To Save Wisely for Retirement, Sometimes Less Choice Is Best
Choice is good — up to a point. After that, too many options are just too confusing, or take too much work to bother with. An embarrassment of riches can make the outcome worse, not better.
This is what’s happened to many 401(k)s, 403(b)s and other “defined contribution” retirement savings plans found in the workplace. At some point, the employer’s well-meant effort to let employees tailor their accounts to their own needs may be overdoing it.
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“What we’ve seen for a long time is that the choice menu for 401(k) plans has been growing more and more complex,” says Olivia S. Mitchell, professor of business economics and public policy at Wharton. “Many companies have hundreds of fund choices on their menus.”
Offering more options would seem to make a plan more appealing, helping to retain workers and attract new ones, and providers like mutual fund companies have made it easy to add options. Why not include a gold fund or foreign bond fund if it’s easy to do? Some employees, at some point, may want it. “Since it often seemed like a simple thing to add, frequently that was just done,” Mitchell says.
But what are the unintended consequences? Over the years, research has shown that “choice itself can be demotivating,” keeping workers on the sidelines, or discouraging them from managing their accounts wisely, Mitchell says.
Because defined contribution plans (DCs) like 401(k)s have largely taken the place of old-fashioned pensions, or defined-benefit plans (DBs), the federal government has been pressing employers to be clearer about plan options and expenses — a goal that becomes harder when choices are too numerous.
“It’s come to a head recently because of various cases where expenses were brought to light or made more salient,” Mitchell explains. Investment results suffer when fees are too high, and employees are more likely to stumble into high-fee funds when having too many options discourages doing proper homework.
So how can employees benefit if a plan is streamlined and better organized?
To find out, Mitchell and Wharton finance professor Donald B. Keim looked at what happened when employers streamlined their plans. The findings are described in the paper “Simplifying Choices in Defined Contribution Retirement Plan Design.”
“The choice menu for 401(k) plans has been growing more and more complex.”–Olivia S. Mitchell
“What we did,” Mitchell explains, “was to get participants’ contributions and asset allocations before and after the change.” Decreasing a blizzard of options to a more manageable list reduced participants’ self-defeating buying and selling, cut the expenses the average participant paid and, in typical cases, could increase the size of the account over a 20-year period by $9,400 per participant, Keim and Mitchell found.
Moreover, participants’ portfolios were less risky after streamlining than before.
A Tiered Approach
The study looked at the DC plan of a large, unnamed U.S. nonprofit institution that had offered nearly 90 mutual funds in its investment menu, ranging from ordinary stock mutual funds to target-date funds, bond index funds, real estate investment trusts, commodity funds and sector funds. The organization decided this menu was too complex and eliminated 39 funds, offering the remaining funds in four tiers, each more sophisticated than the one before. The new lineup took effect in October 2012.
Tier 1, the default for participants who did not make choices on their own, contained 13 low-fee target-date funds (TDFs). A target-date fund, aimed at the investor’s expected retirement date, contains a mix of stock and bond mutual funds considered appropriate for an investor of a given age. When the retirement date is many years away, the fund emphasizes stocks, opting for growth. As the retirement date approaches, holdings gradually emphasize bonds, for safety. A TDF is a fire-and-forget investment that requires little attention from the plan participant.
Tier 2, for investors who wanted to decide for themselves how to divide their holdings to balance risk and potential returns, contained four index-style mutual funds: a money-market fund, a U.S. stock fund, a U.S. bond fund, and an international stock fund.
Tier 3, for investors inclined to more elaborate strategies, had 32 funds divided into various risk categories and offering a full range of investing options.
Tier 4, for the true hands-on investor, was a brokerage account that allowed the participant to choose from among just about any type of investment in the market, including the 39 funds that had been trimmed from the plan.
Keim and Mitchell were granted access to employee data on participation and contribution rates, investments chosen and account balances, plus data on participants’ ages, sex, education and assumed household income based on zip code.
The 4,609 participants were first divided into two groups: a “streamlined” group that had owned the funds removed from the plan, and a “non-streamlined” group that had not held those funds. (About 20% of the nearly $1 billion in the plan had been in the 39 eliminated funds.)
“The streamlining reform had a larger impact on low-income savers, making their portfolios better balanced and less risky than before.”
The streamlined group was further divided into a “plan-defaulted and streamlined group,” which ended up in the Tier 1 default funds for those who took no action, and a “not-plan-defaulted and streamlined” group that had opted to take control by using Tiers 2, 3 or 4.
The non-streamlined group — those who had not held the 39 eliminated funds — left their holdings “virtually unchanged” after the streamlining, the study found. Those employees were able to continue holding the funds they had chosen before the plan was changed. “Because these participants were not directly affected by the elimination of funds from the lineup, their persistence in the surviving funds refutes the idea that the reorganization and tiering of the surviving funds might have affected all participants’ behavior,” Keim and Mitchell write.
The results were very different for employees forced to make changes by the streamlining.
“Both types of streamlined participants significantly reduced allocations to stock sector and international funds, and they shifted contributions mainly to TDFs,” Keim and Mitchell write. The shift was more pronounced for participants who ended up in TDFs by default, since they went from a hodgepodge of holdings to the funds designed for investors their age. Though these investors took no direct action, they were not necessarily passive: Since they could have picked other holdings but didn’t, many presumably were content with the defaults.
Those who were not defaulted put 2% of their holdings into the new brokerage option, perhaps to stay in the funds removed from the plan.
Better Balance, Less Risky
In looking at the participants by income level, Keim and Mitchell found no significant investment changes in the non-streamlined group, regardless of income. But there were income-related differences in investment choices within the streamlined group, especially among those put into the default funds. Most significant was a large shift out of stock funds and into TDFs by low-income members of the defaulted group.
“In other words, the streamlining reform had a larger impact on low-income savers, making their portfolios better balanced and less risky than before,” Keim and Mitchell write.
They found additional benefits to the streamlined group as well. Compared to the participants not affected by the fund cutback, the streamlined group ended up with funds that had less portfolio turnover, and they had bigger reductions in fund expenses and bigger reductions in the number of funds held by the typical participant. These benefits were even bigger for the non-defaulted group. The combination of lower fees and lower turnover, which incurs transaction costs for the fund, produced savings which could compound into $9,400 in extra investment returns over 20 years for the typical participant, Keim and Mitchell calculated.
The fact that very few participants chose the wide-open brokerage option indicates that employees are content with a plan that has fewer, simpler choices.
Though there are many elements to the study’s findings, they boil down to a conclusion that simplifying a defined contribution plan can benefit employees by nudging them toward choices with lower fees and transaction costs, and encouraging a more prudent balance between expected returns and safety. The fact that very few participants chose the wide-open brokerage option indicates that employees are content with a plan that has fewer, simpler choices, presented in a format that is easier to understand.
What’s the ideal number of funds for a workplace plan? “That’s a tough one because it depends a lot on participants’ situations,” Mitchell says. A single participant could be well served by choosing between three to five funds, so a plan offering 90 funds or more is probably overdoing it, she says.
Many plans, she says, now include target-date funds, especially in the default used for employees who don’t choose a portfolio blend for themselves. A company with workers of all ages might offer 10 target-date funds, but for each employee the choice would be simple: just the fund suited to his or her age.
A company can satisfy employees inclined to manage their accounts more actively by offering the brokerage option, which allows investing in just about anything, Mitchell says. That would enable the firm to keep the ordinary list of options short enough to avoid confusion.