The new research "is and isn't contradicting the conventionalwisdom," explained David Blanchett, head of retirement research atMorningstar and co-author of the new study. (Photo:Shutterstock)

For much of the past two decades, the conventional wisdom hasbeen less is more. Plan participants with limited investment knowledge can be overwhelmed by moreoptions—a phenomenon known among behavioral economists as "choiceoverload."

That can trigger paralysis, and in the worst case, scare aworker away from deferring earnings to 401(k)s.

A body of academic research backed that theory. One study,published in 2004, showed that participation rates declined by 1.5percent with every 10 investment funds added to a 401(k)s coremenu.

That was then, this is now

But new research from Morningstar is pushing back on thatconventional wisdom, and in fact shows that with investment menus,bigger is actually better for participation rates and investmentoutcomes.

Morningstar culled data from 500 retirement plans withinvestment menus ranging from 10 to 30 investment options.

Selection of the default investment option increased by 0.7percent for each additional fund in a menu, suggesting that moreoptions—and choice overload–have the effect of motivating savers totarget-date funds and other QDIAs.

The new research "is and isn't contradicting the conventionalwisdom," explained David Blanchett, head of retirement research atMorningstar and co-author of the new study.

On the one hand, the assumption that leaner menus mitigatechoice overload is not necessarily being challenged. On the otherhand, bigger menus may create choice overload, but in a positiveway that nudges savers to TDFs.

But the larger point that Blanchett underscores is that theresearch that supported smaller menus was published before thePension Protection Act of 2006, which introduced TDFs and otherQDIAs that would come to revolutionize 401(k) plans.

"The relevancy of that research is kind of gone," saidBlanchett. "It's a very different world today than it was a decadeago because of the Pension Protection Act."

Strengthening the core

Automatic enrollment and default investments have maderetirement investing less frightening for the typical 401(k)investor.

Still, the core investment menu plays a critical role, even inthe age of default investing.

"The question is how do you utilize the core menu to helpparticipants reach the best outcomes," said Blanchett.

Beyond the influence of menu size on default investing,Morningstar's paper also explores how more menu options impactself-directed savers who don't use default options.

When more options are offered, self-directed savers hold morefunds, construct more efficient portfolios, and ultimately, makemore money, the research found.

The average number of holdings is 4.4 in a menu with 10 options.The average is 8.6 holdings in a menu with 30 options.

Risk-adjusted performance increased on average by 3.6 basispoints for each fund included in a portfolio. Put another way,increasing a menu from 10 funds to 30 funds resulted in anestimated increase of 11 basis points in self-directedaccounts.

"The research suggests both default and self-directed investorsare better off with more options," said Blanchett.

The impact of larger menus on default investors could vary byrecordkeeper—some may have more thorough education andcommunication campaigns that make an impact on decisions to choosedefault investments.

But for self-directed investors, Morningstar's research leaveslittle room for doubt.

"I am certain it leads to more efficient portfolios forself-directed investors," said Blanchett.

Ancillary benefits

To Blanchett, most savers are better served with the defaultinvesting. But some will invariably want to construct their ownportfolios.

"There are ancillary benefits to having larger menus. The onething I don't want people to say is 'I left the 401(k) becausethere were not enough investment options'," said Blanchett. "Most401(k)s are well run—there has to be a fiduciary somewhere, whichis not the case with IRAs."

While bigger may be better, as Morningstar's paper suggests,sponsors still have to be mindful of which funds they select.Despite a decade of migration to passive investing, standaloneofferings in 401(k)s are often, if not typically, activelymanaged.

And simply expanding a menu with duplicative options won't servesavers well.

"Don't include eight large growth funds," said Blanchett. "Justcover the universe of options. Give someone the ability to selectfrom all the different asset classes. If you do that, there is noway someone can claim they can't build a well-diversified portfoliowithin a defined contribution plan."

Retirement plans rarely exceed 30 options, says Blanchett. Someconsultants recommend as few as five options.

And some plans may benefits from smaller menus—perhaps theworkforce is young, and largely defaulted into TDFs. But in typicalplans, at least 15 options should be considered to achieve optimaldefault participation and outcomes for self-directed investors,says Blanchet.

"Everyone that thinks about optimal menu size needs toacknowledge the role menus play for participants today, which is asecondary role," he added. "Using a really smart default option,that's the most important thing."

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