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3 More Ways 401k Plan Sponsors Can Help Employees Make Better Investment Decisions

September 27
00:04 2011

If a picture is worth a thousand words, how much more is a graph worth to a 401k investor? More pointedly, academic research shows there’s a right way and a wrong way to communicate critical investment information. How many 401k plan sponsors 344911_2921_Exhibition_stock_xchng_royalty_free_300have read this research and has the typical fiduciary incorporated it into employee education programs and summary reports? But here’s the scary question: Does ignorance of this knowledge increase fiduciary liability?

We’ve previously reported (“3 Ways 401k Plan Sponsors Can Help Employees Make Better Investment Decisions,” Fiduciary News, September 20, 2011) how the 1999 Benartzi/Thaler research paper “Risk Aversion or Myopia” first exposed the fallacy of certain industry standard performance reporting techniques in retirement plans. Benartzi/Thaler showed how this reporting may lead to ineffective investment decisions by plan participants. The two researchers concluded since the contributions to 401k plans will generally be invested for longer time periods, the data shown to plan participants must echo this fact, not distort or omit it.

Scholarly exploration did not end in 1999. A recent research paper out of the Australian School of Business at New South Wales (“Financial competence, risk presentation and retirement portfolio preferences,” Australian School of Business, Bateman et al., July 3, 2011,” gives insight as to how an employee’s allocation decisions will vary whether given textual descriptions or graphical displays of performance data, and whether the emphasis is on event frequencies or return ranges. Experimenters gave survey participants three portfolio options to choose from: 1) a 100% bank account with a guaranteed real rate of return of 2%; 2) 50% bank account and 50% growth assets with a 3.25% return; and, 3) a 100% growth assets portfolio featuring a 4.5% return. The higher return in the growth portfolio is congruent with the higher long term return of stock dominated portfolios.

Three results of the Bateman paper stand out as informative to plan sponsors.

First, when shown the frequency of losing years (i.e., the number of years where a loss occurred divided by the total number of years in the time period), employees chose the conservative bank account more often. But when shown the frequency of positive years (i.e., the number of years where a gain occurred divided by the total number of years in the time period), they chose the growth portfolio more often. Obviously, the frequency of loss years reveals the frequency of positive years and vice-versa, so, technically, expressing one automatically expresses the other. However, in a manner consistent with the myopia phenomenon discovered by Benartzi/Thaler, investors appear biased by context (or “framing” to use a behavioral term) posed by the presentation.

Second, in another restatement of the Benartzi/Thaler paper, the research of Bateman et al. indicated graphical displays of returns help participants better grasp actual performance data and encourage risk tolerance. When respondents viewed graphs of 90% probability ranges of returns, they chose the bank account less often than when viewing the identical information about risk and return via a textual description of the range presentations. Perhaps even more useful to 401k plan sponsors, Bateman also observed the number of people who switched to the growth option as a result of seeing the graphs was greater among people who scored lower in numeracy tests. (Numeracy measures the ability to use numbers and reason mathematically.) This correlation between numeracy and graphical representation implies the effectiveness of graphical displays on participants amongst all intellectual levels may overcome variations of mathematical literacy, which may therefore supersede the traditional reliance on 401k education programs.

Finally, the Bateman paper reveals the highest number of employees changed their choice after being given data about the probability of just one end of the loss-gain spectrum. Respondents were given information on only a single extreme (i.e., “1in 20 chance of return above y%” or “1 in 20 chance of return below x%”). The researchers concluded “consumers do not infer that a high probability of losses also implies a high probability of gains or vice versa.”

The authors point out factors other than presentation of performance data, such as wealth levels and optimism vs. pessimism, can also impact plan participant choices. Still, they deduce “for a majority of consumers the risk information is significant and influential, but large changes in underlying risk do not change choice probabilities as much as changes in the way the risk is communicated.”

Knowing the tendencies of how employees make complex decisions regarding their retirement savings will help the plan sponsor to be cognizant of and thus help steer participants away from the common mistakes that cause many to be financially underprepared for their retirement. The Bateman paper points to three ways 401k plan sponsors can help employees make better investment decisions.

  1. When expressing returns in terms of frequency, use the word “gain” or a similar positive frame,
  2. Use graphs when showing returns or probability ranges of returns; and,
  3. Avoid one sided measures since investors cannot infer that a high probability of losses also implies a high probability of gains and vice versa.

As with Benartzi/Thaler, Bateman et al. shows 401k plan participants can avoid making suboptimal allocation decisions when 401k plan sponsors and any other investment fiduciary provide information about investment options in a ‘frame appropriate’ context. Being frame appropriate in the case of retirement investments involves the creation of mental accounts which, although unique to each person, exhibit certain universal generalities. These frames would also include a schedule of financial needs. Taking these steps will aid the apportioning of savings to wealth preservation and wealth accumulation investment goals as appropriate. Unfortunately, without regulators imposing the relevant mandated disclosures and presentation requirements on the financial services industry, 401k plan sponsors are left to their own devices in delivering this very useful information to help employees make better investment decisions.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA


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