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Ice-cream lovers know the decision-making dilemma with a Baskin-Robbins menu: There are so many flavors that somewhere between rum raisin and mocha almond fudge it becomes almost impossible to choose one. Sometimes it comes down to risk-free vanilla.
It turns out the same principle applies to 401(k) plans. According to a growing body of academic research, if employees are deluged with too many mutual fund choices, it all becomes too much for them to handle. They can become prematurely risk-averse or unable to choose among 401(k) fund offerings, reverting instead to “plain vanilla” investing decisions—or not joining up at all.
To help employees make informed choices about their retirement planning options and, in particular, their 401(k) funds, HR professionals and benefit managers must provide them financial education. (See “Helping Employees Work Their 401(k)s,” in the June 2003 issue of HR Magazine.) In some instances, helping employees make good decisions may call for reducing, not increasing, their 401(k) fund options.
“There’s a phenomenon called ‘choice overload,’ ” says Sheena Iyengar, an associate professor of management at Columbia University’s business school who studies how employees allocate their retirement funds. “They get nervous about it and just don’t know where to put their money.”
Using reams of data from the Vanguard Group, a major mutual fund company in Valley Forge, Pa., Iyengar has been figuring out how employees decide whether to participate and, if so, how to allocate those investments. Some of her findings: When there are only two fund options in a 401(k) plan, 75 percent of eligible employees participate. When the number of options rises to as many as 10, participation gradually slips to about 70 percent. When there are 10 to 30 choices, the participation rate remains stable at 70 percent, and as the number rises from 30 to as many as 60 options, participation steadily declines. “People feel like they have an obligation to choose the very best fund, but they don’t have the time or feel they have the expertise to identify the best one,” says Iyengar.
Even those who do participate can get a little hamstrung by too many choices. They may be many years away from retirement, for example, and thus not at a stage where they should be avoiding most risk in their investment decisions, but suddenly they shy away from stocks. “The more options they’re given, the more likely they are to choose a safe asset like money-market funds,” says Iyengar. “As a function of the extra choices, they tend to become risk-averse.”
To be sure, factors other than the sheer number of funds can have a bearing on participation in 401(k) plans. “So many powerful things affect savings rates,” says Stephen Utkus, a principal at Vanguard’s Center for Retirement Research and an author of papers based on the research at Columbia. “There’s age, income, whether they have any other savings plans—and, of course, a company match.” In fact, Utkus says, a company match of the employee’s 401(k) contributions, especially a dollar-for-dollar match, is a sure way to generate participation.
But the number of fund choices has an effect too, as Columbia’s Iyengar and her colleagues Gur Huberman and Wei Jiang have discovered. Says Utkus: “We were surprised there was such a strong link.”
Let the Pruning Begin
Now, the link between number of 401(k) fund offerings and levels of participation—long suspected by financial planners and more recently documented by academic researchers—is taking hold among HR professionals and benefit plan managers. As they become wary of choice overload, they are cutting back—both to make decisions easier for employees and to eliminate duplication of funds that offer essentially the same investment mix.
Reducing fund options reflects a major shift in retirement plan managers’ psychology. During the boom years of the late 1990s, conventional wisdom held that more choices made for a better retirement plan. In fact, since 1978, according to the Profit Sharing/401(k) Council of America (PSCA) in Chicago, the average number of fund choices has been rising—to more than 15 per plan last year, up from just two options 25 years ago.
But that trend may be reversed, says the PSCA’s president, David Wray. “It’s harder to make sense of large groups,” Wray says. “Picking the best object out of a million objects, for instance, is impossible. So there’s a point at which it’s overwhelming, and employees just throw up their hands.”
What’s the optimal number of funds to offer employees?
“If you have a highly sophisticated workforce, you might want to have 25-30 funds in your plan,” says Deanna Miller, vice president of education at CIGNA Retirement & Investment Services in Hartford, Conn. “If your workforce is less sophisticated, that may be too many choices.”
Says Wray: “Most people can handle seven choices, plus or minus three. Once you get to 10, you begin to challenge some participants.”
Slimming down a menu of 401(k) offerings means, of course, that some fund choices are going to be tossed overboard. The leading candidates, according to Wray, are funds that concentrate on specific industry sectors. They offer the chance for high returns but also come with relatively high risk. When you’re offering only 10 or 15 funds, the semiconductor or biotech sectors probably won’t make the cut. “Sector funds have never been all that popular in 401(k)s anyway,” Wray says. “So if there’s going to be some streamlining, clearly the number of sector funds might be reduced.”
You can also take the occasion to get rid of your underperforming funds, the ones that have consistently done poorly against their category peers.
Moreover, if you slim down the number of your 401(k) offerings, you might be able to negotiate a reduction in the fees you pay to your plan provider.
Redesigning the Menu
Ford Motor Co. in Dearborn, Mich., had 61 funds in its 401(k) plan when it sought advice on reducing fund overload from Chicago-based investment-research giant Morningstar Inc. in 2001. “We re-examined our portfolio and made changes to eliminate the redundancies,” says Ford spokeswoman Anne Marie Gattari.
Patrick Reinkemeyer, president of Morningstar’s Institutional Investment Consulting division, surveyed Ford’s employee base—its demographics and employees’ education levels, for example—before figuring out the right fund lineup for its workers.
Reinkemeyer notes that Ford’s fund offerings were cut by almost one-third, to 44. “There’s some clutter and confusion in what some companies have been offering, like five different large-cap growth funds,” Reinkemeyer says, referring to funds invested in large companies with high earnings-growth potential. “So with Ford, we got rid of some of that overlap—but actually increased the number of asset classes represented.”
Among other companies that have been trimming their 401(k) offerings is Sierra Pacific Resources, the Reno-based parent company of two Nevada utilities. When Jose Montalvo became the company’s benefits manager this year, he concluded that its 401(k) program needed some changes.
“It’s a question of not just participation but the ability of individuals to understand their investments and make intelligent choices,” Montalvo says. “While we had 55 funds, people were only investing in a few,” he says. “And those few were not a good allocation; people were very poorly diversified.”
Many of Sierra Pacific’s funds were duplicative in investment type, and there were some holes in the lineup: There were almost no international fund choices, and there was a scarcity of small-cap and mid-cap value funds—those invested in low-priced stocks of small and midsize companies.
So Sierra Pacific’s plan administrators boosted the “core” holdings from 11 to 18, which included a thorough mix of different investing styles and asset classes—from large-cap to small-cap, from active management to passive. The rest of the 55 were tossed. Employees who prefer to have a huge range of funds from which to choose, however, can opt for a “brokerage value account,” which enables them to direct their investments into options outside the core 18—indeed, anywhere they wish. (The company bears no fiduciary responsibility for the account.)
Montalvo hopes the recently approved revision of Sierra Pacific’s 401(k) fund lineup will reverse the decline in plan participation. In fact, he is already budgeting for more participants and higher employee-contribution rates (and company matches) across the board.
Sierra Pacific’s offerings, with a base of core holdings, is one example of the tiered approach—starting with simple-to-understand holdings that most employees prefer while also providing a wider fund selection for sophisticated investors. “First, you might offer employees a simple choice, like three funds—say equity, bond and stable-value,” says Wray. “The second tier could be more complex, maybe 10 funds. The third tier might have 30 or 40, so those who want lots of choices get lots.”
The key is to avoid throwing all of them at employees right off the bat. Instead of being shown a laundry list that appears to give all funds the same weight, all employees would be directed to the core set of funds. “Then the more-sophisticated investors would have to go and actively seek out the additional choices.”
Tailoring the Choices
Helping employees make smart 401(k) fund choices can involve not only streamlining the offerings but also aligning them with each employee’s investing needs. That, in turn, can require determining first the level of employees’ investing savvy. The results may indicate a need for increased education, such as materials and courses aimed at boosting 401(k) participants’ financial IQ.
At Sierra Pacific, plan participants fill out questionnaires designed to indicate their risk tolerance. The company also seeks to educate employees who haven’t signed up for the 401(k) plan. They receive personal letters outlining what they could be contributing, what the company match would be, and what that would mean for them in retirement income down the road. “It shows that if they’re not participating, they’re giving all this up,” says Montalvo.
One way to bring fund choices into line with employees’ individual needs is to design suggested portfolios for them, as is done at Sierra Pacific.
For example, for an investor who indicates on the questionnaire that he or she is fairly aggressive, the plan might suggest an allocation heavily weighted toward stocks; the higher-volatility choices among stock-fund offerings would be designated as such in both the plan’s literature and in each fund’s prospectus. A less-adventurous investor, on the other hand, would have more assets funneled into bonds or money-market funds.
The employee is then spared the possibly intimidating task of having to sort through all the individual funds, since the allocations can be automatic.
Another means of helping employees achieve investment balance that’s right for their career stage is the so-called lifestyle fund. Based on an employee’s target retirement date, the fund spreads assets among stocks, bonds and cash, and it shifts that allocation toward more-conservative weighting as the employee gets closer to retirement. “There’s more automatic rebalancing or managing of portfolios, so employees don’t have to actively manage the allocation,” says CIGNA’s Miller. “That’s where the trend is headed.”
The Problems of Plentitude
The dynamics of decision-making—particularly the effects of too many choices—can be observed in far more activities than investing, researcher Iyengar has found. In a study she did before turning to the retirement planning world, she set up two tables of jams in a gourmet supermarket in Menlo Park, Calif., to study shoppers’ buying habits. One table had six selections, the other offered 24. Although more people stopped at the table with greater selection, only 3 percent bought a jar of jam, while at the table with fewer selections, 30 percent made a purchase.
When shaping 401(k) programs, Iyengar says, “it might not make sense to create large menus of options if employees aren’t going to take advantage of them. I think we will see some streamlining.”
Chris Taylor is a staff writer for SmartMoney magazine.
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