Tips 401k Plan Sponsors Can Use to Help Employees Avoid Risk Aversion

Academic research yet again shows there are implications of the way in which investment performance is presented on the decisions that plan participants make. How many 401k plan sponsors currently present information in an unhelpful manner? How many 401k plan sponsors ignore contemporary research that points the way towards presentation formats proven to reduce common mistakes of naïve and time-constricted investors? Here we find ourselves again wading into the stream connecting the waters of fiduciary liability and “paternal” choice architecture as defined by Richard Thaler and Cass Sunstein (see our summary article of their book, Nudge).

We’ve previously shown how industry standards and conventions in the presentation of performance data can lead to ineffective investment decisions by plan participants (see “3 Ways 401k Plan Sponsors Can Help Employees Make Better Investment Decisions,” Fiduciary News, September 20, 2011 and “3 More Ways 401k Plan Sponsors Can Help Employees Make Better Investment Decisions,” Fiduciary News, September 27, 2011). In this article, we cull our academic insights from several papers on the periphery of this topic.

The first paper, “Presenting Investment Results Asset by Asset Lowers Risk Taking,” (Anagol and Gamble 2009), examines how risk taking by investors changes when expressing results for the entire portfolio versus asset by asset. The experiment reports performance results on individuals’ 401k plans in two different formats. The first shows only aggregate portfolio changes while the second shows value changes for each individual asset in the portfolio. The researchers discovered a startling result. Presenting results segregated by asset lowers risk taking by 23% and caused participants to invest in the risk free asset more often. Subjects who observed their investment results asset by asset are sensitive to potential losses at the individual-asset level. The researchers conclude a combination of loss aversion and narrow framing distinct from myopic loss aversion can account for a decreased sensitivity to losses when viewing portfolio wide figures. When investing over long time periods, these people will miss out on the historical equity premium of stocks; thus, it seems like performance should be presented at first, and most largely, for the entire portfolio. There are, of course, disclosure and information supply requirements that would most likely force return data to be available for the individual assets composing the portfolio, but forcing consumers to have to click through to get these segregated results by just initially displaying aggregate portfolio figures and requiring investor to “drill down” to obtain segregated data will help participants make better long term choices.

The Second Paper, “Numerical Information Format and Investment Decisions: Implications for the Disposition Effect and the Status Quo Bias,” (Rubaltelli et al., The Journal of Behavioral Finance, 2005, Vol. 6, No. 1, 19–26), explores whether performance presentation can be manipulated to enhance or combat the disposition effect and the status quo bias. The disposition effect is defined as the observed tendency of investors to sell losing investments too late and to hold on to winning investments for too long. The status quo bias is the tendency for investors to postpone decisions or maintain their current situation unchanged instead of choosing an uncertain outcome. This is noted in the financial industry by examples of investors holding onto a losing portfolio hoping for it to turn around, and by excessive allocations to previous holdings upon receiving large increases of investable capital. The results of the study reveal evidence of a strong absolute magnitude effect on investment decisions. The absolute magnitude effect is the tendency for people to perceive figures as the absolute value of the quantities inherent in them, and not as the actual statistical figures they represent. For example, this would cause a person to perceive a larger change in their portfolio if the return was expressed as 24% versus an identical return of 0.24. The same person would perceive an even larger change if it was expressed in a dollar amount as long as the change was more than $24. The absolute magnitude effect caused participants in this study to help combat the trappings of the disposition effect. This result has direct applicability to 401k plans because plan sponsors – through their investment providers – routinely show plan participants performance data. Being aware of the power of the absolute magnitude effect can help 401k plan sponsors to present the return format with lower absolute values, so as to not overstate investment volatility in the investors mind.

A third paper provides an insight that may underscore the above research. “Asset Allocation and Information Overload: The Influence of Information Display, Asset Choice, and Investor Experience,” (Agnew and Szykman, The Journal of Behavioral Finance, 2005, Vol. 6, No. 2, 57–70),” examines why plan participants often follow the ‘path of least resistance.’ The study showed that the success of certain plans depends strongly on the financial background of the participant, with low-knowledge individuals opting for the default 20% of the time and high-knowledge individuals choosing the default only two percent of the time. These results end up pointing right back to the cries of Nudge, which emphasized the importance of wisely chosen defaults.  It should also be noted taking the time to correctly set up the default options and constructing the choice architecture are one-time fixed costs of man hours, but attempting to raise the financial literacy of a workforce, that group often having significant turnover, would be a sizable variable cost in comparison.

These papers offer 401k plan sponsors and the ERISA fiduciary these valuable tips:

1. Make the first and most emphasized data that of the entire portfolio, not its underlying components;
2. Use the performance measure with the lower absolute magnitude or at least be aware of its effect; and,
3. Take the time to choose your default or ‘easiest chosen’ plan with much care because many may use it and a considered decision update lowers the opportunity (and real) costs down the road.

As these academic research efforts tell us, 401k plan participants can avoid making the wrong allocation decisions when 401k plan sponsors and any other investment fiduciary provide information about investment options in the right context and with the right emphasis. Here we see another instance where regulators and astute researchers can collaborate to help the financial services industry best serve its customers. Unfortunately, regulatory and industry convention appears to have kept performance reporting from being modified by new insights from research and freely morphing to help employees make better investment decisions for their retirements.