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The Fiduciary Focus Blog

3 Savvy Ways to Improve your 401(k) Investment Menu Design

Benjamin Smith, CFA 21 December, 2016


Today, the average 401(k) retirement plan relies heavily on  the non-expert decisions of plan participants, who  typically have no formal financial training. Because they     lack financial expertise, participants often find their  retirement plans daunting or confusing, leading them to  exhibit irrational and counter productive behaviors. For  example, many under-contribute or neglect to make  proactive investment choices. Others make proactive  choices, but they are the wrong choices.

Therefore, participants need help making good  investment decisions. Under ERISA, this responsibility  falls to employers. Any employer who sponsors a  defined contribution plan must also act as a fiduciary,  meaning they must structure and administer the plan  for the exclusive benefit of participants. This includes  ensuring that investment choices are prudent and  diversified. So what are 3 savvy ways  to improve your 401(k)  investment menu design?

1. Reduce Participant Choice Overload by Simplifying the Plan Menu

Research has shown that, for every 10 additional  investment choices, plan participation drops by 2%. Therefore, choice overload risks alienating  employees for whom the path of least resistance (non-participation) is more favorable than is wading through  a list of investment options. In addition, as more choices  are made available, participants tend to reduce stock  allocations . This means participants risk  diminished returns, because stocks have historically  been one of the highest performing asset classes over  the long term .

If you want to read more about  successful investment menu design in  retirement plans,  download our free  Fiduciary  Best Practices for Retirement Plan Menu Design   eBook   from the button below.
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2. Structure the Plan Menu to Mitigate Performance Chasing

Despite disclosures clearly stating that past  performance is no guarantee of future results,  participants tend to gravitate toward recent winners.  This is because they attribute recent outperformance to  manager skill and assume it will continue into the future.   This is what is known as the hot-hand  fallacy.  

Performance chasing can be reduced or eliminated in a  variety of ways. One possible solution would be to,  again, limit the number of investment choices such that  each asset class is represented by only one investment.  This would eliminate the possibility of performance  chasing within asset classes.   As for mitigating performance chasing between asset  classes, plan sponsors should consider supplementing  the plan menu with a series of asset allocation funds,  such as target-date  funds. Target-date  funds rebalance over time in order to reduce  investment risk as the target retirement date nears.

3. Using Guardrails to Steer Participants toward Appropriate Choices

Finally, it is known that participants have poorly defined  preferences, meaning they can be influenced to select  certain investments based simply on how those  investments are juxtaposed or presented in plan  materials. For example, during periods of  strong stock performance, participants might shy away  from bond funds if the returns for those funds are  presented next to the returns for stock funds.  Fortunately, plan sponsors can turn this potential  liability into a positive opportunity, by incorporating an  emerging best practice known as categorization.  Categorization divides the entire plan menu, both core  funds and asset allocation funds, into three or more  categories, each of which is designed to appeal to a  specific type of participant.

Is this clear? Now, there are other questions that are vital to improving 401(k) & 403(b)  investment menu design. We hope this blog post provides you   a solid framework you can follow if you're just getting started or if you're concerned about what you may be missing.  If you want to read more on this topic, feel free to download our free  Fiduciary  Best Practices for Retirement Plan Menu Design   eBook   here.  

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Topics: Retirement Plan Menu Design, Investments, Healthcare