While demographics can significantly influence a DC plan participant’s choice to accept the default investment, new research finds that expense ratios can also play a leading role.
In “Made to Stick: The Drivers of Default Investment Acceptance in Defined Contribution Plans,” Morningstar researchers found that default investment acceptance increases for TDFs with lower expense ratios, lower levels of equity risk and higher relative performance, with expense ratios having the largest effect among the three.
“The expense ratio relation is notable because it suggests funds with higher expense ratios not only have a higher level of expenses to overcome to generate alpha, but they also may result in lower levels of default investment usage,” note Morningstar Investment Management authors David Blanchett, Head of Retirement Research, and Dan Bruns, Vice President of Product Strategy.
They explain that this occurrence creates an additional implicit cost for participants, since those who opt out of the default and self-direct are more likely to build suboptimal portfolios and experience lower returns than those who invest in professionally managed investment options. “While the possibility of lower default investment acceptance is unlikely to create the same type of liability for a plan sponsor as fund expense, it is something that should be considered during the default investment selection process,” Blanchett and Bruns note.
Their analysis is based on the default investment decisions of 46,439 participants across 175 plans using 18 different target-date series, with all plans using a TDF as the plan’s default investment. The authors reason that by understanding the drivers associated with acceptance of a default investment, DC plan sponsors and advisors might have additional success getting more participants into professionally managed investment options with the ability to predict which default investment will be most accepted. In particular, the analysis explored four key attributes:
- expense ratio;
- size of the sponsoring TDF company (which is assumed to be a proxy for general brand awareness);
- relative risk of the respective target-date vintage (equity allocation versus all other funds in the same Morningstar Category); and
- relative performance of the TDF.
While expense ratio appears to be a bigger driver of acceptance compared with historical relative returns, participants, not surprisingly, also seem to prefer TDFs with higher returns. “While target-date funds are complex multi-asset products that should be evaluated across multiple dimensions, using a series with higher than average performance appears to increase default investment acceptance,” the paper notes.
A positive relation was also seen between the number of plan funds and default investment acceptance, potentially due to “choice-overload considerations,” the report notes. Blanchett and Bruns note that this is consistent with the findings from their study on DC menu choices with plan defaults, which suggested larger core menus nudge participants toward accepting the default investment.
Nevertheless, while 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 and Bruns note. For example, in their earlier research they found that default investment acceptance is higher for younger participants with lower deferral rates, salaries and balances. Moreover, they found that managed accounts have a higher default investment acceptance rate compared to TDFs and balanced funds.
