Financial advisors should note that expense ratios play a significant role in the acceptance of a default investment when it comes to target-date funds, according to a Morningstar report.
The likelihood of default investment acceptance in defined contribution plans rises for target-date funds that have lower expense ratios, lower levels of equity risk and higher relative performance, but it’s the expense ratio that plays the biggest part, according to a Morningstar paper from David Blanchett, head of retirement research at the firm, and Daniel Bruns, vice president of Morningstar’s product strategy.
“The expense ratio relation is notable because it suggests funds with higher expense ratios not only have a higher level of expenses to overcome to generate alpha, but they also may result in lower levels of default investment usage,” the paper notes. “This creates an additional implicit cost for participants, since those who self-direct their accounts tend to experience lower returns than those who invest in professionally managed investment options.”
The report analyzed default investment decisions of 46,439 participants across 175 plans using 18 different target-date series.
Nonetheless, financial advisors should note that default investment acceptance rates are more influenced by demographic factors, namely: age, income and account balance. The paper found that “younger participants with lower deferral rates, salaries and balances” have higher default investment acceptance rates, according to the report. Additionally, investors are more likely to accept default investments in managed accounts than in target-date funds and balanced funds, the paper notes.