While past studies of DC plan designs suggest that smaller core menus improve participation rates and outcomes by reducing choice overload, a new study questions that wisdom.
In fact, Morningstar Investment Management’s new white paper – “Bigger Is Better: Defined-Contribution Menu Choices with Plan Defaults” – concludes that plan sponsors should be doing the opposite, asserting that a bigger lineup is actually better.
The 28-page paper by David Blanchett, Morningstar’s head of retirement research, and Michael Finke of The American College of Financial Services, finds that increasing core menu size not only results in increased adoption of a plan’s default investment, but it also can result in more efficient portfolios.
Based on an examination of more than 500 DC plans comprised of approximately half a million participants, and core menus varying between 10 to 30 investment options, Blanchett and Finke explore the relation between core investment menu size and two key participant investment decisions:
- the acceptance of the plan’s default-investment option; and
- the efficiency of portfolios among participants who were self-directing their accounts.
Default Acceptance
According to their findings, increasing core menu size resulted in increased adoption of the plan default investment, from approximately 74% for plans with 10 funds in the core menu to about 87% for plans with 30 funds. The study notes that for each additional fund a plan adds to its core investment menu (moving from 10 to 30 funds), default-investment acceptance increases by approximately 0.7%.
As background, Blanchett and Finke observe that many early DC plan studies found that increasing the number of funds reduces participation rates as a result of “choice overload,” but many of those studies were conducted prior to the Pension Protection Act (PPA) and did not consider the benefits of automatic enrollment in default investment options.
“Increased default acceptance within plans that offer larger core menus is consistent with choice overload: participants in plans with smaller menus may feel more capable of building portfolios themselves, while participants in plans with more funds may feel overwhelmed and therefore remain in the default investment,” the study suggests.
Blanchett and Finke further explain that prior to the PPA, plan menus often provided a limited selection of funds where workers either invested in a suboptimal cash fund or choose not to participate. They note that post-PPA default investments are found, however, to outperform self-directed portfolios and provide more efficient portfolios than what average workers could build themselves. At the same time, sophisticated investors could still reject the default option in favor of a customized portfolio drawn from a larger menu.
Increased Diversification
In fact, the study notes that participants in plans with larger core menus who built their own portfolios had more efficient portfolios, primarily because they used more funds. It found that the average number of funds for participants self-directing their accounts was 4.4 in plans with 10 funds in the core menu, but 8.6 funds for plans with 30 funds.
Additionally, their analysis further shows that the number of holdings among self-directed investors would be expected to increase by at least three funds, resulting in an increase in expected alpha of 10.8 basis points.
Citing Shlomo Benartzi and Richard Thaler, Blanchett and Finke note that it’s “unclear whether improved efficiency is the result of access to a broader range of high-quality investment options or naïve diversification in which self-directed participants simply spread their portfolio among a larger number of funds.”
Nevertheless, they contend that while the basis point increase may not seem material, it represents an easy way for plan sponsors to improve likely retirement outcomes.
“It’s important for plan sponsors and their advisors to consider revisiting their core menu design and rethink how it can be used to nudge participants toward better investment outcomes. While bigger menus might not work for all plans, the role of the core menu is changing and perspectives on how to optimize it need to evolve as well,” Blanchett and Finke write.
The paper does not dive into the specific ERISA fiduciary-related concerns about having a larger core menu of investment options. It does acknowledge, however, that there are additional “administrative and monitoring costs that need to be considered,” but suggests that those costs are likely “significantly lower than the expected benefits.”
