401(k) Investment Options: Less is More
There’s plenty of evidence of the unfortunate consequences for employees overwhelmed by too many investment options in their 401(k) plans. Studies find that confused employees might not join the plan at all, select investment funds that are not well diversified, or throw up their hands and put an equal amount in each fund offered by their employer. And as employers add more options, the new funds often carry higher fees and produce lower returns.
A new study took the opposite tack, examining how employees reacted when one large U.S. employer reduced the number of investment options. The results were lower fees and less turnover, saving employees an average of $9,400 over a 20-year period. Further, their new portfolios were less risky.
The employer, a non-profit organization, cut the number of investment options roughly in half, from the 90 different funds initially in the plan. The employer also simplified the plan by sorting employees’ choices into four groups:
- 13 Target Date Funds (TDFs) with low fees and investments determined by an employee’s age;
- 4 index funds invested in a money market, diversified U.S. stocks, diversified U.S. bonds, and diversified international stocks;
- 32 mutual funds organized by risk level, from small-cap growth funds and REITs to balanced funds and Treasury bond funds;
- A brokerage account with wide latitude to invest.
The researchers – Donald Keim and Olivia Mitchell at The Wharton School – analyzed the responses among those affected by the change, which was anyone who held at least one mutual fund eliminated during the plan streamlining. Those affected who did not choose replacement funds were defaulted into a TDF appropriate for their age.
The analysis, after controlling for the age, sex, income and the education of the plan participants, determined that the changes they made resulted in lower fees, participants holding fewer funds with less turnover, and less risk in their portfolios. Interestingly, allocations to stocks rose for those who were defaulted into TDFs. Stock allocations initially declined for those who picked new funds but eventually returned to their previous levels. [Minimal assets were directed into the brokerage account option.]
The researchers concluded that less is more: plan sponsors should “recognize that the length and complexity of their plan menus matter.”
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My employer offers around 20 mutual funds as investment options within our 401(k) plan. I would say 80% of my colleagues are overwhelmed by all the choices. Most have no idea what the different is between small cap and large cap, or what a REIT is. With that said, its on them (us) to investigate and research all fund options and make a decision. Not investing is not the solution. Everyone should spend some time learning about their plan options and making their best decision. At least invest in a balanced or target date fund.
A couple readers - one on Twitter and one who called me to comment after receiving the blog's weekly alert - properly pointed out that the "simplified" plan in this study still has a slew of options. It's a good point and worth noting! Perhaps the benefits to workers would've been better if the plan had been even simpler? Kim (Squared Away blogger)