While common wisdom (if not common sense) now holds that too many investment options don’t lead to good choices, new research has taken a stab at quantifying the impact.
In a paper titled, “Simplifying Choices in Defined Contribution Retirement Plan Design,” researchers Donald Keim and Olivia Mitchell estimated that streamlining fund menu options could lead to aggregate savings for participants over a 20-year period of $20.2 million, or in excess of $9,400 per participant — at least based on a specific set of circumstances and a set of assumptions made by the researchers.
The Data ‘Base’
The analysis, based on actual data, albeit from a single “large U.S. nonprofit institution,” examines how employees in a large firm altered their fund allocations when the employer streamlined its pension fund menu and deleted nearly half of the offered funds. We’re talking about going from an investment menu that included almost 90 mutual funds, ranging from equity to target date to bond index funds, as well as REIT, commodity and other sector funds. This plan’s investment committee subsequently “streamlined” the plan menu (removing 39 funds — but still a pretty extensive fund menu) and constructed a four-tiered structure for the remaining funds (ranging from TDF-only to a self-directed brokerage account).
Participants who had invested in the funds that would be eliminated from the menu were allowed to reallocate their assets and contributions to any other fund in the menu, although those who did not move out of the funds to be deleted had their funds automatically transferred to the age-appropriate target date fund. Overall, 20% of the total assets were in funds that were subsequently deleted; of those, about 60% had been in equity (stock, balanced or international) funds, 24% in alternatives/sector funds and 14% in bond funds (with the remainder in money market funds).
Demographic Differences
Looking at participants who owned at least one deleted fund (“streamlined”), and those who owned no deleted funds, the researchers found that while the number of participants in each group was roughly similar (2,238 versus 2,371), the streamlined group had accumulated almost 60% more in assets ($603.8 million versus $380.0 million), contributed 30% more on a monthly basis ($1,802 versus $1,356 per participant), and held more funds overall (87 in total versus 47). On average, about one-third of the contributions of the streamlined participants were in funds that were subsequently deleted and two-thirds in retained funds.
There were some additional demographic distinctions found between the two participant groups: Streamlined participants were significantly older, more likely to be male, lived in higher-income households, and were more likely to have earned graduate-level degrees. Moreover, they were more likely to contribute directly to stock funds (sector, domestic and international), while the non-streamlined participants were more likely to obtain equity exposure (indirectly and in more conservative amounts) via what the report described as “significantly larger” allocations to target date funds. As a result, these streamlined participants not only held portfolios containing more equity exposure, they also owned three times as many funds (an average of 6.8 versus 2.1).
The Savings Assumptions
So, what about those savings assumptions? The researchers noted that the (unconditional) average reduction in the annual expense ratio for the entire streamlined group was 4.0 bp (27.9 bp minus 23.9 bp), or a $241,520 annual cost savings (based on the prestreamlining balance for the streamlined group of $603.8 million). They then took the average age of the streamlined group (49), and assumed that those savings could be achieved on an ongoing basis over 20 years and reinvested at 5% annually – and that would add up to $8.40 million, or around $4,000 per participant.
Next they took what they determined was the (unconditional) average decline in within-fund annual turnover for the streamlined group of 11.3% (35.2% minus 23.9%), and taking that difference times the streamlined group balance of $603.8 million at month-end June 2012, and assuming round-trip within-fund transaction costs of 0.50%, noted that that could translate into an annual aggregate cost savings of approximately $3.4 million. They then assumed that those savings could also be achieved on an ongoing basis over 20 years and reinvested at 5% annually, yielding an additional $11.8 million, or $5,400 per participant, which, added to the $4,000 noted above, would mean a per-participant savings of $9,400 over that 20-year period.
What can advisors draw from this research? While the savings projections of the study may well be beyond that experienced by plans with shorter and less exotic fund menus, reducing options that have higher expenses and cutting back on the number of funds to which money can be transferred can certainly expect to result in a lowering of costs, and defaulting participants to lower cost options will have a similar impact.
While it seems unlikely that your average 401(k) plan menu (with somewhere between 20 and 25 funds) would realize the level of savings estimated in this particular study, it surely reminds us all that there are real costs, both in terms of participant behavior and actual experience, from plan investment menus that are, or have become, unduly complex.
