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

That can trigger paralysis, and in the worst case, scare a worker 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 1.5 percent with every 10 investment funds added to a 401(k)s core menu.

That was then, this is now

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

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

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

The new research "is and isn't contradicting the conventional wisdom," explained David Blanchett, head of retirement research at Morningstar and co-author of the new study.

On the one hand, the assumption that leaner menus mitigate choice overload is not necessarily being challenged. On the other hand, bigger menus may create choice overload, but in a positive way that nudges savers to TDFs.

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

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

Strengthening the core

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

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

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

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

When more options are offered, self-directed savers hold more funds, construct more efficient portfolios, and ultimately, make more 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 basis points for each fund included in a portfolio. Put another way, increasing a menu from 10 funds to 30 funds resulted in an estimated increase of 11 basis points in self-directed accounts.

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

The impact of larger menus on default investors could vary by recordkeeper—some may have more thorough education and communication campaigns that make an impact on decisions to choose default investments.

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

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

Ancillary benefits

To Blanchett, most savers are better served with the default investing. But some will invariably want to construct their own portfolios.

"There are ancillary benefits to having larger menus. The one thing I don't want people to say is 'I left the 401(k) because there were not enough investment options'," said Blanchett. "Most 401(k)s are well run—there has to be a fiduciary somewhere, which is 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, standalone offerings in 401(k)s are often, if not typically, actively managed.

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

"Don't include eight large growth funds," said Blanchett. "Just cover the universe of options. Give someone the ability to select from all the different asset classes. If you do that, there is no way someone can claim they can't build a well-diversified portfolio within a defined contribution plan."

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

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

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

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