Should an investment default option be based on fund fees?

Luigi Zingales of Chicago’s Booth School of Business has a new comprehensive paper on securities regulation. In it, he proposes a default rule for unsophisticated investors in 401(k) plans with an eye toward management costs.

A more delicate topic is whether to take a more paternalistic view toward investors who seem to behave in an uninformed or irrational way. At the very least, there is a strong case to apply some version of the “libertarian paternalism” à la Thaler and Sustein (2003), by introducing default options that favor low-cost indexed funds. For example, it could be required that every 401(k) plan contains at least one low-cost index fund, which should be the default option for investors, unless they specify otherwise.

It is true that most investors ignore the cost of management fees, but this perspective on default rules is unique since default rule discussions have typically focused on the underlying diversification and riskiness of assets.

Hat tip: Mostly Economics.

3 Responses to “Should an investment default option be based on fund fees?”

  1. Illuminatus Says:

    So in life we should always as default rule only sell the cheapest product? We should have as few choices as possible?

    I myself invest in my Swedish 401k, Premium Pension Authority (PPM), account, the privatized social security of Sweden. I invest only in Emerging or Frontier Markets. Growth in the long term, pensions is plus 25 years, is going to come from Frontier Markets becoming Emerging Markets and after that mature markets as EU, US and Japan.

    I lost 50 % of my savings in this market correction. BUT because of my long term risk view I still have a annualized return of 6 %, only 2 % of all PPM savers have a higher annualized return. ( PPM started in 1999)

    So the default option for most pensions savers should be 100 % Frontier and Emerging Markets, using the philosophy behind Nudge. A broad index fund in the Euro zone or US is a sure loose situation. Your costs might be low but your return will be far lower, maybe as much as 1/1 to 1/4 lower.

    In my opinion the lower income you have the less money you can save, the more risk you must take. BUT over a 25-50 year period as most pension plans are set up maximum risk is in fact low risk.

    People are not irrational, the are rational. They just do not want to spend time and learn stuff they do not care about.

  2. john Says:

    whether or not people are rational is irrelevant. they are ill informed and don’t have the time to become as educated on these issues.

    The right thing is to default into low cost index-based balanced funds, letting participants choose their risk tolerance (or picking it for them based on age). This requires a limited amount of education and training.

    The alternative favors the investment advisors only. Ultimately this is a public policy issue. What price capitalism?

  3. Illuminatus Says:

    I can agree on that low cost funds should be a default oprion BUT the default option for people younger than 35 shoudl be 100 % Frontier?Emerging Markets.

    My own research in Sweden 15 years ago showed that cost is between 10-30 % of your investment but returns way in with 70-90 %. So the selection of risl level, return potential is 7 to 9 times more important than costs. A basic principle is that you should always focus on the most important issue in investment it is returns.

    To set a default option only focusing on costs and then selecting broad index funds is a disaster. It is then better to have no option at all.

    The problem with default option and libertarian paternalism is that somebody has to make the selction. In the Swedish system 2 default funds were set up and neither performs well nor do they have an adequate investment profile, especially not for individuals that are young or are expecting to have a low income in the future.

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