The Role of the Employer Default Allocation in Defined-Contribution Retirement Plan Design

October 2018

A retirement plan’s default investment portfolio is optimal for some employees. But for others, the default has some drawbacks.

Summary

Most 401(k) and 403(b) retirement plans now provide a default asset allocation for participants who do not choose their own investments. This paper offers plan providers insights on the use of defaults, including explaining why the optimal default is not a riskless allocation; why the default should reflect the characteristics of individuals most likely to use it; what attributes lead employees to select an asset allocation; and why improvement in the default allocation can reduce people’s ability to manage their retirement funds over time.

Key Insights

Modest inclusion of risky assets is beneficial for all plan participants and a more substantial inclusion is potentially beneficial for many participants.

Relatively less-experienced employees with modest funding in the employer’s account are more likely to use the default asset allocation.

Age-based target-date funds, which are used frequently as the default portfolio, may not align with particular employee preferences, such as desired retirement age.

Methodology

The author analyzes how use of the default asset allocation is affected by such factors as risk aversion, plan assets, company tenure and financial sophistication. He develops a formal framework to predict default usage and lays out several propositions stemming from the analysis.