3 Ways 401k Plan Sponsors Can Help Employees Make Better Investment Decisions
Do you think 401k plan sponsors should be interested if they could discover a simple way to help their employees – make better 401k investment decisions? Would these same 401k plan sponsors be surprised to learn government regulations and industry standards actually encourage 401k employees to make inappropriate retirement choices? If a smart class-action attorney happened upon this information, who do you think might be held responsible for the dissemination of this misleading information – the government or the 401k fiduciary?
In 1999, Shlomo Benartzi and Richard Thaler published a seminal paper in behavioral economics (“Risk Aversion or Myopia? Choices in Repeated Gambles and Retirement Investments,” Management Science, Vol. 45, No. 3, March 1999). In the decade-plus since its publication, both the SEC and the DOL have commented on mutual fund performance reporting standard, yet neither regulatory agency has adopted the conclusions of this paper. Worse, both agencies continue to require mutual funds to report performance in a manner contrary to the conclusions of the paper and in a way that might actually mislead investors into making incorrect investment decisions. Needless to say, the industry hasn’t complained. The current mandatory performance reporting requirements actually allow providers to avoid the kind of comprehensive performance disclosure that might impinge on their traditional marketing campaigns.
Despite the general disregard for the fruits of this research on the part of regulators and the industry, a 401k plan fiduciary may be at risk for not framing its reports to plan participants in a manner consistent with the Benartzi/Thaler paper. After all, just because the SEC doesn’t require mutual fund companies to make these disclosures and just because the DOL doesn’t require 401k plan sponsors to report performance consistent with the Benartzi/Thaler findings doesn’t mean some smart class action attorney can’t build a convincing case that a plan sponsor should have incorporated techniques to avoid misleading plan investors.
What’s the secret revealed in “Risk Aversion or Myopia? Choices in Repeated Gambles and Retirement Investment”? If you read the paper, you’ll find a long dissertation on a concept known as the “fallacy of large numbers.” In disproving this concept, Benartzi/Thaler drive a stake into the heart of Modern Portfolio Theory’s very foundation.
The fallacy of large numbers holds that a rational decision maker will make the same decision no matter how many times the decision maker is given the choice to make the same decision. Paul Samuelson explained this in his 1963 paper “Risk and Uncertainty: A Fallacy of Large Numbers.” In the paper, Samuelson tells the story of a flippant offer he once made to a coworker, where he offered to give the party $200 if a coin flip turned up heads as long as his counterpart would promise to give Samuelson $100 if the fair coin flip yielded tails. The mark denied Samuelson’s offer.
But, said the colleague, he would accept the bet if Samuelson allowed him to take this one bet 100 consecutive times. This apparent contradiction inspired Samuelson to develop a theorem that logically proved a rational decision maker must decline the 100 consecutive bets if he declines the bet once.
Benartzi/Thaler show neither the apparent contradiction is irrational nor is Samuelson’s rational decision making theory relevant in the real world. The two researchers had earlier (1995) developed the concept of “myopic loss aversion,” where a decision maker weighs near-term losses more heavily than long-term gains. The rejection of a single coin – with its 50% chance of losing – is consistent with accepting a series of 100 such bets – where the risk of a loss is less than 1%.
Moreso, Benartzi and Thaler suggested the framing of the outcomes can also influence a decision maker. For example, by looking at the bet in isolation, the $100 stands out as a significant sum of money (especially in 1963). On the other hand, had the choice been framed in terms of the decision-makers total wealth (let’s say it’s $100,500), a head would have yielded $100,700 total wealth while a tale would have led to a total wealth of $100,400. Expressed in this manner, the decision-maker may have been less risk averse.
Now, here’s the significant part. Once the two scholars wrapped up their discussion of coin flipping, they performed a test on 401k type retirement investments. In this experiment they asked USC staff employees who were investing in the university’s defined contribution plan to make an asset allocation decision based on two hypothetical funds. The respondents were not told, but one fund represented the average return of stocks and another fund represented the average return of bonds. Some of those surveyed were shown performance in one-year increments and the others were shown performance reflected in thirty-year increments.
The results proved astounding. Those shown the one-year charts allocated only 40% to stocks while those shown the thirty-year charts allocated 90% to stocks. Most financial planners would agree retirement assets should generally be weighted more heavily towards equity investments. Interestingly, a second experiment was conducting involving UC faculty. The faculty allocated 63% to stock when seeing the one-year charts but 81% to stocks when viewing the 30-year charts. In real life, the faculty allocates 66% of their retirement money to stocks. In real life, the faculty generally sees one-year charts.
Finally, Benartzi and Thaler employed two different kinds of 30-year charts. In one type, they expressed performance in annual terms. In the other, they expressed performance as a percentage of meeting the respondent’s retirement goal. The stock allocation choices derived from using these two different 30-year charts were not significantly different.
Benartzi and Thaler conclude “the manner in which the information is provided will influence the choices the employees make.” The paper suggests three ways 401k plan sponsors can help employees make better investment decisions.
- Avoid showing short period returns (typically anything less than 5 years) for long-term objectives.
- Show long period returns (typically at least in 5-year rolling increments) for long-term objectives.
- Encourage employees to review 401k balances only once a year (yes, that means reconfiguring internet access mailing participant statement no more frequently than required by law).