Deck 11: Behavioral Finance and Defined Contribution Plan Design

Question 1

What six conditions are used to qualify a fiduciary for relief from fiduciary liability when investing participant assets in default investment alternatives?

Answer 1

Individual enrolled for retirement plans under automatic enrolment, if also does not make selection among investment options available to them leads the plan sponsor to go for default investment option.
The Pension Protection Act, 2006 permits the plan sponsor to adopt default investment scheme by following all the related guidelines. The relief from any liability should be received by providing of notice to each participant and provide them with all the required information and in case of no responsive selection, sponsor may go for default investment.
Conditions to qualify for such relief are -
1. These relief guidelines involve use of investment alternatives which is known as qualified default investment alternative. The default investment must be made only in qualified default investment alternative which involves few investment options to encourage employee's savings for retirement.
2. The participant even after provided with the opportunity did not elected investment choice.
3. Notice should be given each year that is valid up to 30 days and in case of no response investment should be made.
4. All the related information about the default investment and any material relating to same should be provided to the participant.
5. It allows the participant the opportunity to transfer their invested assets in other options available.
6. It provides opportunity to the participants to make a wide variety of investment options as per the regulations of section 404(c).
These are the conditions to fulfilled by the plan sponsor to be relieved from the liability arising by investing of participants assets in default investments alternatives

Question 2

What are the five requirements for a default investment to be deemed a qualified default investment alternative?

Answer 2

Default investment refers to the option where a plan sponsor has the option to invest the contribution of the participant in any investment where the election of such decision is not made by the employee participant.
In order to get relief from liability of such investment, a plan sponsor must send a notice to each participant every year stating all the required information to them relating to the assets and investment. In case of no responses, the sponsor has the right to make default investment without any liability. This fiduciary relief involves qualifying six conditions.
The first condition involves investment of assets in only qualified default investments alternative. There are present five requirements for a qualified default investment alternative, which are-
1) Investment must not involve acquisition of employer's securities. However, holding of securities of company registered under Investment Company Act of 1940 is allowed. Similarly, employer's securities that are acquired as matching contribution from the employer or on the direction of participant employee.
2) It must not impose any financial penalties or restriction on the transfer of assets to any other form of investment alternative included in the plan.
3) It must be managed by either the investment manager as per the regulations of Employee Retirement Income Security Act of 1974 or investment company registered under Investment Company Act 1940.
4) The investment must be diversified so as to decreases the losses.
5) It should make investment in either of the three types of products, portfolio or services. These three type of investment involves-
a) Investment fund that provides long term appreciation and capital preservation through investment in mixture of equity and fixed-income alternative that is based upon attributes such as age, life expectancy, retirement etc.
b) Investment fund that includes investment in mix of equity and fixed income alternative that is consistent with the target level of risk that is proper for the whole plan.
c) Investment service where the investment manager properly allocates the assets of investment to help earn maximum income by investing in varying alternatives.
Thus, these are the requirements of a qualified default investment alternative

Question 3

Discuss what behavioral biases seem to affect an employee population participating in a defined contribution retirement plan you are familiar with, and describe prescriptive enhancements that could be made to the plan to lessen the effects of these behavioral biases.

Answer 3

The intent of this discussion question is to have the students apply their recently acquired knowledge of behavioral biases to real life situations. They should be encouraged to examine plans they have worked with, plans they are participants in, or a hypothetical situation where they can identify behavioral biases and develop a prescriptive plan enhancement to avoid the biases.

Question 4

What is behavioral finance?

Question 5

Discuss the merits of the alternative choices a plan sponsor has regarding a qualified default investment alternative and what factors should determine which one of these choices is selected.

Question 6

What are some of the key themes that have emerged in the study of behavioral economics?

Question 7

In the context of making investment decisions, distinguish between passive factors resulting in inactivity and active choices that are less than optimal.

Question 8

Discuss types of biases that result in investors being passive or inactive about investing.

Question 9

Discuss types of biases that result in investors making active choices that are less than optimal.

Question 10

How can the identification of investor biases be helpful in improving individual investor decision making?

Question 11

Has behavioral finance had an impact on employers offering defined contribution retirement plans?

Question 12

Have behavioral finance research findings had an impact on governmental policy relative to defined contribution retirement plans? Explain.

Question 13

List and explain some remedial benefit design features using behavioral finance research findings.

Question 14

How does the Pension Protection Act of 2006 (PPA) encourage plan sponsors to invest assets in a way consistent with capital preservation and/or long-term capital appreciation in the absence of participant investment direction?