Individuals who contribute to defined contribution (DC) plans don’t often change their allocations once set. This tendency, known as participant inertia, has led many to believe that the money in DC plans stays put no matter how a fund performs. However, despite the inaction of individual investors, DC plans are monitored by plan sponsors who continually make fund adjustments to improve performance, which means DC plans’ assets are highly fluid and tend to perform better than retail investors’ picks.
Defined contribution plan participants — those who contribute to an employer-sponsored retirement fund such as a 401(k) or 403(b) — tend to be buy-and-hold investors. It’s a set-it-and-forget-it mindset that means individual participants make their initial allocations upon joining a company and then remain inactive, often for years at a time.
This inertia would seem to suggest that DC plan assets invested in mutual funds should be sticky and undiscriminating; the prevailing wisdom is that money moves only when participants change their allocations, and it often remains put no matter how well (or poorly) the fund performs.
Pioneering research by McCombs faculty Clemens Sialm and Laura Starks, along with Nanyang Technological University co-author Hanjiang Zhang, examines for the first time the role DC plan sponsors play in retirement fund performance. They found that contrary to the common perception, plan sponsors regularly delete or add funds based on performance — meaning invested assets are more mobile and discerning than previously believed.
In 1974, the Employee Retirement Income Security Act (ERISA) was enacted to establish minimum standards and regulations for employee benefit plans, and it also created the Individual Retirement Account (IRA) to facilitate private retirement savings. Today, retirement savings assets in the United States are collectively worth nearly $25 trillion, with IRAs and DC plans as the two predominant savings vehicles. Of that $25 trillion, nearly 60 percent is invested in mutual funds, making retirement accounts — and those who hold them — important players in the broader financial market.
However, DC plans are managed in a markedly different way than directly held accounts (such as IRAs) or retail mutual fund investments, and this difference is key to understanding how their assets behave, observe Sialm and Starks. DC plans are selected through a two-tiered approach: The employer first chooses a menu of investment options — often composed of up to 20 mutual funds — and from that menu, employees choose which funds or stock options to allocate their monthly contributions to. Previous research has noted that plan participants are passive, with the vast majority rarely changing their fund allocations once set. This inertia led to the belief that DC assets are sticky and undiscerning when it comes to fund performance, but that assessment overlooks the role of the plan sponsor – that is, the employer offering the retirement benefit.
“Think about who’s making decisions for all of these plans in terms of valuing stocks and bonds, and also who’s deciding whether to move from stocks to bonds and back, or whether to go into alternative assets,” explains Starks. “We have more than 40 percent of mutual fund assets that are coming from retirement money, and how are these funds being selected? For DC money, it’s coming from an employer’s plan, and that’s managed by a plan sponsor.”
Plan sponsors continually monitor their menu of funds, making substitutions based on a fund’s performance. In fact, during the last two years, 71 percent of plan sponsors have replaced at least one fund due to poor performance. As funds change, participants’ assets are shifted accordingly. This counteracts participant inertia and makes assets much more fluid than conventionally believed.
Because assets flow into and out of funds based on their performance, they’re not only less sticky but also more discerning than retail investments. Sialm says, “If you look at the whole set of non-DC mutual fund investors, then you find, on average, a dumb money effect. Investors often purchase the wrong mutual funds or they invest at the wrong time.”
Plan sponsors may be more sophisticated than individual investors, and they often use consultants to guide their decisions, which appears to give them an advantage.
“Plan sponsors do a better job than participants of avoiding funds that perform poorly in the future,” concurs Starks.
Because DC funds comprise a substantial portion of all retirement assets and are demonstrably not sticky, they have the power to influence the broader financial markets. DC fund flows can affect asset pricing and, by extension, put pressure on fund managers to adjust their portfolios and rethink their investment strategies.
The most important implication, however, is one of oversight. The growth of DC assets and the subsequent fund flows into and out of mutual funds means more monitoring of mutual funds and increased managerial effort to maintain a strong investment profile.
Starks explains: “If you had a mutual fund that was performing poorly, but it had a lot of money in it and shareholders didn’t sell out because they weren’t paying attention, then that fund manager may ultimately make bad decisions that are not in investors’ best interest. Plan sponsors help discipline U.S. financial markets to ensure that resources are going to their best and highest uses.”