Investment Strategy

09/18/03 - When It Comes To 401(k) Choices Less Is More Part I

By: Investor Solutions, Inc.

Conventional wisdom suggests that offering more investment choices in a retirement plan is a boon for plan participants. In fact, a recent study from Columbia University supports the contrary. More than $100 billion evaporated from 401(k) accounts in 2002! Without proper education and guidance, retirement plan participants may potentially sabotage their future savings. That makes choosing the right investments even more critical as people try to rebuild their portfolios.

In portfolio construction, diversification is key. But having too many choices hinders the participants' ability to build effective portfolios. Too many choices often result in over diversification, sub optimal returns, investment overlap, concentrated positions and additional costs. Retirement plan participants often lack the knowledge or experience to know the difference, and having too many choices augments the problem.

The Columbia University study found that 401(k) participation is higher when employees are offered fewer fund choices. In plans that give workers only two investment options, 75 percent of workers sign up for their 401(k) plans. When given 60 investment choices, enrollment stagnated at 60 percent. And every additional 10 investment choices, on average, reduces expected participation rates by 2 percent.

Even worse, when employees are confronted with an overload of choices, a "familiarity effect" develops. This results in participants choosing their employer's stock over other funds in the plan because they feel they understand it better. The debacles of Enron and WorldCom confirmed the dangers of owning company stock. The lesson learned - don't own company stock! Some plan sponsors are responding to this research and to the fiduciary risks associated with company stock, by easing plan restrictions on company stock, a process long overdue.

This research on investor decision-making creates important implications for the design of retirement savings plans. Investment menus in corporate plans should be streamlined with 10-12 choices (not 50) for the mainstream employees, and (I say this reluctantly) offer a self-directed option for only the most sophisticated participants. Preferably, no plan should offer company stock as a choice. But, limiting the number of funds does not have to mean less diversification.

Improving the quality, not quantity of funds will drastically improve a participant's chance of investment success. Employers should replace redundant funds with more diverse offerings. Your employer has a legal obligation to "do the right thing". Plan sponsors retain a fiduciary responsibility to act with loyalty and prudence, to diversify plan assets, and act in accordance with plan documents. After Enron (et al) the Department of Labor has been hammering down on employers (plan sponsors) that are not in compliance, or fail to offer appropriate choices and participant education.

The days of plan sponsors cobbling together a bunch of funds and then walking away from the plan are long gone. Unless employers commit to regular investment education for employees, retirement accounts will continue to shrivel. Investment education is a key component of a successful plan.

For many Americans, 401k plans are often their biggest retirement asset. If your account values continue to vanish, retirement will be a distant dream. You have no other choice but to become actively involved in your financial success. The onus is on participants to make informed investment decisions and employers to provide superior, not just quantity, choices. Get involved; it's your money!

Our next segment will discuss how to select appropriate investment choices in your retirement plan.