While giving consumers the maximum amount of choice might seem like an effective strategy, a new research report suggests doing that in defined contribution retirement savings plan may actually backfire on a plan sponsor.

In fact, a lengthy laundry list of plan investment options may actually drive people away from joining their employer sponsored DC plan, according to the report Can There Be Too Much Choice In a Retirement Savings Plan, from The Vanguard Center for Retirement Research. According to the Vanguard study, after controlling for variables such employer match, participant demographics and others, each additional 10 investment choices on average cuts employee participation rates by 2%. A copy of the study is available at http://institutional.vanguard.com/pdf/vcrr_choice.pdf.

“In retirement savings plans, as with consumer decision making generally, an increasing number of options obviously comes at some cost,” wrote Vanguard researchers Gary Mottola and Stephen Utkus. “More choice means more information to digest and more comparisons to make; more choice demands more subtle decision making skills and additional expertise to differentiate among the available options. In short, more choice can mean greater confusion and complexity.”

While many consumers are extremely familiar with various kinds of cars and go through the experience of buying several vehicles during their lives, the report said most participants don’t bring that array of skills to selecting mutual fund investment options. “Brand familiarity is generally a weak guide to purchase behavior, both because an employer has preselected the investment brands and because the decision must be made using the risk-and-return characteristics of a specific fund,” Mottola and Utkus wrote. “Most workers come to the decision making process with limited experience purchasing mutual funds or without the technical knowledge needed to make an informed choice.”

The research reported that an analysis of DC plans recordkept at Vanguard showed that participation rates go down as the number of fund options goes up – after controlling for other variables. For example, a participant in a DC plan with five funds had a predicted participation rate of 72%, while one with 35 fund options had a predicted participation rate of 67.5%. The trend holds for plans with as many as 60 options, the report said.

The report said the typical DC fund at Vanguard offers 15 investment options - up from a dozen in 1999. In 2002, nearly 60% of Vanguard's recordkeeping plans offered more than 10 funds. At the same time, the typical participant is only in three options while more than four out of 10 particpants are only in one or two funds, the report said.

Plan Sponsor Lessons

The Vanguard report said the finding has specific lessons for plan sponsors:

Piling on investment options may do little more than cause participant overload and reduce the participation rate. “One practical conclusion to draw from this research is that investment menus must be streamlined for the majority of workers,” Mottola and Utkus wrote. “A menu with 10 choices is likely to be superior to one with 20 or 30 if one of the (sponsor’s) goals is to maximize participation. Certainly, the practice of presenting a laundry list of investment options – with 25, 50 or 100 different funds – would seem ill-advised.”

One option for sponsors to consider is to present to participants a tiered fund menu with a limited number of “core” choices with fund communications focused primarily on those choices. Sponsors could also select 10 basic fund options and present the rest of the fund universe as an extensive fund window or self-directed brokerage option, the Vanguard report said.

“The notion of the worker as a highly informed, motivated financial decision maker seeking ever-increasing financial choices seems at odds with the current research,” Mottola and Utkus wrote. “Far from shifting all choices to the worker, the plan sponsor must plan an important role in assuming that decision making is streamlined and that critical choices are presented in a form that is easy for employees to comprehend.”

Fred Schneyer
editors@plansponsor.com