Retirement plan fiduciaries have the important decision to make on how to design, implement, and monitor the investment lineup offered to participants. The number and what types of investment choices has long been a primary area of discussion. One of the trends we have seen has been continued consolidation of retirement plan menus. There are a variety of reasons for this including making the participant experience more approachable, decreasing fiduciary risk, and in some cases lowering costs through economies of scale. According to a recent study by Fidelity, just over the past two years 93% of Plan Sponsors have made investment menu changes and 92% have made plan design changes. So "does my retirement plan menu offer too many investment choices? (HINT: It probably does!)
Let’s step into another industry and review additional research. According to this article in the New York Times, there is a famous jam study conducted by Sheena Iyengar, professor of business at Columbia University, that is often used as the basis to decision paralysis discussions. In a California gourmet market, Professor Iyengar and her research assistants set up a booth of jam samples. They switched between offering a selection of 24 jams to a group of six jams for equal time intervals. Over the course of the study, customers tasted two jams on average, regardless of the size of the assortment, and each received a coupon good for $1 off one jam.
So what happened? Sixty percent of customers stopped to sample from the large assortment, while only 40 percent sampled the small one. But 30 percent of the people who had sampled from the small assortment ultimately purchased jam, while only 3 percent of those presented with the two dozen jams made a purchase.
If too many jam choices render consumers unable to make purchase decisions, imagine what happens when individuals are faced with retirement plan options. For plan participants who do not just opt-out entirely, another common outcome from choice overload is what is known as 1/N diversification; instead of developing a rational asset allocation, the participant divides his or her account equally across all the available choices. If your Plan has an overload of equity or stock investment choices this potentially could result in an inappropriate asset allocation through increased risk.
Too Many Choices?
While the optimal number of investment choices is debatable, too many choices can negatively impact participants for a couple of reasons. Too many options can: cause investment overlap, making it difficult for participants to meaningfully distinguish between choices, and result in choice overload, whereby participants fail to properly allocate among choices because they are overwhelmed by the options.
One of the trends we have seen has been continued consolidation of retirement plan menus. There is research linking the benefits of consolidation and beneficial outcomes. A 2016 report published by Donald Keim and Olivia Mitchell, professors from the University of Pennsylvania Wharton School, researched participant behavior as it related to investment choice decision making. The report showed that employees from a large firm altered their fund allocations when the employer streamlined their investment menu. When the Plan Sponsor eliminated nearly half of the offered investment choices, the Plan noticed significantly lower within-fund turnover rates and expense ratios. Over the long-term this can lead to significant cost savings for the participant. Too many choices can result in a poorly informed consumer and consolidation can lessen this confusion.
In 2017 Deloitte reported that 55% of Plan Sponsors were looking at simplifying their investment choices to help their participants plan for retirement. Since 2015 they noted a 13% decrease in the number of investment choices offered within retirement plans.
But, consolidating the menu plan is only one half of a two-part solution. While there may now be fewer options, there are still complex decisions to be made by plan participants who are not experts in investing. So how do you educate and guide plan participants to make the decision that is truly in their best interest?
In 2016, the team at the investment firm Manning & Napier suggested to start by identifying your participant population. They argue that participants can be categorized into two groups and from those groups an appropriate investment tier found suitable.
Group One: Consists of participants who feel comfortable making their own asset allocation decisions. For them the appropriate tier offers a spectrum of category-based investment choices from conservative to aggressive.
Group Two: Consists of participants who do not feel comfortable and experience a lack the time and expertise to make investment decisions. For them the appropriate solution is a managed account of target-date or target-risk choices.
Once your participant population is identified, one way to limit investment choices is to look at your core choices as defined as those being non- target-risk or target-date funds. Identify asset class overlap amongst these choices. This means Plan Sponsors should refrain from offering investment strategies that have very similar objectives and target outcomes. For example, rather than providing three U.S. Large Cap Stock funds, Plan Sponsors might include only one U.S. Large Cap Stock fund. The same logic would apply across other asset classes, such that each asset class is represented by one possible investment.
A possible downside to this approach is that it forces the Plan Sponsor to choose between retaining either an active fund or a passive (index) fund, but not both, for each asset class. It can also lead to a preference for blended funds, to the exclusion of style‐based funds, such as value or growth funds. Therefore, this approach might be modified to include two investments per asset class: one passive and one active, or one value and one growth.
Further simplification can be achieved by limiting or excluding non‐traditional asset classes, better known as alternative investments. Alternative investments have become popular over the past several years, as investors have searched for ways to diversify away from stocks during market downturns. However, instead of offering these additional investment choices a Self-Directed Brokerage Account (SDBA) could be considered. As SBDA allows a sophisticated participant to a larger set of investment options through a link within your retirement plan. You can dramatically reduce the number of funds within your Plan by offering a SDBA, however it can come with additional risks to the participant and possibly the Plan fiduciaries. These options can be more expensive and may not need to be monitored by the Plan Sponsor and fiduciaries.
We believe an initial look into three tiers of investment choices is prudent for most Plan Sponsors.
TIER ONE: might contain a series of target-date funds. These would allow participants who don’t have the desire or expertise to manage their own accounts, but who still want to be actively involved in selecting an appropriate choice. A target-date fund is a diversified investment that becomes more conservative as a participant approaches retirement age.
TIER TWO: might contain individual core or category-based funds that do not necessarily become more conservative over time, as target-date funds do. These choices would include both active and index funds and exist for those participants who want to take a more “hands-on” approach in their asset allocation.
TIER THREE: might be the self-directed brokerage-link (SDBL), giving more sophisticated participants an opportunity to screen their own investments, manage their asset allocations, and invest in individual stocks, bonds, or alternatives. As discussed, this choice can add additional risk for participants and the investments selected are not necessarily required to be monitored by the Plan fiduciaries.
Plan Sponsors can better meet their fiduciary obligations by implementing a tiered approach to investment choices that is thoughtfully designed to mitigate negative participant behaviors, promote useful behaviors, and steer participants toward better decisions. It is important for Plan Sponsors to look internally at their employee population and create plan menus that best suit the needs of their employee population based on their current comfort level with, and knowledge of, retirement investments. As plan participants overcome decision paralysis and become more involved in their investment decisions, they may opt to shift tiers or remain where they are based on their long-term goals.
Further discussion about this topic can be found in our ebook, Fiduciary Best Practices for Plan Menu Design .