Why too many 401k choices can be a bad thing
Limit investment options to boost performance and participation rates
Have you ever stood in a grocery store aisle, unsure which of a dozen brands of spaghetti sauce to buy? Americans are confronted with a similarly dizzying array of choices when it comes to mutual funds in their 401(k) plans.
On the surface, it would appear that consumers benefit from being able to choose from dozens of salad dressings — or thousands of mutual funds. All of this freedom of choice almost feels like a fundamental right.
But research suggests that too many choices can lead to decision paralysis: When confronted with so many choices, individuals would rather make no choice than risk making a “bad” one. In his widely-watch TED Talk, Psychologist Barry Schwartz says choice has made us not freer but more paralyzed, not happier but more dissatisfied.
Nowhere are the consequences of “choice overload” more compelling than with business retirement plans.
In their study, “How Much Choice Is Too Much?” Columbia Business School professors Sheena Iyengar, Wei Jiang and Gur Huberman analyzed data from nearly 800,000 employees in 647 plans. They found that employee participation in 401(k) plans showed significant drops when comparing participation rates in plans offering 10 or more options with plans offering a handful of funds. Every additional 10 investment choices, on average, reduced participation by 2 percent.
In other words, the more funds that were offered in a company 401(k), the lower the participation rate among employees.
For business owners and their employees, these findings lead to a fundamental question: How many options should a plan sponsor offer in a 401k plan?
Instead of loading up on the number of mutual funds in their retirement plans, a growing number of Colorado businesses are taking a different approach. They are scrapping the traditional core fund lineup and only offering professionally managed models that participants are defaulted into by risk profile or age.
The focus on professionally managed models is not new. Traditional pension plans have always been managed by professional asset managers. But by eliminating the ability for participants to select their own mix of mutual fund in their 401(k)s – and too often selecting a basket of non-diversified funds – plan sponsors are bringing the best of 401(k)s and defined benefit plans together. In the end, this approach is more likely to help employees achieve their goal of successfully investing and saving for retirement.
And while participant choice may be limited, professional management clearly improves the likelihood that employees will earn consistent returns over time through proper asset allocation, which accounts for more than 93 percent of portfolio returns.
Taking asset allocation decisions out of the hands of participants will greatly benefit young workers with no equity exposure, individuals nearing retirement who have never re-balanced their portfolio and just about everybody in between.
In many cases, model allocations are yielding results. A study of retirement plan participants in plans serviced by John Hancock Retirement Plan Services found that those who invested exclusively in a single asset allocation portfolio earned better returns on average than participants who selected individual investment options to form their portfolios — by an average of 106 basis points (1.06%) annually over 15 years. The survey was conducted by Burgess Management & Research Inc.
By partnering with asset managers, business owners can create innovative solutions that address individual retirement needs. Low-cost, risk-based asset allocation models, managed by professionals, are crucial components of defined-contribution plans designed for participant success — and they help plan sponsors be better stewards of their employees' retirement future.