NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Lifecycle Funds in 401(K) Plans


The default effect is strong: single lifecycle fund investment rates are nearly 60 percent higher when those funds are automatically designated as the investment of choice by the employer.

Recent lessons from behavioral economics on how to boost worker participation rates in individually-directed retirement plans -- including “opt out” or “automatic enrollment” provisions -- have stirred interest in a broader role for such strategies in retirement plan design, and in other settings where the goal is to limit the impact of potential deficiencies in individual decisionmaking. To shed additional light on this topic, co-authors Olivia S. Mitchell, Gary Mottola, Takeshi Yamaguchi, and Stephen Utkus analyze a rich dataset of retirement portfolios in Default, Framing, and Spillover Effects: The Case of Lifecycle Funds in 401(k) Plans (NBER Working Paper No. 15108). They have data on approximately 252,000 active participants covered by 258 U.S. 401(k) pension plans with a variety of default and voluntary choice options. Between 2003 and 2005, these retirement plans introduced lifecycle funds, when the contributions of those participants who were either automatically enrolled in their company's plan, or who enrolled on a voluntary basis but failed to submit an investment election upon enrollment, were placed by default into a lifecycle fund specified by the employer.

The researchers find that the default effect is strong: single lifecycle fund investment rates are nearly 60 percent higher when those funds are automatically designated as the investment of choice by the employer, primarily because new hires are enrolled automatically and fail to make any other investment election upon enrollment. The lifecycle funds also appeal to less sophisticated investors in plans without a default. These employees actively choose a lifecycle fund, presumably to avoid having to make difficult portfolio management decisions. Even when a lifecycle fund is not the default choice, the authors find, new hires are still 6.6 percentage points more likely to adopt one as their investment choice than are employees who joined the firm before lifecycle funds were available as a menu option.

Typically, a lifecycle fund includes a mix of passively-managed stocks and high-quality U.S. bonds -- structured to optimize portfolio appreciation -- which are rebalanced regularly based on a target maturity date, the expected year of the plan member's retirement. The fund's investment mix usually shifts to more conservative investments, such as fixed income assets, as the pension holder gets closer to retirement. Because a lifecycle fund is designed to serve as the sole holding in a participant's retirement portfolio, it generates an investment framing effect – that is, it consolidates what is potentially a series of complex portfolio allocation decisions into a simple one.

One surprising finding is that the introduction of lifecycle funds produces a large, unexpected spillover effect: it creates a sizeable new class of investors who use the funds in unanticipated ways, in this case as part of a more complex retirement portfolio that includes other investments offered by their plan. That group of mixed portfolio investors, primarily middle-income and middle-wealth investors with some knowledge of the investment process, is only slightly smaller than those who hold only a lifecycle fund, according to the study. Still, their impact can be sizeable and could result in plan managers having to make meaningful changes to the overall plan's portfolio allocations.

While these results are an incomplete explanation of the impact of changing the decision environment, the researchers say, they suggest that when considering altering choice architecture, it is critical to consider the potential spillover effects and whether their impact will be detrimental or benign.

-- Frank Byrt


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