default portfolio could have a number of disadvantages, such as not matching individual employee’s risk preferences or investment sophistication. But mainly, the presence of a default portfolio would encourage use of it and inhibit the extent to which the employee improves his investment decision-making expertise.

“The official sanctioning by the employer of the default portfolio and the manner in which it substitutes for the individual’s choice undercuts the incentive for the employee to develop expertise on lifelong financial security. In this sense, the presence of a default portfolio (and especially a more suitable default portfolio) is a barrier to customizing the portfolio and to learning by the investor,” Spatt says.

He adds that an important challenge confronting employees is to build their expertise in asset allocation and financial management, and the presence of a default allocation, especially one that seems credible, can discourage investors from developing this expertise. Given the differences in views about asset allocation among participants, Spatt says the development of this skill is essential for many participants.

He does note, though, that the presence of a default investment in a retirement plan can increase the incentive to participate for those who are reluctant to choose their own investment allocation.

More information and links to download research materials is available at https://www.tiaainstitute.org/publication/role-employer-default-allocation-defined-contribution-retirement-plan-design.