Testimony by Behavioral Research Associates at June 18th SEC/DOL Hearing on Target-Date Funds

Presented by
Jodi DiCenzo and Michael Liersch
Behavioral Research Associates, LLC
June 18, 2009

Hello. My name is Jodi DiCenzo. My colleague, Michael Liersch and I, represent Behavioral Research Associates, an applied behavioral research firm that specializes in savings and investing decision-making behaviors.

We are pleased to having the opportunity to be here today to discuss three things:

     1. Workers’ misperceptions about target-date funds from our survey of 250 American workers. Behavioral Research
         Associates is one of the only organizations to have conducted research that explores how well
         American workers understand target-date funds.
     2. Potential psychological explanations for what might be causing the observed misperceptions.
     3. The importance of these perceptual problems, particularly in an environment of automatic enrollment, and
          suggest that empirical behavioral research inform future regulatory efforts, should there be any.

Our comments should not be construed as a criticism of target-date funds. In fact, they go a long way in overcoming behavioral obstacles such as inertia and irrational asset allocation.

Workers’ Misperceptions
In March of this year, we conducted an online survey of 250 American workers to better understand their perceptions of target-date funds. Our respondent group is representative of the U.S. population and our methodology was based on standard research protocols.

Prior to asking workers specific questions about target-date funds, we provided them with typical descriptions of target-date funds compiled from actual marketing materials of the top three target-date fund providers.

The survey results include:

61% of people say that target-date funds make some type of promise, which at a 95% confidence level is a statistical majority.

When asked to describe the promise that target-date funds make, nearly 70% of respondents perceive a promise that does not in fact exist. Here’s a sample of what some American workers think the funds promise:

     • “Funds at the time of retirement.”
     • “Secure investment with minimal risk.”
     • “It’s like a guaranteed return on investment even when the market bottoms out.”
     • “A comfortable retirement.”

     • Over 60% of employees say that investing in target-date funds means they will be able to retire on the
        target date.
     • 38% think target-date funds offer a guaranteed return.
     • 30% of workers think they can save less money and still meet their retirement goals if they invest in a
        target-date fund.

Worse yet, when workers ranked five tasks based on their importance to their overall retirement planning, selecting a savings rate, arguably the most critical determinant of retirement success, was ranked first by the fewest number of people. Only 8% of people say it is the most important aspect of their overall retirement planning.

And what about how workers perceive the risk of target-date funds?

     • Over 23% of workers believe that there is little to no chance that they will lose money either before or after the
        target date.
     • 41% think there is little to no chance of losing money in any one-year period, and
     • 70% think they are equally as likely or less likely to lose money in any one-year period, as compared to investing
        in money market funds.

These results are consistent with another survey conducted by Janus. Their survey found that 19% of target-date fund investors believe that the fund guarantees them a certain level of income once they retire. This percentage skyrocketed for investors whose primary source of advice was their employer (56%) and those who relied on friends, family and co-workers (39%).

What Might Explain These Findings?

Although more research is necessary to determine probable psychological explanations, we offer three potential ones. Michael will be happy to further discuss each of these during the question and answer period.

Excessive Optimism. Humans tend to be tirelessly optimistic. Examples abound. It’s why more than a majority of people think they will be better than typical.

Framing Effects. How these funds are framed may fit into a particular schema or mental framework, of investors. For example, the framing may set expectations that the fund will somehow solve general retirement planning issues, rather than just asset allocation issues. These mental frameworks may be so powerful that people will remember what they expect, not what they are told. For example, researchers have found that when people expected books to be in a graduate research office, about a third recalled seeing books in that office, even when there were none. Similarly, how target-date funds are framed may create expectations that the funds make various promises related to retirement readiness on the target date– even when no such promises exist – which will cause people recall those non-existent promises as having been made.

Attention, Salience, and Focusing Illusions. The focus on the investment simplicity of target-date funds and the target date itself may cause people to misperceive them as a superior retirement solution along many dimensions. Psychological research shows that attention to particular features matter, and influences how people will feel. For example, research has found that Midwesterners think they will have more life satisfaction in California because they focus too heavily on the California climate, which exaggerates their perceptions of how much good weather will impact their happiness. In fact, the good weather has far less impact than people think, and, as it turns out, Californians and Midwesterners have similar levels of life satisfaction. Similarly, increased attention to and salience of the target date may cause people to overweight the funds’ ability to address their overall retirement planning needs.

What Might the Future Hold If This Problem is Not Addressed?

When do these working Americans find out that target-date funds do not promise retirement readiness? The day they retire?

How can we drive home the message that how much you save is of critical importance?

Until we can answer these questions, many American workers are investing in false hope. Absent change, we are knowingly accepting that a significant percentage of American workers believe in some sort of target-date fund magic: They believe that the funds offer retirement readiness on the target date and a guaranteed return. These beliefs are not simply naïve and harmless, they are detrimental to the financial well being of hundreds thousands of Americans.

How Can It Be Addressed?
Regulation offers at least two alternatives: disclosure and product restrictions. Let me be clear that we are not suggesting one over the other or even either, for that matter. We are merely suggesting that as you move forward, continued behavioral research may offer valuable insight on what may be effective.

Understanding perceptions is just the first step of this work. Empirical research must illuminate effective methods to improve understanding and behavior. We can hear smart people weigh in all day on what might work, but until we empirically test these ideas to evaluate their behavioral impact, it is all just conjecture. Our actions must be based on rigorous empirical evidence.

A Growing Number of Passive Investors
As you consider ways to address the issue, remember that many target-date fund investors have not been actively engaged in the decision to invest in them; they have been automatically enrolled into them. There are a growing number of passive target-date fund investors as a result of the increasing popularity of automatic enrollment.

Many workers believe in target-date fund magic, and we have a growing number of passive target-date fund investors. As you move forward, consider the research finding that people view default choices as implicit advice. Implicit advice.

In every decision context, there is a default choice. What implicit advice will you provide the American worker and what behavioral evidence will it be based on?

Thank you.