Is an Abundance of Choices Impacting 401(k) Holders?

In the realm of investments, options are usually seen as a positive aspect. However, novel research indicates that an excessive array of choices within a 401(k) retirement plan might prove to be a costly factor for the plan participants.

Streamlining Choices Yields Positive Outcomes

Recent studies have been conducted on a 401(k)-style retirement plan that significantly reduced the number of available mutual funds. Interestingly, the research revealed that investors compelled to reposition their investments due to the removal of certain funds tended to migrate towards funds with lower fees. Remarkably, despite the downsizing of options, the range of fees for the funds after the restructuring remained nearly identical to the pre-reduction variety.

The study further highlights that this adjustment led to substantial estimated savings, averaging over $9,400 per participant over a span of 20 years, which translates to roughly $470 per year. This information was published in a report by the National Bureau of Economic Research (NBER), an institution renowned for tracking economic cycles and recessions.

READ MORE:

• Warren Buffett’s New Endeavor: Investing in Israel Bonds
• Advantages of Co-Investments as Private-Equity Capital Becomes Scarce

Understanding the Shift in Investor Behavior

Although the researchers did not possess insights into the specific reasons behind investors’ fund selections, they did offer a plausible explanation for the tendency towards lower-cost funds. The report, co-authored by Donald B. Keim and Olivia S. Mitchell, both professors at the Wharton School of the University of Pennsylvania, suggests that an excess of choices could result in confusion, leading to less informed decisions among consumers.

Furthermore, the professors noted a discernible change in the risk profiles of investors post the reduction in choices. Despite the risk levels before and after streamlining remaining almost indistinguishable, the post-reform scenario depicted a noteworthy decrease in equity holdings and overall risk exposure among the streamlined participants.

Analyzing the Process

The study focused on a prominent non-profit organization in the U.S. that initially offered participants approximately 90 investment options within their retirement plan. These choices ranged from sector-specific funds encompassing assets like real estate investment trusts and commodities, to more comprehensive stock and bond funds, and target-date funds.

In 2011, the organization, which remains anonymous, took a pivotal step by eliminating 39 investment options. Participants who were previously invested in the discontinued funds were granted the option to redirect their assets into any of the remaining funds, or alternatively, opt for a brokerage account. The latter granted access to the eliminated funds alongside additional alternatives, although this alternative was chosen by only a minority of investors. Those who didn’t make either of these selections saw their funds transferred to age-appropriate target-date funds.

The selection of funds to be eliminated was guided by a range of factors, including annual expenses, participant count, and assets invested. The retained funds represented similar asset classes to those that were removed. According to Dr. Keim, before the restructuring, there existed a substantial redundancy of choice within the same asset class, often comprising six or seven options.

Unveiling the Outcomes of Choice Restructuring

Interestingly, participants who redirected their investments to the new funds demonstrated lower overall turnover rates compared to the funds they transitioned away from. This translated to fewer trades conducted by fund managers, subsequently leading to reduced transaction costs and lower fees for the investors.

RELATED POST:

• The Impact of 2021 Super Bowl Ads on ROI
• Saudi Sovereign-Wealth Fund Acquires Stake in Royal’s Investment Firm

Balancing Choice and Guided Decision-Making

The age-old question of whether retirement plans should maximize choice for participants or adopt a more paternalistic approach of limiting options continues to be a topic of debate. In recent years, there has been a trend towards the latter, with structures designed to steer individuals towards more prudent decisions.

Regarding the NBER study, Jay Vivian, a board member of financial-services firm Rebalance IRA, reflects on the shift towards a more guided approach. Although he acknowledges that the term “paternalistic” might be a tad strong, he suggests that plan structures are now aimed at nudging participants towards more informed choices. Vivian also raises the question of whether the reported savings could potentially be overstated due to some investors who initially moved their assets to target-date funds eventually shifting to options with higher fees.

Dr. Keim, however, downplays the likelihood of such transitions, asserting that retirement-plan participants tend to maintain their asset allocation once set.

Conclusion

In conclusion, the study underscores the intricate dynamics between choice abundance, investor behavior, and the potential benefits of a more streamlined approach. While choices are integral to investment strategies, too many choices can indeed lead to confusion and suboptimal decisions, ultimately impacting investors’ financial outcomes.

https://www.wsj.com/articles/are-too-many-choices-costing-401-k-holders-1454900917