Avoiding Decision Paralysis: How to Create the Ideal 401k Plan Option Menu

(The following is the third of a three part series covering the oft-asked question: “How many options should a plan sponsor offer in its 401k plan?”)

Maybe there’s a way to satisfy both the finding of academia and the practical realities of the real world. As we’ve discussed previously (“How Many Investment Options Should 401k Plan Sponsors Offer?” FiduciaryNews, October 18, 2011), researchers have found too many 401k plan options detrimental to the employee. Sophisticated industry experts (“Professional Advisors Sound Off on Ideal Number of 401k Plan Options,” FiduciaryNews, November 15, 2011) agree with these findings, but must also deal with the “politics” of the marketplace.

Perhaps a compromise is in order. In the next few paragraphs, we’ll lay out a novel way to construct a 401k plan option menu that may satisfy both the finance professors and the financial professionals.

Let’s start with this basic premise: Too many options spoil the investor. The idea that “choice” is bad seems counterintuitive, especially for any red-blooded American raised on the idea of the freedom of wide-open spaces. In fact, in 2005 psychology researcher Barry Schwartz wrote a popular book entitled The Paradox of Choice: Why More Is Less explaining this very phenomenon. In it, he states:

Freedom and autonomy are critical to our well-being, and choice is critical to freedom and autonomy. Nonetheless, though modern Americans have more choice than any group of people ever has before, and thus, presumable, more freedom and autonomy, we don’t seem to be benefiting from it psychologically.

How could this be? One of the most cited papers on this subject was “When Choice is Demotivating: Can One Desire Too Much of a Good Thing?” by Sheena S. Iyengar and Mark R. Lepper (Journal of Personality and Social Psychology, Vol 79(6), Dec 2000, 995-1006). The third study in the paper presented three different scenarios. Two involved choice, one where subjects were given a limited choice of 6 chocolates and the other where subjects were give a wide array of 30 chocolates. In the third scenario, subjects had no choice but were simply given chocolates.

Not surprisingly, it took longer for the 30 chocolate subjects to decide what to select than it did for the 6 chocolate subjects to make their decision. Somewhat surprisingly, though, the 30 chocolate subjects felt they had “too many choices” while the 6 chocolate subjects felt their number of options were “about right.” Oddly, the 30 chocolate subjects found their decision making at once more exciting yet more frustrating compared to the subjects selecting from only 6 chocolates. In both cases, both groups of subjects ended up being confidence in their ultimate decisions. Finally, in terms of “buyer’s remorse,” subjects choosing from 6 chocolates were more satisfied with their decision than subjects choosing from 30 chocolates. Interesting, both choice groups were more satisfied than the no-choice group.

We can summarize this paper in the following manner: Subjects with fewer choices are more satisfied and less regretful and, as a result, are more willing to continue “playing the game.” Subjects with too many choices ultimately suffer a “tyranny of choice,” a fundamentally disheartening and demotivating phenomenon. With this ammunition, we can create a new kind of structure for a 401k plan option menu that addresses both fiduciary concerns and behavioral concerns. It involves the creation of categories (or “tiers” as presented in “How Much Choice is Too Much?: Contributions to 401(k) Retirement Plans” by Sheena S. Iyengar, Wei Jiang and Gur Huberman, Pension Research Council Working Paper, March, 2010). Here are five steps to create this ideal menu:

1. Create four categories of options with each category having a limited number of options (1-5 funds);
2. For those employees who prefer professional management but don’t want to think about anything else, place them in the “Default” category catering to the Wealth Accumulation investment objective (which ideally contains only one diverse asset allocation fund appropriate for the overall demographics of the plan);
3. For those employees preferring professional management but willing to identify only their general risk preferences, place them in the “Lifestyle” category catering to the Wealth Accumulation and possibly the Wealth Distribution investment objectives (which ideally contains 3-4 asset allocation funds ranging from “conservative” to “moderate” to “aggressive”);
4. For those employees preferring profession management and willing to identify their specific Goal-Oriented Target, place them in the “Traditional Long-Term Growth” category catering to the Wealth Accumulation investment objective (which ideally contains 3 multi-cap equity funds each with distinct characteristics – e.g., a domestic “Value” fund, a domestic “Growth” fund and an international fund);  and,
5. For those employees preferring to do things themselves in lieu of professional management, place them in the “Do-It-Yourself Asset Allocation” category catering to both the Wealth Accumulation and the Wealth Preservation investment objectives (which ideally contains index funds across relevant “style” categories – e.g., large-cap, mid-cap, small-cap and international – as well as stable value fund).

Obviously, nothing would prevent an employee from picking funds across categories, but that would be the employee’s choice. Those employees willing to use the category structure will benefit from two decision steps, each with limited choices, satisfying the academic researchers. At the same time, the 401k plan as a whole can still contain roughly a dozen funds, satisfying the current marketing environment which suggests to plan sponsors this is a “safer” number.

Life may or may not be a box of chocolates, but what we learn from that box can help plan sponsors and the typical ERISA fiduciary build a better 401k plan.

Be sure to read all the informative installments of this three part series:

Part I: How Many Investment Options Should 401k Plan Sponsors Offer?
Part II: Professional Advisors Sound Off on Ideal Number of 401k Plan Options
Part III: Avoiding Decision Paralysis: How to Create the Ideal 401k Plan Option Menu