On 401(k) plans, the less choice the better

July 10, 2011

A friend who works in finance for a small business recently complained to me that few of the employees participate in his company’s 401(k) plan. Low enrollment means that the plan has relatively few assets, which in turn means higher expenses. The problem, thought my friend, was that the plan didn’t offer employees a broad enough selection of mutual funds. He wanted suggestions for additional funds that would entice more of his co-workers to sign up.

Adding more funds is precisely what he should not do. Our brains aren’t wired to choose easily among lots of options. In fact, when faced with too many choices, we punt.

In 2000, a simple experiment was conducted at a supermarket known for its extreme selection — about 250 varieties of mustard and more than 300 flavors of jam. Who doesn’t like a variety of jam? Most of us, it turns out. In the experiment, two tasting displays, one with six jams and one with 24, were set up in the store. More people stopped at the 24-jam table, but far more people who stopped at the six-jam table bought jam.

The theory: We use mental shortcuts to help us make choices, but the process gets jammed with too many options. We tend to stop when we reach a satisfactory, not optimal, choice.

The same holds true for 401(k) plans. Professors Julie Agnew and Lisa Szykman, of the College of William and Mary, conducted a study of employees grouped according to those who were less knowledgeable about investing and those who were more knowledgeable. The study found that when the number of fund choices increased, both groups were more likely to fall back on a default option. Often the default was too conservative to increase a nest egg significantly over time.

Compounding the problem is inertia, which makes us resist signing up for payroll deduction to our employer’s 401(k) plan in the first place. If we do sign up, we often stick with a bad choice.

But inertia can work to our advantage. To coax greater participation, many firms automatically enroll new hires in the 401(k) plan at a low level — say, 3 percent of their salary. Employees are given the choice to opt out, but most don’t. Studies show that automatic enrollment increases the number of people in a plan by 20 percent.

Some critics say automatic enrollment smacks of paternalism. Frank Satterthwaite, an executive with Vanguard who works with institutional clients on retirement plans, disagrees. “To me, paternalism would be I’m putting you in the plan and I’m not letting you out,” he says.

He advises his corporate clients to turn human behavior to their advantage. As behavioral studies show, we tend to make the best choices when presented with fewer options. We also tend to prefer simpler choices and to accept the first ones we’re presented with. So Satterthwaite recommends that the first choice in a 401(k) plan should be a one-stop, target-date retirement fund.

The second option should be to allow employees to choose from a half-dozen or so index funds that cover broad swaths of the market. Because asset allocation accounts for 90 percent of the return in a portfolio, both target-date retirement funds and broad index options “cover as much of the market return as possible,” Satterthwaite says. The third alternative, he says, is to let employees build their own portfolios from among a broad menu of funds.

From a behavioral standpoint, target-date funds are the best option for most people. They offer automatic rebalancing, which is vital to a healthy portfolio. And because we don’t see and can’t control the individual components of target-date funds, we’re not tempted by fear and greed to jump out of low-performing assets and rush into high-performing ones. In other words, we’re not tempted to sell low and buy high.

Frick is a senior editor at Kiplinger’s Personal Finance.

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