Businesses are going to need help from financial advisors as they choose default investments for their 401(k) or other defined-contribution plans, according to recent research from Putnam Investments. Under Pension Protection Act legislation passed in August, all 401(k) plan sponsors can now include an auto-enrollment feature for employees. More recently, the Department of Labor issued guidance indicating what kinds of investments are appropriate default options: age-based lifecycle funds, risk-based lifecycle funds or professionally managed accounts. Still, employers seem to be confused about how to choose the best default investment for their own employees, says Putnam’s head of retirement research Chris Thompson. “Plan sponsors may not have enough information to compare and contrast between those two,” he says.
So Putnam set out to offer such a comparison in a white paper called Defined Contribution Default Options: A Framework for the New Environment. First, the firm identified three main risks that plan sponsors should think about when selecting their default option, says Thompson: Wealth accumulation—or the risk of not saving enough; wealth preservation—too much risk at the end could mess up a long history of strong saving; and loss aversion—the risk that a participant will experience a sudden period of negative performance that causes them to opt out of plan.
Then it measured each fund type on the basis of these risks. Putnam found that, in the end, it’s particularly important for a plan sponsor to determine what degree of loss aversion its participants have: If they seem prone to opting out, then the employer should pick one of the risk-based funds. But if the firm thinks employees have low loss aversion—that they will stay the course—then the age-based option would make more sense.
“We would hope that advisors would use this as a building block in their conversations with plan sponsors,” says Thompson.
