We've written repeatedly on the shortcomings of the typical 401(k) plan, most of which reflect the malignant presence of non-fiduciary practices in a category of financial services defined by fiduciary principles. (Previous topics include the high and hidden costs of many 401(k) plans, a full accounting of 401(k) costs, recent research on the 401(k) universe, investor decision-making in retirement plans, the regulatory definition of default investment options, and exchange-traded funds (ETFs) in defined contribution plans).
Here's another problem that affects far too many plans: Choice overload. As Chris Taylor wrote in HR Magazine in late 2003, academic research has demonstrated that the availability of too many investment options makes it more difficult for plan participants not just to choose wisely but in many cases to choose at all.
Here's a key excerpt from Taylor's article, which draws on research published by Columbia University's Sheena Iyengar and her colleagues:
"There's a phenomenon called 'choice overload,'" says [Iyengar], who studies how employees allocate their retirement funds. "They get nervous about it and just don't know where to put their money."
Using reams of data from the Vanguard Group, a major mutual fund company in Valley Forge, Pa., Iyengar has been figuring out how employees decide whether to participate and, if so, how to allocate those investments. Some of her findings: When there are only two fund options in a 401(k) plan, 75 percent of eligible employees participate. When the number of options rises to as many as 10, participation gradually slips to about 70 percent. When there are 10 to 30 choices, the participation rate remains stable at 70 percent, and as the number rises from 30 to as many as 60 options, participation steadily declines. "People feel like they have an obligation to choose the very best fund, but they don't have the time or feel they have the expertise to identify the best one," says Iyengar.
Even those who do participate can get a little hamstrung by too many choices. They may be many years away from retirement, for example, and thus not at a stage where they should be avoiding most risk in their investment decisions, but suddenly they shy away from stocks. "The more options they're given, the more likely they are to choose a safe asset like money-market funds," says Iyengar. "As a function of the extra choices, they tend to become risk-averse."
Taylor goes on to cite examples of companies that pared their retirement plan menus, though one of those examples still left a pretty long menu: Ford Motor Company trimmed its list from 61 mutual funds to 44 (!).
Iyengar, et al., summarize their argument this way:
The very act of making a choice from an excessive number of options might result in "choice overload," in turn lessening both the motivation to choose and the subsequent motivation to commit to a choice.
We think Iyengar's research is hugely important, but for us, its primary implication is not that 401(k) sponsors should just trim their mutual fund menus and leave the rest of the structural elements of the typical participant-directed plan in place. Instead, the basic model needs more fundamental overhaul, one that improves the probability of participant success by ensuring a high-quality investment discipline in the context of a defined-contribution plan.
Think about the dilemmas presented by the menu-trimming process in a typical plan. How exactly should sponsors (and the financial services salespeople who advise them) decide which funds to jettison and which to keep? On the basis of recent performance, keeping the strong performers and eliminating the weaker ones? That may seem like a plausible approach, but research indicates that outperforming funds don't tend to stay that way, so keeping the strongest recent performers might not be helpful to plan participants. But then keeping underperforming funds and eliminating the stronger ones isn't particularly defensible either.*
What other decision rules might apply? Low expenses would be a good place to start. Favoring passive alternatives over actively managed funds would be another serviceable approach, one that help eliminate the choice-paralyzing uncertainty that flows from investors' desire to "pick the best one" in a given category.
But even those prudent moves would leave one significant problem: Participants would still be expected to cobble together sensible, suitable portfolios of funds...and would be left vulnerable to the many (primarily emotional) pitfalls of self-directed investing (e.g., performance-chasing, inadequate diversification, capitulating to short-term market stress, &c.). Indeed, a plan that featured only very inexpensive index funds, and only one in each major asset class, would still expose participants to the too-common impulse to chase the hottest asset class.
We think the 401(k) plans of the future (and better yet, the present) should feature a small number of high-quality, low-cost, fully diversified investment options (i.e., balanced portfolios of index funds or ETFs). Such plans would be consistent with Iyengar's important research on "choice overload." More importantly, they'd be consistent with ERISA's core fiduciary principles.
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*We've seen some research indicating that the underperformance of funds that trail their benchmarks by wide margins is more likely to persist that is the outperformance of funds that beat their benchmarks by wide margins. Lagging badly, in other words, is a relatively durable trait of mutual funds. So choosing recent laggards on the expectation of "reversion to the mean" would tend to be just as unwise as one might instinctively expect.
Sources
Chris Taylor, "The Fewer the Better," HR Magazine, December, 2003
Sheena Sethi-Iyengar, Gur Huberman, and Wei Jiang, "How Much Choice is Too Much? Contributions to 401(k) Retirement Plans," in Mitchell, O.S. & Utkus, S. (Editors), Pension Design and Structure: New Lessons from Behavioral Finance, Oxford University Press, 2004
