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(From the June 7, 2004 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
During the bull market of the late 1990s many 401(k) plan sponsors rushed to add new investment options to their plans, and some even introduced brokerage windows so participants could have maximum flexibility to invest their retirement savings. But new research published by the Center for Retirement Research at Boston College indicates fewer investment choices may be better for plan participants, including those with above average financial knowledge. The findings by Professors Julie Agnew and Lisa R. Szykman, both of the William and Mary School of Business Administration, are important because they provide additional evidence of the significant role plan design can play in participants' investment behavior.
How Many Investment Options Do 401(k) Plans Offer?
According to Deloitte Consulting's 2003 Annual 401(k) Benchmarking Survey, 401(k) plans offer an average of 13 investment options, up from slightly less than 10 in 2000. (Of course, it is not unusual to find plans with many more investment options, sometimes numbering in the hundreds.) Furthermore, 10 percent of 401(k) plans in 2003 reported offering either a selfdirected brokerage window or mutual fund window option. The incidence of these window options has not changed much since 2000, when 8 percent of sponsors offered either a selfdirected brokerage window or mutual fund window.
There are many possible explanations for this increase in the number of investment options available to 401(k) plan participants. One is that employees asked for more options, and employers responded. Another is that employers have concluded a greater number and range of investment choices will better protect them from possible fiduciary liability for one or more "bad" options. Whatever the reason, Professors Agnew's and Szykman's research suggests many participants lack the financial knowledge to make good use of their options, and even those with sufficient knowledge may be overwhelmed by the number of choices they have.
Summary of Findings
Each of the study's 398 participants took a written financial literacy test. Although most (84 percent) participants understood they risked losing their principal when investing in a stock fund, less than half (43 percent) knew they suffered the same risk when investing in a bond fund. Furthermore, less than a quarter (24 percent) knew the difference between actively managed stock funds and index funds. Out of a possible 10, the average score on the financial literacy test was less than 4.
Not surprisingly the study found less knowledgeable participants (those that scored below average) are overwhelmed regardless of whether they have relatively few or many investment options to choose from. But the study found even the more knowledgeable participants (those that scored better than average)-- the group that might be expected to benefit most from more investment choices-- are more likely to use default investment options when the number of choices increase. Unfortunately, these default options generally are too conservative to generate the types of returns participants will need to accumulate adequate savings for retirement.
The study's authors suggest several steps employers can take to address these problems. For more knowledgeable participants the answer may be fewer investment options, and especially fewer investment options that are similar. (The study also found these participants more likely to choose default investment options when more funds are offered and the funds are more similar.) More investment advice and education may be the best answer for less knowledgeable participants. However, many employers are reluctant to offer investment advice due to potential fiduciary liability. And, as the study's authors put it, "You can lead a horse to water, but you can't make him drink." According to the Deloitte Survey, 79 percent of 401(k) sponsors that offer investment advice report less than 25 percent of participants take advantage of the service. The study, "Asset Allocation and Information Overload: The Influence of Information Display, Asset Choice and Investor Experience," is available from the Center for Retirement Research's Web site, at www.bc.edu/crr.
|The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.|
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Copyright 2004, Deloitte.
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