Simplifying the Investment Menu or How to Help Participants Avoid the Paradox of Choice
As human beings, we usually tend to believe that more choices are better. It gives us a feeling of comfort and more control over the outcome. However, several studies have proved the opposite – the more options we have, the less likely it is that we will select any. In the book, “The Paradox of Choice – Why More Is Less” by Barry Schwartz, he concluded that more choices generate even more anxiety.
While you may wonder what all of this has to do with your 401(k) plan, the relationship is pretty straightforward. Sheena lyengar, an expert on choice and the author of the original Jam Study, concluded that when there are more investment options available to 401(k) plan participants, fewer of them actually participate in the plan than when there are only a few options.
Although the implementation of auto-enrollment of new employees into QDIAs has helped improve participation rates, there is still a lot that plan sponsors can do to help DIY plan participants make better investment decisions.
There are a few ways plan sponsors can achieve that goal and simplify the investment menu:
1. Reduce the number of investment options offered. Most plan sponsors offer 19 investment funds on average, and think more options will provide participants with more control over investment returns. But as we already know, too many choices paralyze employees and they usually do not make the best choices. Consider having 6 to 12 funds plus a set of target-date funds. Alternatively, consider having at least one fund per asset class.
2. Create a multi-tiered investment menu.
Tier 1 - Do it for me. As the name suggest, this tier is for those participants who don’t want to make any investment decisions. Auto-enrolling or re-enrolling them into target-date or risk based funds is the best option for them.
Tier 2 - Do it with me. This tier is for participants who opted out of the default investment options, and want to build their own diversified portfolio using core options. 6-12 core investment funds will be more than enough to achieve this goal.
Tier 3 - Do it myself. Participants who would like to get access to investment options outside the plan can do so through a self-directed brokerage account (SDBA). The SDBA is not very popular among employers for one simple reason: lack of investment knowledge among participants. It is not rare to see participants chasing hot stocks, or putting all of their eggs in one basket and then seeing their account balance evaporate over time. Thus, many plan sponsors, for the safety of their participants, don’t offer SDBAs.
3. White labeling. The idea of white labeling is to reduce the number of investment options by merging them into groups identified by objective and investment strategy. Plan sponsors then create a generic name for a fund and combine single or multiple managers into that fund. By combining managers in one fund, plan sponsors are able to exercise more control and flexibility when changing managers, help participants better understand their options, and lower fees.
Single Manager/Single Strategy White Labeling
Multi-Manager/Multi Strategy While Labeling
Objective-based White Labeling
By understanding that too much choice overwhelms participants’ and doesn’t help them make good investment decisions, which leads to poor results, plan sponsors can focus on simplifying the investment menu. When it comes to the amount of investment funds, there is no doubt that less is better. Having 6 to 12 core investment options outside the set of target date funds seems to be the sweet spot.
For those participants who want to exercise more control and create custom-made investment portfolios, creating a multi-tiered investment menu structure can be a good choice. Those participants who don’t want to make any investment decisions will be automatically enrolled into target-date or risk-based funds. While DIY participants will have an option to create their investment portfolio on their own, either from core options or by utilizing a self-directed brokerage account, if the plan sponsor allows it.
Finally, white labeling simplifies the investment menu even further by creating fewer options with clearly defined investment objectives and strategies. For example, by merging existing fund options into objective-based categories that replicate employees’ age, like capital appreciation, growth and income, and income, will allow them to make decisions more easily while remaining confident that the choices they’ve made are aligned with their age and risk tolerance.