Win By Default - the Most Important Investment Option
Author: Hubert Lum, CFA
Investment Options
The dramatic growth in investment options offered by Defined Contribution plans has generated considerable and useful debate. On the one hand, the discussion encompasses participant utility via diversification, choice and enhanced welfare and, on the other hand, participant paralysis in the face of excessive choice with limited understanding and interest in asset allocation. In this discussion on investment options, it is imperative to focus on the most important investment option, the default option - the option designated by the pension plan to receive undirected contributions from participants.
 Default Option Trends
A review of the Cost Effectiveness Measurement ("CEM") database showed that the number of plans offering a default option has grown since 2001 from 54% to 78%. Further, the default option retained a high level of stability. For plans with three consecutive years of data, 90% of plans maintained the same default option. There were three principal default options: Balanced/Lifestyle Funds, GIC/Stable Value Funds and Cash. These three asset classes represented 93% of all default options offered. Use of Balanced/Lifestyle Funds recorded the greatest increase from 21% to 29% from 2001 to 2004.
The Default Option and Automatic Enrolment
As expected, in 2004, 100% of plans with an automatic enrolment program also offered a default option while 70% of plans with no automatic enrolment program offered a default option. It was surprising however that almost 40% of plans with automatic enrolment offered a Balanced Fund default compared with 23% for plans without automatic enrolment. The expectation of a more conservative default option profile in plans with automatic enrolment, as suggested in research literature, was unfounded.
The Default Option and Access to Investment Advice
The default option was not a substitute for access to investment advice. On the contrary, access to advice increased at an increasing rate. In 2001, the proportion of plans which offered a default option and also offered access to advice was one-quarter. By 2004, this proportion exceeded one-half. The proportion of plans in the universe which offered neither a default option nor access to investment advice was 10%.
The Most Important Investment Option
Nobel Laureate Daniel Kahneman argues that the default option is essential to the pension plan design. It serves all the participants who lack the confidence or interest to establish their own asset allocation: "If we are going to make people fly their own planes, we should expect them to rely on the autopilot, and it must be designed accordingly"1.
The CEM database highlights the importance of the default option. For the period from 2001 to 2004, default options increased the percentage holdings for a given asset class by a significant level. For example, as shown in the graph below, plans whose default option was Balanced Funds had 22% of total assets invested in Balanced Funds. By comparison, plans whose default option was not Balanced Funds had only 11%. The multiplier effect was 2.0x. On average, across different types of default options, the multiplier effect was 2.3x.
The strong propensity to invest in the default option is supported by research literature. In a US study, Choi found that almost one-half of study participants invested solely in the default option after three years2. Also, Kahneman reports that three years after the establishment of private pension accounts in Sweden, the number of participants selecting the default option rose from 33% to 93%3. Given the powerful impact of the default option on asset allocation, the success of a pension plan’s ability to provide suitable diversification and long run wealth accumulation will reflect the careful consideration given to the selection of the default option.
Hubert Lum, CFA, is Research Director of Cost Effectiveness Measurement Inc., a global benchmarking company.
1 Daniel Kahneman, Terrance Odean and Brad Barber, "Privatized pensions: an irrational choice," Global Agenda 2005. 20 July 2005 http://www.globalagendamagazine.com.
2 James Choi, David Laibson, Brigitte Madrian, and Andrew Metrick, "For Better or For Worse: Default Effects and 401(k) Savings Behavior," Perspectives in the Economics of Aging, ed. David Wise (Chicago: University of Chicago Press, 2004) 81-121.
3 Kahneman.
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