Defined contribution plan executives should be moving to a strategy of simplifying investment options while addressing participants' different investment styles, according to a new report by the Defined Contribution Institutional Investment Association, Washington.
“We don't think there's an absolute right or wrong way to create an investment menu,” Seth Masters, a member of the DCIIA executive committee and one of five authors of the DCIIA report, said in an interview. But the menus shouldn't make participants feel overwhelmed by the number of choices.
“When defined contribution plans were created, they had very few features,” said Mr. Masters, a partner and chief investment officer-allocation for AllianceBernstein (AB) LP (AB), New York. “But in the 1980s and 1990s, they began to offer more and more choices. The investment menu looked like one of those diner menus with so many choices.”
However, behavioral finance and DC plan experience shows that too many choices “makes it harder to make good choices or even any choice at all,” Mr. Masters said. As a result, some plans are starting to approach the investment menu the way the restaurant business offers different types of dining, he said.
For DC plans, Mr. Masters said, there has been an evolution to three tiers based on participants' confidence in investing: the “do it for me” tier, which is a target-date fund or other qualified default investment alternative; the “do it with me” tier, consisting of core funds offered by the plan; and the “do it myself” tier, representing self-directed brokerage accounts that give participants multiple investments.
Using the restaurant analogy, Mr. Masters said the target-date fund tier could be likened to a restaurant in which the menu has limited choices chosen by the chef; the core fund tier could be the equivalent of a restaurant with a broader a la carte menu; and the brokerage account tier could be akin to a food court.
The DCIIA report said plan design depends on four objectives for each sponsor:
- Is the DC plan the primary source of retirement savings, or is it supplemental to a company's defined benefit plan? In the case of supplemental plans, some employers might view the DC component as enabling participants to take more risk. “Sponsors with this perspective tend to have broader investment menus,” according to the report.
- How much guidance does an employer wish to offer participants? Sponsors must determine whether offering too many choices will backfire, so that participants make “sub-optimal” choices or “freeze into inaction.”
- Do employers want participants to stay in the plan after they leave the company? Some sponsors believe “there is a fiduciary risk associated with keeping terminated participants in the plan, and may encourage rollovers or implement other design features” that encourage departing employees to leave the plan, according to the report. Other sponsors want the employees to stay in the plan, especially employees with high account balances, so the plan can have more assets and greater bargaining power to reduce costs and increase services.
Mr. Masters said an impediment to plans simplifying their designs and menus is inertia. “It's a lot of work to get a record keeper to change the menu, and it takes a lot of time,” he said. “The idea of a tiered structure is seen by practitioners as the right way to simplify things.”