When it comes to defined contribution plan investment options, giving participants an abundance of choices can backfire. Yale University recently dodged a bullet in this regard when it beat back — at least initially — a class action lawsuit accusing the institution of an ERISA breach. Although the trial court granted Yale’s motion to dismiss on the specific claim, the case is instructive for plan sponsors.
100+ Investment Options
Yale’s plan had more than 100 investment options, including as many as 28 within a single asset class. That, according to the plaintiffs, “placed a monumental burden on participants in selecting options in which to invest.” Participants would have been better served, they argued, if Yale had narrowed the choices to a few “best-in-class” funds within each asset category.
Some of the best-in-class funds in the Yale plan (as measured by investment performance) also had lower fees. The plaintiffs’ complaint argued that reducing the number of investment options would concentrate the plan’s assets into a smaller group of funds and annuities. This would, in turn, increase Yale’s ability to demand lower share prices and qualify for less expensive institutional shares.
Yale filed a motion to dismiss the case without a trial. The judge ruled the case could proceed on other charges, but not the excessive investment option issue.
Although the court didn’t reject the principle that participants could be harmed by excessive investment choices, the judge concluded that the plaintiffs merely hadn’t presented sufficient evidence. While the plaintiffs discussed behavioral economics and “decision paralysis,” the complaint didn’t allege a theory of harm or provide facts explaining how the “dizzying array” of choices harmed them.
So what about research showing that people make better choices when given a smaller number of options? For example, a 2011 paper published by the Harvard Business School, titled “When Smaller Menus Are Better: Variability in Menu-Setting Ability,” concluded that people “find that smaller menus are objectively better than larger menus.”
Another study, “Choice proliferation, simplicity seeking, and asset allocation,” published by the Journal of Public Economics, evaluated data on the behavior of 500,000 employees and 638 plan sponsors from the Vanguard Center for Retirement Research. It found that, for every additional 10 investment options available, participants’ equity allocation dropped by 3%, with a similar increase in the number of participants who allocate none of their retirement funds to equities.
And there is yet another consideration for plan sponsors: the relationship between the number of fund options and plan administration fees. Inevitably, the cost of recordkeeping and plan administration services is tied to the complexity of plans. So too are auditing fees. Unless the plan sponsor absorbs those costs, participants are arguably harmed by the additional expense.
Benchmark for Perspective
The Plan Sponsor Council of America’s 60th Annual Survey of Profit Sharing and 401(k) Plans reflects that the average number of funds available for participants is between 18 and 20. All of this begs the question: Is there an ideal number of funds? The answer is elusive — and it would vary anyway according to each plan’s demographics — but benchmarking can still be illuminating.
In addition to looking at benchmark data, plan sponsors can assess whether they’re offering enough — but not too many — fund choices by periodically reviewing where participants are putting their money, and surveying them about why they have made their choices.
If, for example, many participants arbitrarily split up their dollars earmarked for U.S. equities into multiple funds with similar goals but dissimilar performance track records, that might suggest your fund lineup within that category could use some winnowing. The same could be true if polling reveals that many participants are suffering from “decision paralysis.”
Take a Look
Avoiding litigation in the first place is better than being hauled into court. This case should be an impetus for many sponsors to take a closer look at the array of funds offered in their qualified retirement plans.
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