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The Paternalization of Participant-Directed Plans

In a white paper published by Arnerich Massena, Inc. in March 2014, the authors review a variety of research studies that look at the investment returns of DC participants’ accounts compared with the returns of index funds, market returns, committee- or trustee-directed defined benefit accounts and asset allocation accounts.

After considering research completed by Center for Retirement Research in Boston College, Towers Watson, DALBAR, Vanguard and Fidelity, the authors draw the conclusion that, “Participant-directed accounts, in aggregate, consistently underperform over long periods of time in nearly every comparison. Furthermore, studies that take a close look into participants’ asset allocation strategies reveal a lack of diversification that is likely to damage participants’ long-term outcomes.”

They continue: “The conclusion that people are beginning to draw from these studies is that participants in defined contribution plans may need more help making appropriate investment choices. Concerns about underperformance and poor diversification echo participants’ own requests for more help and more advice. It may be time to consider returning to a more paternalistic approach to retirement savings.”

As importantly, the white paper posits something that we all know or suspect: “Over the past two decades, participants have been inundated with investment education… Great strides have been made to provide education that is accessible and friendly. However, investment education appears to have done little to improve participants’ investment choices and thus investment returns.”

The Arnerich Massena white paper finally proposes that paternalization is the answer, suggesting that, “benevolent guidance, such as a parent would provide to a child, not about dictating or eliminating choices” is part of the solution. This would appear in the form of professionals making all decisions for participants (at their discretion), “from enrollment to contribution rates to contribution increases to asset allocation." They essentially liken “paternalization” to a return to a defined benefit way of thinking about managing retirement assets with participants having the option to make their own choices.

I would agree that education within the context of DC plans has been largely ineffective and has resulted in sub-optimal outcomes for participants’ retirement readiness. Partially as a result, the DC industry has adopted automatic products and features such as target date funds, automatic enrollment and automatic deferral increases.

To understand why education has not reached its goals, we need to look at the powerful behavioral forces that mitigate the impact of education on participants’ decisions. Participant education makes the assumption of rational behavior by participants. If given rational information and guidance, the rational participant — “Homo Economicus” — will, it is assumed, make rational decisions. Behavioral economics, of course, questions that assumption. The question is: Why is the ‘rational information = rational decisions’ equation violated so often?

If we look at forces working on participants as they make decisions, we see that education is a minor weapon against irrational choices. Framing, for example, has an enormous impact on deferral rates. In the Boston Research Group's latest research, we show that the power of framing of the match is two to three times more powerful a force than financial literacy in selecting a deferral rate. Other powerful forces such as loss aversion, regret aversion, hindsight bias, illusion of control, overconfidence, the Endowment Effect and hedonics neutralize the impact of great education. The list of forces goes on and on, seemingly without end.

Regulations require that participants receive a reasonable education about their plan, plan choices and investing. In a sense, these regulations are burning up enormous resources in the DC industry and affecting participant costs. It may be time to turn the focus of education away from teaching participants how to invest and turn it more towards showing them how to use automaticity to their full advantage.

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