Default investment acceptance increases for target date funds with lower expense ratios, lower levels of equity risk and higher relative performance, according to a new Morningstar report.
But expense ratio clearly has the largest effect among those three factors, David Blanchett, head of retirement research at Morningstar Investment Management, says in the report, “Made to Stick: “The Drivers of Default Investment Acceptance in Defined Contribution Plans.”
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,” Blanchett writes. That “creates an additional implicit cost for participants, since those who self-direct their accounts tend to experience lower returns than those who invest in professionally managed investment options.”
The “negative expense ratio/default investment acceptance relationship is especially interesting because higher expense ratios already create a higher explicit return hurdle,” he writes. His research suggests there is an “additional implicit cost as well with the lower potential default investment acceptance.”
A fourth factor explored by Blanchett was the size of the sponsoring TDF company, which is “assumed to be a proxy for general brand awareness,” he points out in a related blog post.
Overall, although he found that “certain target-date attributes do have a relation to default investment acceptance,” he writes in the report that they “tend to be less important than certain demographic variables, such as income and balance.”
Summing up his conclusions in the report, he writes: “Successful investing typically requires a level of knowledge and experience that the average investor doesn’t have. As DC plans have emerged as the predominant method of retirement saving for many Americans, investment options have evolved to help participants make better investment choices.”
An example is the “widespread use of default investments in DC plans,” which, he notes, tend to be TDFs. Although they are “far from perfect,” TDFs are “professionally managed multi-asset portfolios that are likely to result in better investment outcomes than if a participant was to self-direct his or her own portfolio,” he writes.
“Therefore, the goal should be to get as many participants in the default investment as possible, and to keep them there,” he writes.
Blanchett’s research extended Morningstar’s prior research that explored what types of investors were likely to accept the default investment by exploring which attributes of the default investment are likely to affect acceptance, he notes.
The firm’s 2019 white paper, “Which Default Investment Is the Stickiest?,” found default investment acceptance tended to be higher for younger participants with lower deferral rates, salaries and balances.
— Check out Morningstar’s Retirement Whiz Warns Against Misusing Target Date Funds on ThinkAdvisor.