Does a smaller investment menu really improve a plan?
October 24, 2019
For over a decade, “keep your investment menus compact; too many investment options will confuse participants” has been among the collection of rote sayings that are frequently repeated, often without real thought, by consultants and providers. In this case, the advice may be good, but the usual reasoning is questionable. A compact investment menu is indeed, often, a good thing, but not necessarily for the reasons most advocates provide. In this article, we look at the history of the recommendation and its current utility.
A Brief History of “Fewer is Better”
Few realize it, but the source of “fewer is better” is a study about jam. In 2000, Sheena Iyengar and Mark Lepper published a remarkable study about how the breadth of choice influences decision-making. They’d conducted an experiment on consumers in a high-end food market: one day, they presented shoppers with a display table offering 24 types of gourmet jam and a $1 coupon to any who would try a sample. Another day, they ran the trial with the same $1 coupon but displayed only 6 types of jam. Iyengar, et. al. found that the shoppers who stopped at the larger display were only 10% as likely to make a jam purchase as those who saw the smaller display – a dramatic difference in favor of confined choice.
In 2003, Iyengar and colleagues made the progression from preserves to defined contribution plans, releasing “How Much Choice is Too Much?: Contributions to 401(k) Retirement Plans”. The upshot of the extensive survey of over 700,000 employees in 647 retirement plans was this: “Our results confirm that participation in 401(k) plans is higher in plans offering a handful of funds, as compared to plans offering ten or more options.”[i]
The retirement industry took hold of the “fewer is better” headline, and the mantra was born.
BEHIND THE CURTAIN
While there may be technical issues with the 2003 study (the Department of Labor’s Clearinghouse for Labor Evaluation and Research found: “The quality of causal evidence presented in this study is low. This means we are not confident that the differences in the 401(k) participation rate were the result of the differences in the number of fund options. Other factors are likely to have contributed.”[ii]), there are two larger issues with the industry’s attitude toward the study:
Lots of people only read the headline
While the headline was simple and made intuitive sense, many people never looked at the actual results, which painted a more subtle picture:
It took a whole lot of choices to decrease enrollment meaningfully. The data showed that, for each additional option added to the menu of a 401(k) plan, participation rates decreased by roughly 0.15% to 0.20%. Doing this math, it would take ten additional options - or about one half of the average number of options offered in an average DC plan menu - to lower participation by about 2%. Any dip in participation is meaningful, but the impact of adding one or two funds could hardly be described as earthshaking.
Most fiduciaries would be unlikely to offer either the “best” (i.e., few options) or “worst” plans (i.e., many options). The study concluded that participation was highest (about 75%) among plans offering fewer than five funds. On the other side, participation dropped most dramatically (to below 70%) only after the options offered numbered in the low 30’s and fell to just over 60% when options numbered in the high 50’s.
In over 20 years of institutional retirement work, I’ve encountered only one or two sponsors who limited choice to five or fewer options and I’ve never worked with a plan that offered more than 35 options (counting target dates funds as a single choice). By now, plans at either extreme are exceedingly rare, indeed.
Things have changed
As mentioned, the DC study dates from 2003, with data from 2001. There have been some key evolutions in the defined contribution world since then:
Enrollment can be automated. In 2001, participation depended on employee initiative, driven by enthusiastic HR groups, physical mailers, and on-site workshops. Today, automatic enrollment has levered participant inertia to make incredible impacts on the rates of participation in plans where it has been implemented.
Participant investment decisions can be automated. Back in 2001, participants who did make the effort to enroll were then forced to either choose their own investment allocation or, likely, be defaulted into a stable value or money market fund. Today, the contributions of participants who don’t make an investment election are most often invested in target date funds, in generally reasonable, diversified allocations that, in theory, may never require maintenance during the participant’s working years.
Participants have access to help. In the late 1990s, I was on a team at a recordkeeper that developed one of the first “managed account” services, delivered via highly qualified advisors in the plan call center using (then) cutting edge software. The solution was well-thought-out, demonstrably effective, and is still, in an evolved form, offered today. But it was brutally difficult to get any sponsor to go along with it (though, coincidentally, I met first Vergence partner Jay Young during this effort: he was in the treasury group of one of the few sponsors that enthusiastically adopted the service). Today, managed account advisory services are commonplace, especially among larger defined contribution plans.
So, given the misapplication of the study’s headline and innovation in defined contribution, is fewer really better?
Fewer is Usually Better (but for a different set of reasons)
In most cases, offering an appropriately compact investment menu is better than offering an expansive list of choices, but participant “analysis paralysis” isn’t high on the list of reasons why. Why might fewer be better?
Very large menus don’t necessarily increase opportunities for diversification. The diversification value of an investment is based on how uncorrelated its performance is with that of other investments (colloquially, how differently the investments perform at a given time). A plan offering 30 investment options is likely offering multiple options in one or more categories, and those multiple offerings are likely to have a high correlation. Participant choice is increased by offering two large-cap value funds, but it’s unlikely that the opportunity to diversify will meaningfully increase.
Offering investments from different categories is more likely to offer opportunity for diversification, but only a confined set of investment categories are potentially appropriate for use in a DC plan menu. For perspective, Vergence Partners analyzes just over 20 investment categories on a regular basis. All those categories aren’t appropriate for every plan and categories beyond those offer limited, if any, utility in a defined contribution setting.
More options mean a greater demand on fiduciary resources. Every resource is limited, including the time of plan fiduciaries, and the effort required to monitor a plan’s investments grows arithmetically with the number of investments offered. Since comprehensive and consistent processes are the key to fiduciary success, any threat to the integrity of those processes is dangerous. Every plan option must be justified in terms of participant benefit. Options that can’t be justified in terms of participant benefit simply increase fiduciary burden, and therefore fiduciary exposure, for no good reason.
Few participant groups can effectively utilize an extensive list of options. As the number of investment options grows, the differentiation among options often decreases. For example, a plan might offer a “deep value” fund as well as a “relative value” fund, a distinction that few participants could understand much less employ effectively. In addition, “specialized” or niche investment options, even those options that offer a real diversification benefit (e.g., ex-US small cap), may occupy only a relatively small allocation in even a sophisticated institutional investor’s strategy and are often prone to misuse by less sophisticated investors.
In Conclusion
The days when references to the 2003 Iyengar DC study were relevant have been over for some time. However, the notion of fewer being better, albeit for a different set of reasons, is still a good one. Plan menus should be only as large as they need to be in order to most effectively meet the needs of each plans’ participant base. Anything more is too much and is more likely to lead to trouble for both fiduciaries and participants in the long run.
[i] Sethi-Iyengar, Sheena, et al. “How Much Choice Is Too Much? Contributions to 401(k) Retirement Plans.” Pension Design and Structure, 2004, pp. 83–96., doi:10.1093/0199273391.003.0005.
[ii] “How Much Choice Is Too Much? Contributions to 401 (k) Retirement Plans (Iyengar Et Al. 2003).” United States Department of Labor, Clearinghouse for Labor Evaluation and Research (CLEAR), Clearinghouse for Labor Evaluation and Research (CLEAR), 2014, clear.dol.gov/study/how-much-choice-too-much-contributions-401-k-retirement-plans-iyengar-et-al-2003.
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