Financial advisers — and plan sponsors — could help investors the most by taking a page from Costco: Offer fewer choices at lower cost.
The takeaway: Providing lots of options isn't in the best interests of most investors, according to
a paper co-authored by Ray Sin, a behavioral scientist at Morningstar Inc. (His co-authors are Ryan Murphy, the head of decision sciences at
Morningstar, and Angela Fontes and Mark Lush of NORC at the University of Chicago.)
The problem: Many retirement plans offer a number of similar investment options that have widely different costs. And retail investors seem remarkably unaware of the
costs of those investments.
"That's one of the puzzles," Mr. Sin said. "If you read the news for the past several months, you'd note the general decline of fees. The question is, is it because investors are more savvy, or because institutional players are pushing down the fees?"
The answer doesn't seem to be that investors are more savvy, Mr. Sin and his colleagues said.
"We see a hint of this issue when we look at the money flowing into investments that are identical except for cost," the authors noted. "For example, investments like
Invesco S&P 500 Index C (SPICX) have positive net inflows, despite having an expense ratio of 1.31% and even though the nearly identical (in terms of performance and holdings) Schwab S&P 500 Index (SWPPX) has an expense ratio of 0.03%"
To prove the thesis that retail investors are relatively unaware of fees, the authors surveyed 3,622 participants drawn from the AmeriSpeak panel fielded by NORC, a social research organization at the University of Chicago. They asked members to allocate $10,000 among three index funds, which were identical except that one had an expense ratio of 0.40%, another had an expense ratio of 0.09% and the third had an expense ratio of 0.04%.
One group was asked to put all their money in one of the three options. About 47% chose the cheapest one.
The other group was asked to allocate among the three funds. On average, they put 27% in the most expensive fund, 31% in the midpriced option and 42% in the cheapest option. In short, those surveyed were an example of
naïve diversification, in which investors split their money evenly among the options available. In this case, that tendency would have hurt their returns.
"It's more common than generally thought," Mr. Sin said. "We went through our database of retirement plans for 2016 and found multiple options for near-identical investments at different price points."
People often invested in the highest-priced funds, presumably because they wanted to diversify. But people who resorted to naïve diversification paid about four times more in fees than those who chose the cheapest option.
"This has a real impact on people's lives," Mr. Sin said.
The best solution for most retirement plans, then, would be to take a page from Costco, which offers a selection of low-cost choices to shoppers.
"Advisors and fund providers can curate their menus to help real people make smart decisions, even when they feel hurried, overwhelmed, and unsure," the authors said.
Advisers and the financial services industry can help investors by keeping bad products out of retirement lineups, limiting the number of alternatives and reducing the costs.
