Defined Contribution Pension Plans: Sticky or Discerning Money?

• DOI: http://doi.org/10.1111/jofi.12232
• Author: CLEMENS SIALM,HANJIANG ZHANG,LAURA T. STARKS
• Date: 01 April 2015
• Published date: 01 April 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 2 •APRIL 2015

Defined Contribution Pension Plans: Sticky

or Discerning Money?

CLEMENS SIALM, LAURA T. STARKS, and HANJIANG ZHANG∗

ABSTRACT

Participants in defined contribution (DC) retirement plans rarely adjust their portfolio

allocations, suggesting that their investment choices and consequent money flows are

sticky and not discerning. However, participants’ inertia could be offset by DC plan

sponsors, who adjust the plan’s investment options. We examine these countervailing

influences on flows into U.S. mutual funds. We find that flows into funds from DC

assets are more volatile and exhibit more performance sensitivity than non-DC flows,

primarily due to adjustments to the investment options by the plan sponsors. Thus,

DC retirement money is less sticky and more discerning than non-DC money.

MUTUAL FUND HOLDINGS in employer-sponsored defined contribution (DC) plans

are an important and growing segment of today’s financial markets. Assets in

DC plans increased from $1.7 trillion in 1995 to $5.9 trillion in 2013. Further,

at the end of this period, DC plans constituted 23% of total U.S. mutual fund

assets and 27% of U.S. equity fund assets.1Such holdings are expected to

∗Clemens Sialm is at the University of Texas at Austin and the NBER, Laura Starks is at the

University of Texas at Austin; and Hanjiang Zhang is at the Nanyang Technological University

Singapore. We thank Susan Christoffersen, Zhi Da, Magnus Dahlquist, Steve Dimmock, Nancy

Eckl, Michael Halling, Campbell Harvey (the Editor), Jennifer Huang, David Musto, VeronikaPool,

Jim Poterba, Jonathan Reuter, John Simon, Mikhail Simutin, Irina Stefanescu, Marno Verbeek,

an Associate Editor, two referees, conference participants at the 2012 SIFR Conference on Mutual

Funds in Stockholm, the 2013 Asian Bureau of Finance and Economic Research Conference in

Singapore, the 2013 China International Conference in Finance in Shanghai, the 2013 Conference

on Professional Asset Management at the Rotterdam School of Management, the 2014 Society for

Financial Studies Cavalcade at Georgetown University, the 2014 Western Finance Association in

Monterey, and seminar participants at Georgia State University, Hanken School of Economics,

the Helsinki School of Economics at Aalto, New York University, Stanford University, Tilburg

University,the University of Oklahoma, the University of Texas at Austin, the University of Texas

at Dallas, and the University of Virginia for helpful comments. We thank Veronika Pool and Irina

Stefanescu for sharing their Form 11-K data with us. The authors thank Tania Davila for research

assistance. We thank the sponsors of the Kepos Capital Awardfor the Best Paper in Investments at

the 2014 WFAmeeting. Clemens Sialm thanks the Stanford Institute for Economic Policy Research

for financial support during his sabbatical. Hanjiang Zhang thanks REGA Capital Management

for providing a research grant for this project. Laura Starks is a trustee of mutual funds and

variable annuities offered by a retirement service provider. She has also previously consulted for

mutual fund management companies and 401(k) plan sponsors.

12014 Investment Company Fact Book and Investment Company Institute Report on the “U.S.

Retirement Market, First Quarter 2014.”

DOI: 10.1111/jofi.12232

805

806 The Journal of Finance R

remain important with the increasing number of Americans moving toward

retirement and with the transition of corporations and public entities toward

the use of DC plans rather than defined benefit (DB) plans.

Despite the prevalence of mutual fund holdings in employer-sponsored re-

tirement accounts, little is known about the effects of DC plan sponsors (i.e.,

employers) and participants (i.e., employees) on mutual fund flows. Our paper

analyzes the behavior of these sponsors and participants and asks whether DC

pension plan investments constitute a source of sticky or discerning money for

mutual funds. Conventional wisdom, based on previous studies of DC plan par-

ticipants’ behavior, suggests that the DC plan assets in mutual funds should be

sticky and not discerning.2However, decisions regarding the composition of DC

plan menus are made by DC plan sponsors, who might frequently delete funds

with poor prior performance and add funds with superior prior performance.

Which of these influences has a greater effect on fund flows is an empirical

question, which we address in this paper. We further consider the implications

of these influences for both plan participants and the mutual fund industry.

Although investors who own mutual funds directly can choose among the

universe of mutual funds, participants in employer-sponsored DC plans typi-

cally have limited choices.3These choices arise through a two-stage process.

In the first stage, plan sponsors select the DC plan menus and adjust the in-

vestment options over time by removing or adding options. In the second stage,

employees allocate their individual DC account balances among the choices

made available to them by the plan sponsors.

This two-stage process contributes to different investor behavior patterns

for DC plan investors versus ordinary mutual fund investors. We therefore

expect the fund flows from DC plans to behave differently from flows from

non-DC sources. On the one hand, DC plan participants make periodic retire-

ment account contributions and withdrawals, which are persistent over time.

In addition, they may evaluate their present and prospective fund holdings dif-

ferently from non-DC fund investors due to longer investment horizons and a

different tax status.4These factors may explain the documented inertia by DC

plan participants in the previous literature whereby retirement savers have

a tendency to rebalance and trade infrequently and to follow default options.

This inertia in DC plan participants’ investment decisions leads to the com-

monly held belief that retirement money flows should have low volatility, high

autocorrelation, and low sensitivity to prior fund performance.

2See, for example, Benartzi and Thaler (2001), Madrian and Shea (2001), Choi et al. (2002),

Agnew, Balduzzi, and Sunden (2003), Duflo and Saez (2003), Huberman and Jiang (2006), Carroll

et al. (2009), and Dahlquist and Martinez (2013). In contrast, evidence suggests that individual

investors exhibit relatively high turnover in their traditional (directly held) brokerage accounts

(e.g., Barber and Odean (2000), Grinblatt and Keloharju (2001), and Ivkovi´

c and Weisbenner

(2009)).

3For example, a Deloitte (2011) survey of DC plan sponsors finds that the median DC plan

includes 16 investment options.

4The tax on income to investments in DC plans is deferred until the income is distributed. See

Sialm and Starks (2012) for a discussion of tax clienteles in equity mutual funds.

Defined Contribution Pension Plans 807

On the other hand, the infrequent trading by individual plan participants

could be offset by plan sponsors’ adjustments to plan menus—to satisfy their

fiduciary responsibilities, plan sponsors monitor the available investment op-

tions5and may replace poorly performing funds with investment options that

exhibit superior prior performance.6Thus, rather than being sticky, DC money

could actually act as an important disciplining mechanism for fund managers,

resulting in money flows that have higher volatility,lower autocorrelation, and

higher flow-performance sensitivity.

To test these competing influences regarding the effects of DC plans on mu-

tual fund flows, we compare the flows of DC and non-DC mutual fund investors

from 1997 to 2010. We find that money flows into mutual funds by DC plan

participants are more volatile and exhibit a lower serial correlation than the

flows into mutual funds by other investors. Thus, DC asset flows tend to be less

sticky than non-DC flows.

Furthermore, our empirical results show that DC flows are more sensitive

to prior fund performance than non-DC flows. In fact, the flow-performance

sensitivity of DC flows is particularly pronounced for the funds in the lowest

and highest performance quintiles. Using the piecewise linear specification of

Sirri and Tufano (1998), we find that a 10 percentile deterioration in prior-year

performance for a bottom quintile mutual fund generates outflows of 11.9%

by DC investors compared to only 3.3% by non-DC investors. In contrast, a

10 percentile improvement in prior-year performance for a top quintile mutual

fund generates inflows of 17.8% by DC investors and only 4.9% by non-DC

investors. Thus, contrary to the widely held conventional wisdom, we find that

DC money is actually more sensitive to prior performance than non-DC money.

These results suggest that plan sponsors counteract the previously docu-

mented inertia of DC participants. To test the follow-on hypothesis that the

high flow-performance sensitivity of DC funds is driven by the actions of the

plan sponsor, we use data on a sample of 401(k) plans that have 11-K filings

with the U.S. Securities and Exchange Commission (SEC). These data allow us

to decompose flows following Pool, Sialm, and Stefanescu (2013) into flows re-

sulting primarily from plan sponsor actions and flows resulting primarily from

participant actions. We find that our flow results are predominantly driven by

the actions of the plan sponsors, and, consistent with previous research, we

confirm that the plan participants themselves exhibit inertia and do not react

sensitively to prior fund performance.

5See the U.S. Department of Labor’s Employee Benefits Services Administration

website for information on fiduciary obligations in DC plans: http://www.dol.gov/ebsa/

publications/fiduciaryresponsibility.html. Over the last decade there have been numerous

lawsuits filed against plan sponsors and service providers. Most of these lawsuits al-

lege that the plans are charging excessive or hidden fees; however, the complaints have

also included allegations of improper monitoring of options. See http://online.wsj.com/article/

SB10001424052970204777904576651133452868572.html.

6In 2011, 43% of plan sponsors responding to a Deloitte (2011) survey of DC plans stated that

they had replaced at least one fund due to poor performance within the previous year.When a fund

is replaced, the plan assets are typically transferred to the new fund.