Since 2000, there’ve been at least five academic studies in behavioral finance that prove giving 401(k) plan participants too many choices leads to bad outcomes. Too much choice can both “demotivate” them and lead them to make poorer long-term investment decisions. In fact, a study released late last year concluded “we find that larger menus are objectively worse than smaller menus.”
Academic evidence suggests a 401(k) plan should have anywhere from three and, perhaps, nine choices. Any practitioner, however, will tell you corporate politics can often generate dozens of options. Here’s a simple way to satisfy both the ivy tower and the board room—place mutual fund options in distinct “decision-style” categories. Before they consider any investment options, have employees first identify the appropriate category they should choose from.
Let’s explore this through an example.
We’ll create four different categories, each designed for a unique decision-making style. First, we’ll separate all the “Do-It-Yourselfers” from the rest by asking all employees whether they prefer professional managers or not. If they don’t want professional management, the go into the “Do-It-Yourself” category consisting of index funds representing various asset classes. The category can have anywhere from three to 30 (or more) options. Having more choices here is less risky because these people actually want to do the research necessary to select their options.
For the remaining employees, we’ll need to gauge how much effort they want to extend in the decision- making process. The next question identifies those willing to put in the least effort. We’ll ask “Do you want to do at least a little research into your investment options?” If they say “no” they’ll be placed in a “No-Action Required” category consisting of a single option managed as if the plan were a traditional profit-sharing plan.
For those left, we’ll ask “Are you willing to put in extra effort to increase your chances to achieve your retirement goal?” If they answer “no” they will be placed in the “Lifestyle Asset Allocation” category. They’ll need to make only one simple decision: “Do they want ‘conservative,’ ‘moderate’ or ‘aggressive’ investments?” Based on this answer, they will be placed into the appropriate one of three asset allocation funds. (N.B.: There’s not enough history on Target Date Funds to determine their suitability, so a true fiduciary might be challenged to justify placing these products into a plan menu).
Finally, those employees who have not been placed into a category will go into the “Traditional Long-Term Growth” category. Here, again, they’ll be offered no more than three distinct (however the plan sponsor wants to define it) options.
There you have it. Three “yes/no” questions place a participant into the relevant category, only two of which require more research. With “fewer” choices, employees are more likely to “play the game” (i.e., save) and are let intimidated by the “tyranny of choice.” What’s more, in the end, if they don’t like the categories, any participant is still free to choose any of the options.