This rule of thumb about 401(k) investments is wrong

More funds may be better than fewer funds

Nov 13, 2019 @ 2:07 pm

By Greg Iacurci

For years, the conventional wisdom regarding 401(k) investments was simple: Less is more.

In this line of thinking, fewer funds available to 401(k) participants meant less choice, which equated to less confusion around fund selection, less investor paralysis and ultimately, a larger number of participants saving money in their 401(k) plan.

But times have changed, and so has the rule of thumb, new research suggests. In fact, a better rule of thumb may be "more is more."

"It's a rule based on an old-fashioned [line of thinking]," David Blanchett, head of retirement research at Morningstar Investment Management, said of the prior framework. "It's the past, it's not the present."

"In 401(k)s, we're just in a different spot [than we used to be]," he added.

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Mr. Blanchett and Michael Finke, chair of economic security at The American College of Financial Services, argue in a new paper that the increased use of automatic enrollment and default investments such as target-date funds in defined-contribution plans has dramatically altered how employers and financial advisers should consider assembling a 401(k) plan's lineup of investments.

It's not that the prior rule of thumb was wrong — it's just that plan design has changed a lot over the past decade.

The researchers found that increasing the number of investment funds in a 401(k) plan from 10 to 30 provides a 0.1%, or 10 basis point, increase in total risk-adjusted returns for a defined-contribution plan. Although Mr. Blanchett and Mr. Finke don't qualify that savings in dollar terms over a participant's life, they note that it's enough to have an "economically significant impact on retirement outcomes."

"While this may not seem material, it represents a relatively easy way for plan sponsors to improve likely retirement outcomes for participants," according to the report, published Tuesday. "When it comes to core menus, 'bigger is better.'"

Previous research found that "choice overload" deterred employees from saving in their workplace retirement plan. One 2004 study — authored by academics Sheena Sethi-Iyengar, Gur Huberman and Wei Jang — found participation rates declined by more than 1.5% for every 10 additional funds in the 401(k) investment menu.

"I think the common knowledge would still be relevant if we were still in an environment without automatic enrollment and default investments," Mr. Blanchett said.

Around 61% of employers automatically enroll employees into their 401(k) plans, up from around 40% in 2008, according to the Plan Sponsor Council of America.

Nearly 71% of 401(k) plans offer a target-date fund, up from 58% a decade ago, according to PSCA. Cerulli Associates, a consulting firm, estimates that TDFs will capture four out of every five dollars contributed to a 401(k) plan by the end of 2023.

These dynamics shift the 401(k) investment rule of thumb in two significant ways, Mr. Blanchett and Mr. Finke said.

A larger investment menu causes "choice overload," nudging participants to stick with their default investment option — typically a TDF, which is often well-diversified, inexpensive and has an age-appropriate mix of stocks and bonds, which benefits participants by providing better overall portfolio quality. Acceptance of the default option increases by 0.7% for each additional fund in the 401(k) menu.

In addition, participants who choose not stay in the default investment tend to have more efficient 401(k) portfolios if they have a greater number of funds available. This is because they tend to hold more funds, and therefore have more diversified portfolios.

Risk-adjusted performance increases, on average, by 3.6 basis points for each fund included in the client portfolio, the researchers found. So, increasing a fund menu from 10 funds to 30 funds would boost risk-adjusted returns by 11 basis points for these participants.

Meshing these two benefits together creates the 10 basis points of aggregate improvement in risk-adjusted returns mentioned earlier, according to Mr. Blanchett and Mr. Finke.

This isn't to say that 401(k) plans should have dozens and dozens of investment funds — 25 to 30 is likely the ceiling, Mr. Blanchett said. (A suite of TDFs would count as one fund.)

That's also not to say a menu of 30 funds is always the best option — it isn't necessarily good, for example, if a plan has six large-growth funds.

The research findings are meant to provoke advisers and plan sponsors to ask, "Why do I only have 10 funds in the plan?" Mr. Blanchett said.

The analysis used data from more than 500 DC plans that have a total of500,000 participants and investment menus ranging from roughly 10 to 30 investment options.

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