Traditional approaches to finance and investment have had their day, said experts in a recent PSCA webinar, arguing that behavioral finance has changed the equation.
In “Investment Menu Design that Improves Retirement Readiness,” Matthew Gnabasik, Connie Mulligan and Neal Smith suggest that new approaches are transforming the way retirement plan assets are managed and invested. Gnabasik and Mulligan are Partners at Cerity Partners; Smith is Principal there.
Under the old paradigm, they said, picking funds was advisor-driven; in addition, they were too numerous too expensive. And they cited a 2016 Morningstar argument that “The expense ratio is the most proven predictor of future fund returns.” Now, said Gnabasik, behavioral finance is a “complement” to the traditional approach to finance and investment control.
Behavioral Finance Applied
One factor this new tool can ameliorate, said Gnabasik, is recency bias—the tendency of employees to make investment decisions based on recent performance. “We all know that current trends don’t continue,” he said, suggesting, “Eliminate this bias by removing the growth/value style boxes and replacing with a single blend/core option.”
Another pitfall behavioral finance also can help in understanding and addressing choice overload—having so many investment choices that their number threatens to overwhelm their employees. “Consider simplifying your core investment menu to 8-12 investment options,” Gnabasik suggested.
Gnabasik added that behavioral finance aids in understanding and identifying naïve diversification, an imbalance between equities and fixed income options on an investment menu. This, he said, could lead employees to an unintended asset allocation in which investors allocate the same percentage across all available options.
Investments
Behavioral finance also has applications concerning investment of plan funds, speakers indicated.
Ninety percent of retirement plan participants are delegators, said Gnabasik, meaning that they want to make as few investment decisions as possible. Target date funds (TDFs) are an excellent option for such participants, he suggested.
TDFs offer other advantages for them, as well, suggested Mulligan; for instance:
- limiting the range of investment returns compared to those who set their own asset allocation;
- providing higher absolute return compared to those who set their own allocation; and
- automatically adjusting asset allocation as the individual approaches retirement.
TDFs are “set up and forget about it,” Mulligan said, adding that they don’t require that participants make investments. TDFs combat inertia, Mulligan continued, adding that they are “Nice from a solution perspective.” Smith added that there are benefits to custom TDFs, but that altering a TDF’s glide path involves the work of an investment manager.
Collective investment trusts (CITs), pooled, tax-exempt investment vehicles, are available to defined benefit plans as well as defined contribution plans other than 403(b)s and 457s, and trustees are bound by fiduciary standards set forth by ERISA, Smith observed. The advantages of CITS, he said, include reduced fees relative to mutual funds, simpler disclosure requirements, transparency and mitigation of fiduciary risk. Through CITs, Smith said, “what was once only available to mega plans is now available to smaller plans.”
Dynamic QDIAs are a “nascent trend that is gathering traction,” said Smith. Through a DQDIA, a plan sponsor can elect to auto-invest a participant into different investment options over time, depending on their age or other relevant demographics, he noted. Smith said that dynamic QDIAs are designed to provide a more personalized experience to individual investors.
Behavioral finance provides insight into participants’ views on retirement income solutions, Smith indicated. He cited research in which 80% of participants said it would be helpful if their employer provided secure income options in their workplace retirement savings plan. Researchers also found that participants consider income solutions to be rational when they are framed as a way to protect their ability to spend over time; on the other hand, they found that participants consider those solutions to be a bad investment if they focus on the risk that they will not collect enough income payments in return for the purchase price.
Behavioral Finance: New Ingredient in Finance and Investment Recipe - ASPPA Net
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