As discussed in previous articles, participant savings are undoubtedly the most critical factor in improving retirement readiness. Although less critical than savings, the return on investment is also important in helping improve participant outcomes. This article will provide a brief history of how investment menus have evolved since the 1980s, and then address some of the issues that too many investment options create for participants.
Investment Menu Evolution
In an April 2013 paper, “What’s on the Investment Menu?” the Defined Contribution Institutional Investment Association (DCIIA) provided a brief synopsis of how Defined Contribution (DC) plan investment menus have evolved from the time the number of DC plans began to increase in the 1980s until present. The typical plan in the 1980s was characterized by a limited number of institutional offerings, usually three to five. Often, a stable value fund and company stock fund were the most popular choices for participants. As the number of plans and assets held continued to grow in the 1990s, DC plans responded to pressure from their more active participants by adding many more options. It was not unusual for plans to have 30 or more offerings of retail mutual funds. Since the early 2000s, there has been a trend of investment menu simplification; however, it is still common to see plans with 20 or more offerings (not including their target date funds, if any).
Why the change? A primary driver of the simplification trend was the research coming from the field of behavioral finance. Some of this research looked at the relationship between plan participation, asset allocation decisions, and the size of plan investment menus. The results began to raise questions about the benefits of large investment menus.
So What’s Wrong With Lots of Choices?
Although the saying, “the more investment choices, the better,” seems like a no-brainer, the research by behavioral finance academics does not appear to support it. In his book, 401(k) Fiduciary Solutions, Christopher Carosa cites several articles on relevant research in this area. Two of the common conclusions from the cited research are particularly eye-opening. First, there appears to be a negative correlation between the number of fund options and the participation rate. Second, an abundance of fund choices appears to negatively impact participants’ asset allocation decisions. Neither of these results bode well for participants’ retirement readiness.
If you are someone who is interested and knowledgeable about investing or have a savvy investment advisor, then an abundance of choices may not be a bad thing. However, only a very small minority of plan participants meet this description. The “average” participant is not very sophisticated when it comes to investing. When faced with numerous choices, paralysis sets in and the employee either does not participate at all, or delays his/her participation. My own experience from talking with friends, relatives, acquaintances, and even employees of my firm (before we adopted auto enroll), confirms this phenomenon. Many people described their paralysis and indicated they just needed time to investigate the investment options.
In addition to its impact on the participation rate, the investment menu can also negatively impact allocation decisions. The larger the number of choices, moreover, the more difficult it is for the average participant to construct a properly allocated portfolio. Research has shown that more choices result in poor allocation decisions. One common allocation problem, as noted by researchers, includes overly conservative allocations (e.g. big allocations to stable value or money market options). Another one often cited is the use of simplistic allocation methods (e.g. equal allocations to all funds). Neither of these allocation methods will result in an appropriate portfolio for a participant’s retirement savings.
Having too many investment fund options can have a negative impact on your plan participation rate and the participant investment allocations. Consequently, the goal of helping participants achieve retirement readiness is hindered. As a plan sponsor, you should evaluate your plan’s investment menu to determine if it could be improved to help drive better participant outcomes.
The inclusion of target date funds in investment menus and other means of assisting participants with allocation decisions will be discussed in future articles. Click here to view more resources on this subject.