KOREA CAPITAL MARKET INSTITUTE

Korea plans to implement the prior investment management designation system (hereinafter referred to as the “default option”) for retirement plans in the second half of 2022. In many overseas retirement pension markets, the default option scheme has positive effects on the post-retirement income security of plan members through high returns on plan assets. Against this backdrop, Korea has high expectations for the introduction of default options. However, it is worth noting that Japan’s default option has fallen short of expectations and the design of Korea’s default option structure is somehow different from that of other countries. Policymakers of major countries have taken into account the evidence from behavioral economics-based research when adopting default options. Under the context, this article intends to explore default options in major countries and to present some implications for the successful default option scheme. 
 
 
Behavioral economics behind default options 
 
The retirement pension scheme encourages individuals to save a certain share of their income annually for post-retirement income. Plan members generally make contributions to plan assets over their employment period of 20 to 30 years. Given that retirement plans have the nature of long-term savings, the value of retirement savings by DC plan members varies greatly depending on the types of savings or the performance of investment portfolios. Simply put, plan members’ reasonable investment strategy is of utmost importance in DC plans. But it seems complex and difficult for individuals with no experience in long-term investment for plan assets. Considering that a proper mix of stocks, bonds, funds, or alternative investment instruments is suitable for long-term investment, they may face difficulties in selecting and managing investment products. For these reasons, many DC plan members are indifferent to their investment, or reluctant to determine specific investment vehicles for plan assets. Diverse studies conducted on behavioral economics found that DC plan members were ignorant of investment or made unreasonable investment decisions due to various behavioral biases. In the 2000s, policymakers in the US and other major countries began to pay attention to this issue and decided to adopt default options¹⁾ as an institutional fix to the problem. 
 
 
Major countries’ default option scheme
 
This part covers default options introduced by the US, Sweden and Japan. 
 
The 401(k) plans, a representative retirement plan of the US, have actively embraced default options on the back of the US government’s tacit support and laws such as the 2006 Pension Protection Act. Most companies in the US have adopted a nudging approach for new employees to accept the default, opt-out and automatic enrollment features with regard to 401(k) enrollment and determination of the contribution ratio and investment products for plan assets, unless the employees choose otherwise. With this nudging system, they encourage employees to join 401(k) plans and provide support for their decision on investment portfolios. These measures have been generally applied thanks to the 2006 Pension Protection Act which aims to make it easier to enroll employees into 401(k) plans, provide qualified automatic contribution arrangements and offer a wide selection of qualified default investment alternatives (QDIA).²⁾ Under the Act, high-risk funds such as balanced funds or target date funds (TDFs) have been added to the QDIA,³⁾ which has motivated a growing number of companies to designate TDFs as a default option. According to the data released by Vanguard, TDFs account for 98% of the total default option funds as of 2019, while balanced funds, money market funds (MMFs) and stable value funds take up 1%, respectively. The rapid growth of TDFs can be attributable to the fact that since the introduction of the Pension Protection Act, employers and plan providers have been able to designate default options without concerns about legal liability and there has been a widespread perception that TDFs are suitable for long-term investment of plan assets. 
 
Sweden’s Premium Pension System (PPM) recognized the importance of default options after finding that contrary to its expectations, many plan members made irrational investment decisions. When introducing the PPM in the 2000s, the Swedish government launched a campaign to induce plan members to select funds for plan asset management on their own. Since then, it has evaluated the status of plan asset investment by plan members and investment outcomes every four to five years. The evaluation revealed that plan members generally lacked financial literacy and interest in investment and were affected by behavioral biases. Given this finding, Sweden currently recommends default option funds consisting of TDFs tailored for each generation. In the initial phase of the PPM, it respected individuals’ rational decisions but later conducted a policy shift towards providing practical support for plan members. 
 
Default options have failed to take hold in Japan, leading to a 2016 revision to the Defined Contribution Pension Act. Before the revision was made, only 15 percent of new plan members selected default options while more than 96 percent of plan sponsors designated principal-guaranteed products as a default option. Under the circumstances, the amended Defined Contribution Pension Act prescribed qualitative criteria for default options as a way of promoting the designation of investment trusts as the default option. The qualitative criteria do not specify exclusion or inclusion of a certain plan asset investment product but require the designation of products that could hedge against inflation risk and facilitate diversified investment. Although principal-guaranteed products may satisfy such criteria depending on an employee’s risk appetite, products designed for diversified investment are a more suitable tool and thus, are expected to bring about a change to the composition of default options. Additionally, the revision requires plan providers to offer information including visualized data regarding the default option management plan and the projected return after fees to help the employer and employees make a reasonable decision. Plan providers also need to inform plan members of prospects for the return on a default option, potential loss and the reason for selecting a default option. The revision also includes procedural rules for the opt-out approach that would consider plan members to have chosen a default option if they give no investment instruction within a certain time frame. This policy shift indicates that for the retirement pension scheme, Japan recognizes the importance of the default option suitable for long-term investment and the nudging strategy.   
 
  
Comparison of default option schemes and implications
 
The default option scheme introduced by Korea allows employees to obtain information regarding various default options from plan providers and designate one product as a default option. This differs from the approach adopted by other countries which does not require DC plan members to select a default option because there is only one designated default option product. Korea’s default option scheme can protect DC plan members’ right to choose by enabling them to select one from more than one designated default option product. However, this structure may undermine the default option’s intrinsic function of helping those with difficulties in choosing investment products to make better decisions. In this regard, the Korean government should closely examine problems arising from such a structure and how to improve the scheme. 
 
The US and Japan have established institutional instruments that require plan sponsors to designate default options fit for long-term investment. A case in point is the qualified default option provision of the US. As for Japan, a system has been set up to add qualitative criteria, effective information delivery regarding default options and training programs for investors. Korea should offer default option-related information and training programs to raise awareness of DC plan members about the importance of selecting a default option suitable for long-term investment. In the meantime, plan providers should design proper default options and make an investment prospectus easy to understand to guide DC plan members with a lack of interest or low financial literacy in the right direction. If this competition is sought among plan providers, the default option scheme adopted by Korea would serve as an opportunity to improve the return on DC plans.    
 

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1) The default option scheme is a sort of libertarian paternalism-based system in that it supports the management of plan assets by plan members who lack interest or face difficulties in investment by designating investment products approved by relevant authorities as a default and sometimes inducing their choice.
2) Before the 2006 Pension Protection Act took effect, only a few companies implemented default options and labor laws and regulations for the protection of workers imposed many restrictions on their selection of default options. In the early 2000s, the US government reviewed the results of behavioral economics research that found advantages of default options, based on which the Pension Protection Act was introduced.
3) The Qualified Default Investment Alternatives (QDIA) were limited to conservative products such as MMFs and bond-type stable value funds prior to the adoption of the Pension Protection Act. An employer who designates one of the QDIA as a default option could gain immunity from the plan asset management performance.