Default Investment Options

Default Investment Options

Recall that the other drawback of the plan studied by Madrian and Shea was that the default investment plan was a low-risk money market account. The firm chose this because it was the only option then blessed by the U.S. Department of Labor, the regulator of retirement plans in the United States. Fortunately, after much nudging (bordering on noodging), the Labor Department issued new regulations creating a set of what they called Qualified Default Investment Alternatives.9 Most companies now pick a so-called balanced fund, which means a mixture of stocks and bonds.

The most popular version of this is called a “target-date fund” because participants choose a date at which they plan to retire and the fund adjusts the portfolio over time with this goal in mind. The idea is that as investors get closer to retirement they become more conservative about their investments, so the fund gradually reduces the proportion invested in stocks over time. Although the specifics of how these funds are constructed varies considerably, the general concept is sensible and practical as long as the fees are kept low. It is sensible because such funds offer customization based on a known attribute of the investor: his or her age. If the investor does not choose to actively change the fund, the target date will be based on a good guess of when someone that age plans to retire. Target-date funds also protect many investors from their instinct, which is to panic when stock prices fall. (Sunstein invariably panics when that happens, and immediately calls Thaler, who usually, but not always, calms him down.)

Sunstein is not the only Human investor who gets spooked when markets get volatile. Throughout the history of defined-contribution retirement plans, investors have shown an uncanny ability to mistime their investment decisions. They end up seeming to be following a policy of buying high and selling low—not a good pattern. There is growing evidence that most people would be better off not paying attention to the ebbs and flows of the stock market. In 2019, the financial research firm Morningstar estimated that the average fund investor lost about half a percent per year from badly timed trades.

The market timing trap is not just a danger for people inexperienced with financial markets—in fact, some data suggests the opposite is true. Some retirement plans offer “brokerage windows,” which allow investors to access investment options outside their own plan’s menu and often lead to more frequent trading. While individuals who enroll in brokerage windows have significantly higher incomes and account balances, an Aon Hewitt study found that in 2015 the average brokerage-window participant return trailed other 401(k) investors by more than 3 percent per year. People’s instincts to sell or buy at the “right time” once again ended up in worse outcomes.

As readers would now guess, the vast majority of workers who are automatically enrolled invest exclusively in the default fund, at least for a while. Over time, as assets begin to accumulate and workers take a greater interest in investing, a growing number choose to modify their investment portfolio, for better or for worse.