401(k) Investment Options

My friend David asked what I think of adding more participant investment options to his company’s 401(k) plan. He’s on his company’s 401(k) committee, and their investment advisor has recommended adding more options to the current array of 15. Additional fixed income options are on the table.

The easy, short, and largely correct answer is: If that’s what your professional advisor recommends, then do it. That’s what you pay them for.

But maybe David was looking for more substance than that rather facile response.

Initially my reaction is how can more choices ever be bad? If your 401(k) plan is thin on fixed income options, why not add one or two more? It’s always better for participants to have more choices, right?

Not always. Behavioral finance research (which I’m too lazy to look up and cite) has shown that offering too many choices can actually paralyze some people. When faced with too many confusing choices they can react by not choosing at all. In the context of a 401(k) plan, that might mean that their account defaults to some “safe” option determined by the plan, which in the past has often meant a money market fund. In the long run that's a bad choice. (That’s changing, as more and more plans move to a life-cycle fund as the default option.)

For some employees, 401(k) paralysis might be worse. It might mean that they're put off from making an elective deferral at all, which is an awful result.

So the desire to improve the array of options for the group should be tempered by the desire to limit 401(k) paralysis. How many employees can benefit by adding more refined asset classes, compared to how many will now suffer 401(k) paralysis? That’s not an easy question. For one thing, the more fine-grained the asset classes you offer, the fewer employees who can appreciate the subtle distinctions among them. My speculation is that with 15 options you’re getting to the point where only those employees who are receiving professional advice can actually benefit from more options.

Now, having nibbled around the edges of the question, I may as well offer a couple of substantive observations.
One: As long as you’re increasing your plan’s fixed income options, it would be a shame if you fail to offer a TIPS (Treasury Inflation Protected Securities) option.
Two: If you really want to do your employees a favor, offer them a pure annuity option. Not a variable annuity, but a pure annuity that they can add to on a paycheck-by-paycheck basis. This will enable those employees who long for a traditional pension to create one of their own within the confines of your company’s 401(k) plan. (For why I think annuities are valuable for a portion of one's retirement assets, see March 9's post and March 15's post.)

Thank you, David, for giving me the opportunity to shoot my digital mouth off.