Menu choices in defined contribution pension plans.

• Author: Sialm, Clemens
• Position: Research Summaries

Significant changes in the structure of retirement saving programs have occurred in recent decades in the United States and across the world. Defined Contribution (DC) pension plans, such as 401(k) and 403(b) plans, have become an important source of retirement funding, while the relative significance of Social Security and Defined Benefit (DB) pension plans has declined. As a result, more savings and investment decisions need to be taken by individuals, who might not have the time and knowledge to take optimal investment decisions. In addition, there are potential conflicts of interest between providers of the newer plans and retirement savers. Investment choices that maximize the profits of plan providers are not necessarily the optimal choices for retirement savers. It is therefore crucial to scrutinize the impact of DC plan design on savings and investment decisions.

I discuss here some key findings of two recent research projects that analyze the mutual fund investment options offered in DC pension plans. The structure of the retirement savings system affects the investment strategies, the money flows, and the performance of retirement savers. DC plan design needs to take into account behavioral biases and bounded rationality by retirement savers as well as conflicts of interests by service providers.

Mutual Fund Menu Options

Mutual fund holdings in employer-sponsored DC plans are an important and growing segment of today's financial markets. Figure 1 depicts the total value of mutual fund assets in the United States. Between 1992 and 2014, total mutual fund assets grew from $1.6 trillion to $15.9 trillion. Mutual funds can be held in DC pension plans, in Individual Retirement Accounts (IRAs), and in non-retirement environments. The growth of mutual fund assets has been particularly strong in DC plans. Currently, around 23.5 percent of mutual fund assets are held in DC plans, 22.4 percent in IRAs, and the remaining 54.1 percent in non-retirement accounts. (1) Thus, mutual funds have mixed clienteles that differ according to their distribution channels, their time horizons, and their tax implications. (2)

Whereas investors who own mutual funds in IRAs or in non-retirement accounts can choose from the universe of mutual funds, participants in employer-sponsored DC plans typically have limited choices. These choices arise through a two-stage process. In the first stage, the plan sponsor, typically the employer, together with the service providers, select the DC plan menu, which defines the set of investment options for participants. In the second stage, plan participants --the employees --allocate their individual DC account balances among the choices made available to them by the plan sponsor. Thus, final allocations in DC plans reflect decisions of the sponsor, the service providers, and the participants.

Sticky vs. Discerning Money

Despite the importance of DC mutual fund holdings, little is known about the properties of money flows in...