Want to make your 401(k) plan clients happier?
Consider offering to help them set up plans that offer employees less choice.
If you are new to the retirement savings market you might think that, all other things being equal, a longer menu of investment options is better than a shorter menu, but advisors who survived the recent downturn may tell you a different story.
During the late 1990s, it seemed as if every plan sponsor was under pressure to add more investment options to the 401(k) plan. A vocal minority of plan participants asked why they couldn’t have this or that growth fund with an annual return of more than 100%, or why couldn’t they buy any of the tech stocks with equally astronomical returns.
Many of these employees were the highest earners (and the highest-placed executives), so sponsors responded by adding new funds and self-directed brokerage options that gave participants access to many mutual funds as well as to individual stocks and bonds.
When choosing appropriate investments for a plan, sponsors have an obligation as fiduciaries to provide a suitable array of investments while limiting the liability of the plan sponsor for possible investment losses within the accounts. For the most part, plan sponsors attempt to meet these obligations by complying with Section 404(c) of the Employee Retirement Income Security Act of 1974, which generally provides sponsors with relief from potential liability as long as the plan fulfills a number of requirements. The requirements include:
- Offering a broad range of diversified investment options.
- Allowing regular transfers between the offerings.
- Disclosing these options.
- Providing plan participants and beneficiaries with extensive plan information.
Although plans are not required to comply with the regulations under Section 404(c), sponsors should have thorough discussions about ERISA investment guideline compliance with their tax and legal advisors.
Although compliance with Section 404(c) could be accomplished with as few as 3 well-diversified investment options, most providers offered at least 8 to 12 options as part of their standard offerings throughout most of the 1990s, with increased menus available as dictated by demand.
However, as many plans added investment options, they often didn’t add much in terms of diversification because many of the “hot” funds of the era were of a similar nature. Although investors may have owned 4 different funds, they weren’t particularly well diversified if all 4 were large-cap growth funds with a technology focus.
Of course, this point was reinforced during the market downturn when each of these funds dropped in an equally dramatic fashion, another example that more isn’t necessarily better. Likewise, self-directed brokerage accounts allowed investors access to the high-flying individual stocks of the day, sometimes just in time to feel the pain at the end of the “irrational exuberance” era.
Lost in the frenzy to expand investment options within a plan was the possibility that increased investment options could actually have a negative impact on participation in that plan. Columbia University Assistant Professor Sheena Iyengar has concluded in a recent study that “choice overload” may cause plan participation rates to fall. Rather than investigating a long menu of investment options, employee who feel overwhelmed by the number of options might choose not to participate at all.
The responsibility of the plan sponsor is to strike a balance between offering a well-constructed lineup of diversified investment offerings without burdening the participants with an excessive degree of options. To fulfill this responsibility, many employers are turning to diversified “lifestyle” or “asset allocation” investment options. This type of investment usually bundles 4 to 12 separate investments into 3 or 4 investment options to address the various risk-return profiles of participants within the plan. These investments allow participants to select a single, simply-named investment option, such as an aggressive, moderate or conservative portfolio, which serves as a diversified investment vehicle in and of itself.
Plan sponsors can further simplify the investment selection process for the plan participants by pairing the asset allocation portfolios with a risk-assessment questionnaire. Plan participants may answer 5 to 10 questions about topics such as length of time till retirement and reactions to hypothetical investment scenarios. The answers can help match portfolios with participants’ risk profiles. Advisors can use the answers to guide discussions with participants who have mixed feelings about investment risk.
Most sponsors who choose the asset allocation options will still want to offer 6 to 10 investment alternatives that represent each of the major debt and equity asset classes. The individual fund options can help more sophisticated investors fine tune their asset allocation models.
is president of MFS retirement Services Inc., Boston, a unit of Sun Life Financial Inc., Toronto.
Reproduced from National Underwriter Edition, October 14, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.