401(k) Choices: Too Often, More Is Less
By Christopher Farrell
The genius of capitalism is meeting and creating consumer choice. Our grandparents didn't have anywhere near the vast number of material goods most Americans can buy just by visiting a Home Depot, a Target, a grocery store, or any shopping mall. Most of us wouldn't want to go back in time. We're glad we have ample choice among a variety of products and services so that our buying habits can reflect our individual needs, passions, and pleasures.
Still, is more choice always a good thing? Anybody trying to choose a cell-phone plan can easily get overwhelmed by the vast menu of services and pricing options. And some businesses thrive on offering limited choices. Charlie Trotter's is tops among Chicago's restaurants, and New York's Peter Lugar's is one of the best steakhouses in the country. Yet customers can choose between only two tasting menus at Trotter's, and don't bother to dine at Lugar's if you don't like steak.
In fact, a clever experiment by economists Sheena Iyengar and Mark Lepper demonstrated that customers sometimes prefer less to more. The economists set up sampling booths with either 6 or 24 flavors of jam. Substantially more customers were drawn to the vivid 24-flavor display. But a mere 3% ended up buying jam there, vs. 30% of those who stopped by the stand with only 6 flavors.
OVERWHELMED WITH OPTIONS.
Now, it's beginning to look like investors may have too much choice in their retirement savings plans. That's the conclusion of recent research by behavioral economists Shlomo Benartzi from UCLA's Anderson School of Management and Richard Thaler of the University of Chicago. (Here's a link to their report, "How Much Is Investor Autonomy Worth".)
A decade ago, most 401(k) plans offered a handful of mutual funds, say, an equity fund, a bond fund, a money-market fund, and company stock. But in recent years, plan sponsors souped-up their 401(k)s with 50, 100, 200 fund choices. Many companies even added a brokerage option for trading individual securities within their pension plan.
The trend toward more choice is international. Sweden's social security system now allows workers to invest 2.5% of their salary into 450 different funds. Britain's comparable social security plan lets employees choose from a wide range of investment vehicles.
RULES OF THUMB.
The problem is that workers, the supposed beneficiaries of these increased retirement-savings options, may well be worse off. Who hasn't been confused trying to figure out what percentage of contributions to allocate to stocks and bonds, let alone which of 10 large-cap stock funds to pick in their 401(k)?
Little wonder many workers turn to their colleagues for advice. Or they may rely on investment maxims, such as subtracting your age from 100 to decide on the right percentage of equities in your retirement portfolio. If you're 40, that would mean 60% equity and 40% bonds. Yet this simplistic rule takes only age into account and not other important factors, such as a willingness to tolerate risk and job security. Even MBAs introduced to such new-fangled finance concepts as the "efficient frontier" and "mean-variance analysis" don't seem to do much better than the ad hoc approach of the average worker.
Benartzi and Thaler devised a series of survey investigations into the portfolio choices of 410(k) participants at UCLA and at SwedishAmerican Health Systems. The basic idea was to learn whether participants preferred their own portfolios compared to an average portfolio and the median portfolio. (The average allocations are 21% cash, 7% bonds, 44% large-cap stocks, 7% international stocks, and 21% small-cap stocks. The median portfolio, based on the median level of risk, is 8% cash, 4% bonds, 50% large-cap stocks, 15% international stocks, and 23% small-cap stocks.)
In essence, 401(k) participants generally preferred the median portfolio to their own. Employees didn't seem to place a high value on being able to choose their own portfolio or, put somewhat differently, found comfort from joining the pack. Benartzi and Thaler argue that their results suggest "most participants simply do not have the skills and/or information available to pick portfolios that line up with their risk attitudes."
The study has important implications for pension-plan design. Clearly, the gains from adding more options to a 401(k) plan are limited, with a handful of well thought-out investment options preferable to hundreds of options. Plan sponsors also need to be careful in how they present their investment package. For instance, in another set of experiments, Benartzi and Thaler asked participants to choose between three different investment programs ranging from high risk to low risk. But then the scholars shuffled the options and found that people continued to choose the middle one on the assumption it was the medium-risk choice -- even though it no longer was.
The nub of the issue is that workers are human. O.K., that reads somewhat silly so baldly stated. But Daniel Kahneman of Princeton University just got one-half of the Nobel prize in economics for making just that point. Kahneman, a pioneer in the field of behavioral economics, devised a number of ingenious experiments showing how investors and consumers are intensely human: overconfident at times, fearful at others, coping with complexity by using rules of thumb, and generally befuddled by their choices in an uncertain world. People are far from the coolly rational, risk-calculating, knowledgeable homo economicus favored by mainstream economists.
The insights of behavioral economists are more than just a passing curiosity. An awareness of how much all of us rely on rules of thumb, the tug of emotions, and a cognitive preference for the middle course can make us better investors. An added bonus: Self-knowledge will help you stay focused on long-term financial planning and your own best interests.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online
Edited by Beth Belton