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How Plan Sponsors Can Restructure a 401k Investment Menu to Increase Participation

June 05
01:52 2013

(The following is the second of a three part series covering the trend among plan sponsors to increase employee participant and savings rates by reducing choice overload.)

When researcher Sheena Iyengar and her team measured the impact of choice overload in 401k plans, they found participation dropped by nearly 5% when comparing plans with 5 funds versus plans with 15 funds. The participation rate 1400044_61978383_castle_under_construction_stock_xchng_royalty_free_300continues to drop steadily when a plan has more than 30 funds. Beyond that, the participation rate drops approximately 4% for every 5 funds added to the menu. For 401k plan sponsors looking to increase participation – or to avoid failing the annual nondiscrimination test – the consequences of choice overload can be devastating.

But here’s the good news for these worried plan sponsors. There’s a growing trend in the 401k industry to restructure investment option menus to specifically address the proven issues that thwart high participation rates. Leading plans and their service providers from across the country are already altering their menus in the manner recommended by Iyengar and her associates. Here’s a look at how professional advisers have successfully implemented the four proven strategies to reduce choice overload in 401k plans.

Reduce the Number of Choices: One of the easiest ways to reduce choice overload – and the first one often chosen by plan sponsors – is simply to cut the number of options available to employees. Robert J. Pyle, President of Diversified Asset Management, Inc. in Boulder, Colorado says, “Too many choices are paralyzing. It is well documented. Typically, there is a ton of overlap in plans. I have seen as many as 14 options for US stock funds. When there is a lot of duplication, the correlation between the funds are high.” Pyle believes plans should offer no more than “10 or 11 funds max.”

Similarly, Jerry Korabik, Senior Financial Advisor with Savant Capital Management in Geneva, Illinois, says, “Our preference is to give participants choice, but manage that choice by offering them 15 pure asset class funds that are mutually exclusive in what they own. Many plans we run into offer many funds in the same asset class category and there is a lot of overlap and confusion for participants. Plan sponsors sometimes may have 4 mutual funds under one asset class, but the funds may overlap and own the same stocks (lack of diversification) or they may own too many asset classes within the fund than what the participant thinks they may be buying (lack of clarity).”

Make the Consequences of their Actions More Vivid: The next easiest way to convince employees to save is to have them “be the ball.” For those not familiar with that overused cliché, it means have them picture the results of their decisions. Korabik says, “In our educational sessions, we use a lot of visual tools that allow participants to put themselves in a certain setting and see how they would react the same or differently. We take them through examples of saving a little early vs. saving a lot later on (catch up) and how different market conditions will effect that decision and the outcomes. We also have them visualize their retirement and longevity vs. what it may have been like in the early 1900s, etc.”

This visualization becomes more vivid in a group session, where employees can encourage each other to imagine the positive effects of participation. Bradley K. Arends, CEO of Alliance Benefit Group Financial Services, Corp. in Albert Lea, Minnesota, says “At new enrollee meetings and group meeting for existing participants, we too ask participants to envision their idea of retirement and then assist participants with determining the investment strategy and contribution commitment that will help them achieve that dream.”

Group Investment Options into Groups More Aligned with Employee Psychology: Here, we begin to get to the heart of the matter. This strategy is difficult for many to employ for two reasons. From the point of view of the plan sponsor, it means making an effort to understand the psychology of decision-making. They must then have the courage to restructure the 401k plan’s investment menu based on this behavioral approach rather than traditional investments long advocated by the financial services industry.

For investment professionals, the challenge is even greater. Taught to speak in the vernacular of their business, to successfully restructure a 401k plan investment option menu requires them to forsake everything they ever learned about investments and modern portfolio theory. In fact, to be truly effective, they must re-educate themselves to think, act and breathe like a 401k plan participant. For most employees, it’s not about investments, it’s about savings. Indeed, a 2012 Wharton study says exactly this (see “New Study Reveals Three 401k Strategies More Important than Asset Allocation,”, August 14, 2012).

The better financial service providers understand this. Ted Jenkin, Co-CEO and Founder of oXYGen Financial, Inc. in Alpharetta, Georgia, says “The hardest part is actually getting people started with these plans. By offering multiple categories, it makes the process much more palatable for an employee to begin savings. It’s much like going to a wedding. If you give people the option of fish, prime rib, or chicken, they will find something that suits them. This is about behavioral finance. If you emotionally give people choices that can help them fit who they think they are within the context of the options, more people will sign up. Once that starts for an employee, they rarely stop unless they have unforeseen financial circumstances in their personal situation.”

Arends believes restructuring an investment menu so employees see broad categories first “can increase the likelihood of understanding and free up time for participants to devote to understanding other key concepts and determining how much they should save in the plan.” He says, “Plans with tiers/categories see greater employer contribution amounts because, quite simply, they are easier to understand. The simpler the approach, the higher the likelihood for comprehension and those who can understand the investment menu are more likely to contribute to the Plan. This takes some of the fear out of the equation simply by removing some of the unknown factors.”

The question then becomes not “how many investment options?” but “how many employee categories?” While we all know the fewer the better, everything can’t be limited to an “either/or” choice between two options. Some service providers do have two options – a “professionally managed” option and a “do-it-yourself” option. Others expand on the first option by breaking it down to a “Do-It-For-Me” option (i.e., a single default fund, often a form of a balanced fund) and a “Lifestyle” option (i.e., a series of balanced funds or “model portfolios” with varying asset allocations), with others even adding a third “Traditional” option (i.e., several multi-cap all equity funds with substantially unique investment philosophies).

Even with this broader array of categories, you’ll find a majority of employees opting for the “Do-It-For-Me” category. “Most employees are in the default category.  The more sophisticated employees gravitate towards options which allow them control,” says Bruce Givner, Tax Attorney, Givner & Kaye, Los Angeles, California.

Arends categorized participants into three categories and finds this breakdown among employees: “15% Do-It-Yourself (give them a list of options and let them go); 35% Confirmer (believe they know what they want, but would like someone to confirm the decision); 50% Do-It-For-Me (just want someone else to make their elections).”

Pyle includes a “Lifestyle” category featuring a spectrum of balanced funds with asset allocations ranging from aggressive to conservative.

Restructuring a 401k plan investment menu to lead with employee categories instead of investment options begins to realign the language of the plan more towards the perspective of the employee rather than the service provider. This is why categories have been so successful in increasing participation. Korabik says, “Plans are moving down this road because the industry is loaded with financial jargon and most participants tune it out because they can’t understand it. If they don’t understand, they don’t participate. By using more life cycle categories, participant can relate more to the category they are in and the sense of urgency for them to save or not to save. Participants are either Do-it-yourselfers or Model Portfolio investors. We initially take them down these two paths and give them a description of the type of investor they are if they go down one of these paths. Some investors may have a little bit of overlap on the two paths, but most clearly fit into one of the two categories. Through proper education, we find that the majority of 401k plan participants go down the Model Portfolio path.”

Develop a Decision Tree Beginning with Questions with the Fewest Options and Ending with Questions with the Most Options: Categories are great, but their real power is only seen when the plan sponsor creates an easy-to-follow decision tree to aid employees. Unfortunately, most plan sponsors are more familiar with shoe trees than decision trees, but decision trees aren’t hard and can be quickly learned. A decision tree is basically a series of questions whose answers branch out to other questions until a decision is made. (These “answer branches” give us the sense of a “tree.”)

For example, in a typical 401k investment menu with categories as described above, our first question (i.e., the one with the fewest options – in this case two) is “Do you want to manage your investment allocation yourself or do you want a professional portfolio manager to manage it for you?” This creates two branches – the “Do-It-Yourself” branch and the “Do-It-For-Me” branch, to refer to our earlier category names. The former branch goes directly to fund options while the latter branch could either lead to fund options or another category question and then to fund options.

As you might guess, when using a decision tree like this, advisers often see employees opting for the less stressful decision. “Whether is it technically true or not, participants like the idea that someone is doing the asset allocation for them and adjusting it all the time versus them having to pick a fund in 8 or 10 different categories and monitoring it,” says Jenkin.

Once the participant decides on the general category, a decision on the investment will often still have to be made (except for the single-option default category). Korabik says, “Similar to the Category section above, we start with the 5 model portfolios and the 15 asset class funds. If you are a do it yourselfer, you will focus mostly on the 15 funds and have access to online and print resources on each of those funds so that you can better build your own customized portfolio. With the 5 models, we give participants one-page data sheets on each of the 5 models, and we have a quiz for them to fill out that based on how they feel about risk, market conditions, their goals, etc. The scoring of the questionnaire will lead them into one of five categories and each category is tied to one of the five models.”

These are but a few real-life examples of a growing trend in designing and implementing 401k investment option menus. This restructuring will echo throughout the plan, from the investment policy statement to the education plan. In our next and final installment, we’ll offer a sample 401k investment option menu using the approach outlined by both the academic researchers in the first installment and the practitioners in this article.

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

Part I: 4 Proven Strategies to Reduce Choice Overload in 401k Plans
Part II: How Plan Sponsors Can Restructure a 401k Investment Menu to Increase Participation
Part III: Adding Categories: A Sample of a New and Improved 401k Investment Option Menu

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the concepts outlined here.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


  1. Dave Baker
    Dave Baker June 06, 09:50

    Hi, Chris!

    “(The following is the first of a three part series covering the trend among plan sponsors to increase employee participant and savings rates by reducing choice overload.)”

    should be

    “(The following is the third of a three part series covering the trend among plan sponsors to increase employee participant and savings rates by reducing choice overload.)


  2. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author June 06, 11:49

    Thanks Dave! Fixed it.

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