New data questions conventional wisdom

In the cautious defined contribution world, it takes a long time for new ideas to become conventional wisdom. So what happens when conventional wisdom is challenged by hard data?

Recent research has raised questions about the conventional wisdom that says target-date investors simply "set it and forget it" and participants don't need to mix target-date investing with other options in a DC fund lineup.

Other research has challenged the conventional wisdom that shrinking the investment lineup is necessary to prevent "choice overload," or that stretching the corporate match will encourage greater investment and contributions by some participants. (See related story on page 59.)

Authors of the research projects as well as veterans of the DC industry say these challenges to conventional wisdom can reflect new perspectives on a changing industry rather than a repudiation of past practices.

"The landscape we play in is different," said Drew Carrington, senior vice president and head of the defined contribution business at Franklin Templeton Investments, San Mateo, Calif. "Conventional wisdom emerging from research before the passage of the Pension Protection Act in 2006 may not be as significant today."

DC sponsors move slowly to adopt changes "until they reach a tipping point," said Lori Lucas, president and CEO of the Employee Benefit Research Institute, Washington. One tipping point was the Pension Protection Act, which encouraged greater use of automatic enrollment, changing how sponsors designed and managed their plans, she said.

After the law was passed, it still took time for DC plans to offer auto enrollment, according to annual research by Vanguard Group Inc. Among its clients, 10% offered auto enrollment in 2006; the rate grew steadily each year to reach 48% in 2018.

Ms. Lucas said sponsors also must be aware of other data that raises questions about conventional wisdom. For example, recent EBRI research challenged the assumption that people can expect to spend a constant level of pre-retirement income every year in retirement.

The recent unconventional wisdom research relies on real numbers — surveys of DC sponsors and/or analyses of record-keeping data — rather than economic models or behavioral finance assumptions.

"We have to let go of some assumptions of what's the right thing to do," Mr. Carrington said. "Beware of models. Sometimes, we tend to over rely on a study that becomes conventional wisdom."

For Robert Austin, the growth of target-date funds as a set-it-and-forget-it investment prompted him to ask how participants were perceiving the industry's sales pitch.

"Target-date funds were always billed to be the turnkey solution" to diversified investing, said Mr. Austin, the Charlotte, N.C.-based director of research for Alight Solutions. "Here's a product that had been advertised in a certain way. We had the data. We wanted to know how people were using this."

Alight found that many participants decided against set it and forget it. Among participants who were fully invested in target-date funds, 49% of them were no longer fully invested after 10 years.

Some investors left target-date funds completely, while others remained partially invested. Alight defines "partially invested" as more than zero and less than 100%. The average partial investment was 40%.

Mr. Austin was surprised by the results, which were based on 2.5 million target-date investors in plans for which Alight was the record keeper. These plans had $87.6 billion in target date fund assets and total DC assets of $331 billion as of Jan. 1.

"Target-date funds can be a very good product, but there is a disconnect between how it is being communicated and how people are using it," said Mr. Austin, adding that the research goal was to "let sponsors know that people may not be using target-date funds appropriately."

Vanguard research and data analysis has produced results that ironically indicate advances in plan design appear to be restoring conventional wisdom about role of target-date funds.

Target-date funds have been promoted to DC plan participants as the only investment they need to achieve a diversified portfolio. Yet, Vanguard researchers began noticing that many participants invested in other options available in plans' menus, contradicting the original conventional wisdom as well as the belief that mixing these investments was a misuse of target-date funds.

The researchers have examined this behavior periodically, the latest in a January 2017 report based on data from 3.8 million participants in approximately 1,650 plans for which the firm is record keeper. It reviewed investments in target-date funds offered by Vanguard and other providers.

"We looked at those investors who did this by choice," said Cynthia Pagliaro, senior research analyst for Vanguard's Center for Investor Research, Malvern, Pa., who conducted the research with Steve Utkus, principal and head of the center. "We found that most of the participants mixing investments were making reasonable investment choices."

The mixed investors tended to be older, wealthier and "more engaged decision-makers," the report said.

Ms. Pagliaro said she expects the mixing strategy to decline over the years thanks to more plans adding auto enrollment and establishing qualified default investment alternatives, which are usually target-date funds, and conducting re-enrollments.

"We refresh our research every three years, so the next one will be in 2020 when I expect there will be a higher percentage of people wholly invested in target-date funds," she said.

The percentage of target-date-fund-only investors vs. mixed investors was 50-50 in 2010. Five years later, the former represented 62% of target-date fund investors. Subsequent data compiled by Vanguard shows the target-date-fund-only group accounted for 68% in 2018.

Vanguard's research goal is to "provide information to our audience about what we think is valuable and to educate sponsors on why this was occurring," she said. Vanguard representatives use the data to discuss strategies with clients, such as re-enrollments, and to pinpoint the behaviors of specific participants, she said.

As DC plans built up their investment menus, some research emerged saying sponsors should trim their size to reduce plan costs and to guard against "choice overload" — giving participants so many options that they couldn't make proper decisions.

However, Morningstar researcher David Blanchett — in a November paper, "Bigger Is Better " — challenged conventional wisdom among 401(k) plans.

He found that increasing a 401(k) plan's investment menu to 30 core choices from 10 core choices can produce an increase of about 10 basis points in the total expected risk-adjusted return.

The research analyzed one record keeper's data — more than 500 defined contribution plans and about 500,000 participants — where core menus varied from 10 to 30 options. Mr. Blanchett declined to identify the record keeper.

For participants who choose their own options rather than rely on a target-date fund or other professionally managed option, the larger menu helps them achieve a more efficient portfolio, he said. Conversely, for participants defaulted into a QDIA, larger core menus lead to "higher default acceptance" and greater use of the QDIA, which is usually a target-date fund.

"Our findings suggest that plan advisers can feel more comfortable adding a broader range of investment options that sophisticated plan participants can use to build a customized portfolio," said the report written by Mr. Blanchett, head of retirement research for Morningstar's investment management group, Chicago, and Michael Finke, professor of wealth management and Frank M. Engle Distinguished Chair in Economic Security at the American College of Financial Services, King of Prussia, Pa.

"I hope other people will do research to confirm or not confirm our findings," Mr. Blanchett said. "We need to rethink the role of the core menu."

Mr. Blanchett said his research illustrates that conventional wisdom may change if DC plan strategies and practices change. For example, much of the "choice overload" research was conducted prior to the boom in auto enrollment and target-date funds as a QDIA, triggered by passage of the Pension Protection Act, he said.

"The old paradigm wasn't wrong," Mr. Blanchett said. "It was right for that time."