Study: DC Default Option Choice Important

August 1, 2005 ( - Even though eight in 10 defined contribution plan sponsors currently feature a fixed-dollar mutual fund as their retirement plan default investment option, a new research study suggests that choice may not be the best one.

The reason, according to the study from the Vanguard Center for Retirement Research: such investments are primarily designed for short-term savings goals and not for long-term objectives such as funding one’s retirement.

“The choice of a fixed-dollar fund seems inconsistent with two main investment principles underlying participation education programs: the existence of a positive equity-risk premium and the inverse relationship between age and risk-taking ability,” the Vanguard researchers wrote.

Instead, the researchers asserted, plan sponsors should consider a balanced fund or a balanced fund of funds investing in both equities and fixed income. “For participants who are unsure of how to make investment choices, often the simplest and lowest-cost solution is a balanced investment fund,” the Vanguard researchers wrote. “Yet the law does not encourage employers and providers to communicate this simple fact.”

Focusing on 1,900 defined contribution plans administered by The Vanguard Group, the researchers found that 53% of plan sponsors had designated a money market fund while 27% listed an investment contract fund and 1% a bond fund as their default. The researchers said the data, as of December 2004, reflects a slight movement to balanced or equity options as defaults.

Among 15 plans featuring auto enrollment, however, 40% of plan sponsors chose a balanced or equity fund and 60% opted for a money market or investment contract fund.

The default fund decision can be an important one, the Vanguard researchers emphasized. In a Vanguard simulation, researchers found that over 30 years, a participant in the balanced fund default ended up with a median value of $469,000 while one in the fixed-collar default ended with $287,000.

By educating participants that the default option exists, plan sponsors would be giving considerable help to a particular group of employees. “The active use of default funds would meet the needs of participants unable or unwilling to make investment decisions,” the Vanguard researchers wrote. “Moreover it would be an easy way for sponsors to encourage long-term investment decisionmaking.”

The study report is here .