We live in a world of almost unlimited choices thanks to online shopping which might seem to be a good thing. But when it comes to investments in a defined contribution (DC) plan like a 401k or 403b, too much choice can cause severe harm to investors as shown in a Wharton study of a large $1 billion DC plan for a not for profit organization.
In their paper “Simplifying Choices in Defined Contribution Retirement Plan Design” Wharton professors Olivia Mitchell and Donald Keim divided the almost 5,000 workers allowing half to choose from the plans 90 investments while putting the other half into four tiers. The results were telling. Simplified investment menus made a difference.
Of those that were allowed to remain in the plan’s 90 investments, very few made any changes. The others were given a choice of four tiers:
- Index target date funds (TDFs), which was the default
- A choice of:
- 4 index funds
- Money Market
- US stock and bond funds
- International Bond
- 32 funds
- Brokerage window
Most people defaulted into the TDFs which meant lower fees and less turnover; only 2% opted to use the brokerage window.
So what’s the optimal? UCLA Professor Shlomo Benartzi in his seminal book “Save More Tomorrow” suggests three tiers with TDFs or professionally managed investments as the default, seven to nine funds for dabblers and a brokerage window for the rest. There’s also a concept called choice architecture where participants are asked if they want their money managed by a professional. If yes, all the money goes into that fund which is usually a TDF or managed account. If not, investors get to design their own portfolio and, for those that want optimal choice, usually 1-2%, a brokerage window is used.
While easier to manage, the real benefit of aa streamlined investment menu is better outcomes and greater participation.
