Simplifying Investment Choices Helps Focus Decisions

An analysis of a large U.S. nonprofit found that when the organization’s defined-contribution plan was streamlined, employees chose fewer funds, reduced their portfolio risk and lowered costs.

Both the number of investment choices and how they are presented impact an investor’s decision of funds to own. An analysis of a large U.S. nonprofit found that when the organization’s defined-contribution plan was streamlined, employees chose fewer funds, reduced their portfolio risk and lowered costs.

The plan previously included nearly 90 mutual funds in its investment menu. The organization’s investment committee then decided a simpler plan would be easier to administer, explain and rationalize. In revising the plan, the committee eliminated 39 funds and grouped the remaining funds into one of four tiers, increasing in complexity from target-date funds (Tier 1) to a brokerage-type account with access to a wide number of funds (Tier 4).

Employees who held the deleted funds reacted to the plan’s changes by significantly reducing their allocations to international, bond and stock and sector funds. They instead primarily shifted their allocations to target-date funds. In addition, these employees—relative to those who didn’t hold the deleted funds—had greater reductions in portfolio turnover, larger reductions in expense ratios and a larger decline in the number of funds held. Costs fell as well; those who previously held the deleted funds benefited from a greater reduction in expenses than those who didn’t hold the deleted funds.

Most employees do not have control over the investment options included in their workplace retirement plans. Similarly, all investors do not have control over how the information about the mutual funds and exchange-traded funds offered through their brokers is displayed. Studies on choice show, however, that decisions are easier to make when the number of options is reduced or at least simplified. To that end, there are steps individuals can take to improve their fund selection process.

The first is to have a predefined allocation plan. This will narrow the field of offerings to those funds that fit specific characteristics (e.g., large-cap stocks, bonds, etc.). The next step is to look at costs relative to a fund’s category peers. Lower expenses reduce the excess return a fund has to realize just to match its benchmark. Only then, if the choices are still close, should you consider performance.

Source: “Simplifying Choices in Defined Contribution Retirement Plan Design,” Donald Keim and Olivia Mitchell, TIAA-CREF Institute Research Dialogue, November 2015.