401(k) Best Practice Series Part 1: Simplify the Investment Decision
“An expert is someone who has succeeded in making decisions and judgments simpler through knowing what to pay attention to and what to ignore.”
— Edward de Bono
It makes academic and intuitive sense: the easier your 401(k) plan is to navigate, the more enthusiastically plan participants will get on board. Happily, a simplified investment offering can also be among the best ways for participants to steer toward a successful retirement, while minimizing your personal liability and administrative overhead as the plan sponsor. How do you create this level of simplicity? Three words: Professionally managed portfolios.
Professionally Managed Portfolios: How It Works
Too often participants are left confused by plans that offering a hodge-podge of fund choices, with little guidance on how to choose which funds meet their needs. Participants end up arbitrarily picking funds that fail to reflect their goals and circumstances. Or lacking confidence, they fail to choose at all, sitting in cash and losing out on available market returns.
A better way is to hire an investment professional to construct a set of model portfolios that resembles the pie charts seen on our website.
Suddenly, the decision-making shifts from expecting participants to craft and maintain their own properly diversified portfolios, to selecting from a handful of professionally designed models that will provide and maintain that portfolio for them. Not only is that less overwhelming for the average participant, it’s likely to improve their investment outcomes.
Incidentally, at a glance, professionally managed portfolios may resemble target date funds (TDFs), but they are different in important ways. A TDF assumes all participants need their money on or starting on a certain date, so it locks in investment allocations based on age rather than personal circumstances. Professionally managed portfolios offer simple decision-making, but with increased flexibility to meet real-life needs.
Why Simplicity Counts
There’s a reason the adage, “less is more” is so popular: It’s so often true. Several academic studies have explored the relationship between the number of options available to plan participants and their success as investors. For example:
A study published in the 2008 Journal of Consumer Affairs offered a group of participants between 3 and 21 mutual funds from which to invest in a 401(k) plan. For less-knowledgeable investors, a larger selection caused them to allocate more of their assets to riskier holdings, which could cause them to take on more risk than intended.
In her 2011 book, “The Art of Choosing,” Columbia University Professor Sheena Iyengar presented a body of evidence she and colleagues had compiled over the years. Among the findings, she described how too many choices in a 401(k) plan played against investors in two ways: it discouraged participation to begin with, and it led to worse decisions by those who did participate.
A study published in the August 2012 Journal of Marketing Research found that increasing the number of fund selections in a plan tilted participants toward selecting a few funds (presumably somewhat at random) and simply spreading their assets evenly across them. When both fund selection and asset allocation were relatively arbitrary choices, participants lost out on achieving a well-tailored solution for meeting their particular needs.
These and other analyses indicate that most participants – particularly those with less investment experience – can fare better when they are offered a menu of model portfolios. This provides them with a short-list of simplified investment choices, each of which offers a diversified portfolio to suit varying needs.
This isn’t to say that the investment line-up should only offer models. For meeting the needs of participants who have increased investment acumen or a personal advisor guiding their selections, plan sponsors should also offer individual funds representing all major asset classes … but with a strong tilt toward encouraging most participants to use the model portfolios.
Professional Portfolios Call for Professional Advice
Even a short menu of well-managed choices will only get you so far. It’s still important for participants to choose the right selection(s) for themselves and their families. It’s equally important they feel confident that they’ve made a good choice, so they stick with their long-term plans through changeable markets. This provides the perfect segue to our next 401(k) best-practice post: offering individual investment consultation.
Alliant Wealth Advisors is located in Prince William, Virginia. To learn more, visit www.alliantwealthadvisors.com.