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Improving Outcomes: Financial Literacy and Premixed Portfolios

Two interesting studies on improving DC investor outcomes were published last week:

• “Financial Knowledge and 401(k) Investment Performance,” a Pension Research Council (PRC) working paper; and
• “The Outcomes of Participant Investment Strategies 1998-2012,” a commissioned study prepared for John Hancock Life Insurance Company by Burgess Management & Research.

The PRC study concludes that the most “financially knowledgeable employees” achieved 130 basis points of greater risk-adjusted annual return (a 10-year period ending with 2013) than those with less financial knowledge. The authors conclude that these findings “may provide a rationale for efforts to enhance financial knowledge in the population at large.”

The PRC study is based on the study of more than 20,000 employees of “a large financial institution.” The determination of who had the greater financial knowledge was based on an online survey consisting of five investment related questions designed to test the level of financial literacy. Of the total plan participants, 16% volunteered to take the survey.

The study found that the more financially literate group had greater equity exposure, more volatility and were more diversified. Meanwhile, the less knowledgeable “were more likely to invest in the conservative asset allocation fund” and “were more likely to be holding bonds than not.”

There are several aspects of the PRC study that raise concerns. The survey is of only one employer plan. The plan is sponsored by a financial institution to boot. The fund lineup is confusing to say the least — there are eight bond funds, four stock funds, one real estate fund and three risk-based asset allocation funds. One has to wonder if the less knowledgeable participants ended up with poorer results largely as a result of such a confusing fund lineup. At least one study has found that DC investors tend to “divide their contributions across the funds offered through the plan” (Benartzi and Thaler, 2001).

Given this propensity to allocate evenly across funds, what results should be expected when, in a fund lineup, there are twice as many bond funds as there are stock funds? For those participants who decided not to guess, it is not surprising that many threw up their hands and chose the conservative asset allocation fund. In many ways this fund lineup is simply an incomprehensible investment maze for most of the less knowledgeable DC investors.

Finally, a large financial institution will have a good number of investment professionals as well as a large number of non-investment professionals. One would expect a large gap in the survey results given this fact alone.

What would the outcomes of the PRC study have looked like if participants could only invest in target date funds unless they specifically opted out for a self-managed asset allocation program? Would there be this large gap in return between those who are more financially literate than those who are not?

Plan advisors, seeking to improve investor outcomes, would fare better to consider the results of the study commissioned by John Hancock. The report found that, of the 1.7 million participants who are serviced by John Hancock, those who invested exclusively in a single John Hancock asset allocation portfolio earned better returns on average than participants who selected individual investment options to form their portfolios over the 5-, 10- and 15-year periods ending Dec. 31, 2012.

Specifically, the group in a single asset allocation fund exceeded the average annual return of those invested in non-asset allocation investment options by 106 basis points over a 15-year period.

The John Hancock study goes to the heart of what is needed for probably more than 80% of participants — to be in a single asset allocation fund that matches up with their individual risk profile. It is all about how a DC investment communication campaign is structured as opposed to how well versed participants are about investing.

Conclusion

Financial literacy is a laudable goal as a matter of public policy. This is true as it relates to such matters as the need to save for retirement, buying individual investment services and products and becoming more self-sufficient in an increasingly complex financial world. However, DC investors need help now and they cannot not wait “to invest more profitably” as a result of “efforts to enhance knowledge of the population at large” (PRC). That help is here today in the form of asset allocation constructs like target date funds, which only require that an investor choose a retirement date and check the box.

Teaching financial literacy as it relates to helping DC investors build their own individualized asset allocation program is mostly a lost cause. A much better approach is to automate as much as possible. Fortunately, many effective ways to help participants are also the least costly interventions: small changes in plan design, sensible default options and opportunities to increase savings rates and rebalance portfolios automatically. These design features help less sophisticated investors while maintaining flexibility for more sophisticated types (Benartzi and Thaler 2001).

Who doesn’t wish that someone had automated their savings levels and provided automated professional asset allocation advice? Even the “financial literate” can see the wisdom in being forced out of what is often simply a mode of inertia as it relates to saving and managing one’s retirement assets over time.

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