Over the last several weeks, we've spilled a lot of pixels on various characteristics and (especially)shortcomings of typical defined-contribution retirement plans. Last night we ran across an excellent source on these and other matters: Stephen Rosenberg's "Boston ERISA & Insurance Litigation Blog."
One post that caught our attention describes recent research on plan design and participant behavior. After describing one paper that integrates concepts of design as a non-neutral plan characteristic, "choice architecture," and investor decision-making, Rosenberg turns to an important paper (SSRN subscription or payment required) by Jeffrey Brown and Scott Weisbenner of the University of Illinois and Nellie Liang of the Federal Reserve. Though we mentioned this research in a September discussion of index funds in 401(k) plans, Rosenberg extracts a few additional details that remind us how dysfunctional participant-directed plans can be.
Here's the abstract from Brown, et al.:
This paper examines how the menu of investment options made available to workers in defined contribution plans influences portfolio choice. Using unique panel data of 401(k) plans in the U.S., we present three principle findings. First, we show that the share of investment options in a particular asset class (i.e., company stock, equities, fixed income, and balanced funds) has a significant effect on aggregate participant portfolio allocations across these asset classes. Second, we document that the vast majority of the new funds added to 401(k) plans are high-cost actively managed equity funds, as opposed to lower-cost equity index funds. Third, because the average share of assets invested in low-cost equity index funds declines with an increase in the number of options, average portfolio expenses increase and average portfolio performance is thus depressed. All of these findings are obtained from a panel data set, enabling us to control for heterogeneity in the investment preferences of workers across firms and across time.
The notion of "improving" plans by adding more--and more expensive--options is truly backward. That said, however, what Brown and his colleagues find is that overall asset allocation is in part a function of the number of choices in each asset class. So if a plan has, say, ten domestic equity funds and two international options, participants will tilt strongly toward domestic equities.
As we've noted before, the best plans encourage employees to choose among a small set of fully diversified, pension-caliber portfolios. Short of that minimalist design, plan sponsors--and let's not forget their advisors in the financial services industry--should consider the potential effects of plan design on participant behavior by eliminating as many counterproductive features as they can.
As suggested by the authors of the first paper mentioned by Rosenberg (among them behavioral finance luminary Richard Thaler), there is no neutral design. There's no perfect design, either. But there are more and less helpful designs, and plan fiduciaries should work hard to push their plans toward the more helpful end of the design continuum.