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.
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.
