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What Factors Could Contribute to Default-Investment Acceptance in Defined-Contribution Plans?

Morningstar Investment Management’s research explores the participant demographics and fund attributes related to default acceptance

In past research, we’ve demonstrated that a variety of factors affect whether a participant ends up in the default investment for a defined-contribution plan. For example, our study “ Which Default Investment is the Stickiest?” found that default-investment acceptance tends to be higher for older participants with higher deferral rates, salaries, and balances. The study also showed that acceptance appears to be higher when managed accounts are used as the default investment, versus target-date funds or balanced funds.

Additionally, research such as Alight’s study “ The Impact of Managed Accounts and Target-Date Funds in Defined-Contribution Plans” has shown that participants who self-direct their accounts tend to underperform participants who are invested in professionally managed options. For this reason, plan sponsors and consultants should consider if they should help maximize participant acceptance of the default investment, as well as the use of other professionally managed solutions (for example, managed accounts or advice when the default investment is a target-date fund).

In order to help get participants to consider professionally managed investment accounts, it may be helpful for plan sponsors and defined-contribution plan consultants to understand which investment attributes are associated with default-investment acceptance. For example, when choosing between two potential default investments, plan sponsors may consider the one that is expected to result in higher usage, even if it is more expensive, or has other attributes that may make it appear less attractive.

In “ Made to Stick: The Drivers of Default Investment Acceptance in Defined-Contribution Plans,” we extended our previous default investment research to consider how certain attributes of the plan’s actual default target-date fund investment were related to default investment acceptance.

Here are some of the key findings from this research.

The attributes associated with default investment acceptance

This analysis is based on the default investment decisions of 46,439 participants across 175 plans using 18 different target-date series. All plans used a target-date fund as the plan’s default investment. Our analysis explored four key attributes:

  • expense ratio,
  • size of the sponsoring target-date fund 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 target-date fund.

We found that default investment acceptance increases for target-date funds with lower expense ratios, lower levels of equity risk, and higher relative performance, with expense ratio having the largest effect among the three. However, these attributes tend to have less of an impact than certain demographic variables, such as income and balance. These results are shown on the chart below.

A few key takeaways include:

  • Expense ratio. Higher expense ratios have not only a higher level of expenses to overcome to generate alpha, but they also may result in lower levels of default investment usage. This creates an additional hurdle for higher-cost target-date funds to overcome for selection purposes.
  • Return rank. Although expense ratio appears to be a bigger driver of acceptance compared with historical relative returns, participants also appear to prefer target-date funds 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.
  • Number of plan funds. There is a positive relation between the number of plan funds and default investment acceptance, potentially due to choice-overload considerations. This is consistent with the findings from our study “ Bigger is Better: Defined-Contribution Menu Choices with Plan Defaults,” which suggested larger core menus nudge participants toward accepting the default investment.

While this study does support our previous research that demographics, such as age, seem to be the primary driver of default investment acceptance, these additional aspects of the target-date funds—particularly expense ratios and higher relative performance—can also contribute. Therefore, they are equally as important to consider when selecting the plan’s default investment. (Still keep in mind, of course, that past performance doesn’t guarantee future results.)

For the full analysis, download “Made to Stick: The Drivers of Default Investment Acceptance in Defined Contribution Plans.”
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