The case for taking 401(k)s out of employees’ hands

Like in the grocery store aisle, Americans are confronted with a dizzying array of choices when it comes to mutual funds.

On the surface, it would appear consumers benefit from being able to choose from dozens of salad dressings — or thousands of mutual funds.

But research suggests that too many choices can lead to decision paralysis: When confronted with so many choices, individuals would rather make no choice than risk making a “bad” one.

Nowhere are the consequences of “choice overload” more compelling than with 401(k) plans. In their still influential 2004 study, “How Much Choice Is Too Much?” Columbia Business School professors Sheena Iyengar, Wei Jiang and Gur Huberman studied data from nearly 800,000 employees of 647 plans in 69 industries in the year 2001, obtained from the Vanguard Center for Retirement Research.

They found that employee participation in 401(k) plans showed significant drops when comparing participation rates in plans offering 10 or more options with plans offering a handful of funds. In other words, the more funds offered, the lower the participation rate.

FUNDAMENTAL QUESTION

These findings lead to a fundamental question: How many options should a plan sponsor offer in a 401k plan?

The answer may be to scrap the traditional core fund lineup and only offer professionally managed models that participants are defaulted into by risk profile or age. By eliminating the ability for participants to select their own mix of non-diversified funds, plan sponsors and advisers are taking the stance that investment management should be left in the hands of professionals — exactly the same way defined-benefit programs operate.

While participant choice may be limited, professional management clearly improves the likelihood that employees will earn consistent returns over time through proper asset allocation, which accounts for more than 93% of portfolio returns. Taking asset allocation decisions out of the hands of participants will greatly benefit young workers with no equity exposure, individuals nearing retirement who have never re-balanced their portfolio and just about everybody in between.

Not surprisingly, model allocations are yielding results. A study of participants in qualified plans serviced by John Hancock Retirement Plan Services found that those who invested exclusively in a single asset allocation portfolio earned better returns on average than participants who selected individual investment options to form their portfolios — by an average of 106 basis points (1.06%) annually over 15 years. The survey was conducted by Burgess Management & Research Inc.

Other crucial components of participant success — auto-enrollment and auto-escalation programs — are surprisingly popular among employees. Again, the idea of taking away choice from participants seems counterintuitive, yet studies show that support among those who remained in the plan is close to universal, and even a large majority of employees who opted out of automatic enrollment also approve of the automatic enrollment feature. Strong employee support makes including these 401(k) features an effective tool to retain valued employees and recruit new talent.

Automatic enrollment is making a significant impact in participation rates, according to recent research by index-fund giant Vanguard Group Inc. on investor trends in 401(k) plans and other defined-contribution plans it administers. Plans with automatic enrollment had an overall participation rate of 82%, compared with a participation rate of 65% for employees who joined through voluntary enrollment, according to Vanguard.

Automatic enrollment and automatic escalation may also enable senior executives and more highly paid employees to save more for retirement by improving the company’s performance under the 401(k) non-discrimination tests. Higher rates of participation among moderate- and lower-income workers is a key factor in allowing higher paid managers to save more.

INNOVATIVE SOLUTIONS

By partnering with plan sponsors, retirement plan advisers can create innovative solutions that address individual retirement needs. Low-cost, risk-based asset allocation models and automatic enrollment are two crucial components of defined-contribution plans designed for participant success — and they help plan sponsors be better stewards of their employees’ retirement future.

Tom Gonnella is executive vice president of Lincoln Trust Co., a 401(k) administrator for businesses and retirement plan advisers.

Related Topics: Retirement Plans