Research shows investing decisions made based on order options are listed

Never mind expense ratios or fund volatility. What determines how retirement plan participants select their investments is a matter of where the investments appear on a list.

That's according to an academic paper that identifies and quantities what it calls "alphabeticity bias" in 401(k) investing.

The paper, published in October in academic journal The Financial Review, shows that investments that appear higher up on alphabetically listed lineups are those participants select the most. The bias exists regardless of the length of the lineup, surfacing even in plans with fewer than 10 fund choices.

"I think it's the type of thing where people suspected it was happening," said James Veneruso, a senior vice president and defined contribution consultant at Callan LLC in New York. "If there's a list of eight options, nobody picks the last option because they've already picked one of the previous seven. By the time they get to the eighth, it's like I'm already out of bullets."

Plan sponsors are taking note. While alphabeticity bias has been shown to affect other types of decision-making, including the selection of individual stocks, and is well-known in psychology literature, it is the first time it has been studied in the context of 401(k) investing.

"It's fascinating research," said Mary Nell Thompson, Hilton World- wide Holding Inc.'s Memphis-based senior director of global retirement programs. While she hadn't heard of alphabeticity bias per se, she was very aware from behavioral finance studies that "people in general are very influenced by the way you present material," she said.

The magnitude of the bias is significant. The study shows that funds that appear at the top of the list receive roughly a 20% higher allocation than those that appear at the bottom, a "huge" difference, said Thomas W. Doellman, one of the four authors of the paper and associate professor of finance in Saint Louis University's Chaifetz School of Business in St. Louis. Even Vanguard Group Inc. — a company that he said "should be recognizable to the vast majority of employees" — gets substantially more allocations to its funds when they are at the top instead of at the bottom of the list.

"The magnitude of the bias was surprising," Mr. Doellman said.

The bias appears to affect plan participants regardless of the size of the company or the industry in which they work. Employees of large companies, which presumably "would have more resources for educational purposes," as well as employees of the financial and other "white-collar industries," where one would expect "the average employee to have more education," display the bias equally, Mr. Doellman said.

The findings are noteworthy as most plan lineups are typically organized by asset class, which are then alphabetized, Mr. Doellman said. That approach was prevalent in 2007, the year the researchers used to sample nearly 7,000 plans, and continues to persist today despite evolutionary changes in the industry, he said.

"I'm surprised how common it still is to see it in alphabetical order," Mr. Veneruso said of plan lineups.

Mr. Veneruso laments the fact that while plan sponsors put a tremendous amount of energy into developing their plan lineups, they sometimes neglect to consider how the choices are presented to participants.

"The way a lot of plan committees think about the fund lineup is not necessarily followed through to the participant level," he said.

Sometimes the sponsor's record keeper lacks flexibility in how much customization is allowed on participant websites, but in other cases it's a matter of sponsors simply not being aware of how the information is presented, he said.

Hilton, for example, organizes its plan lineup into three tiers, one of which is a "do-it-yourself" tier with a mix of 11 passive and actively managed funds, which are listed in alphabetical order, according to Ms. Thompson. The other two tiers consist of T. Rowe Price target-date funds and a self-directed brokerage window.

Ms. Thompson said the company has never discussed the order of the funds with T. Rowe Price, its record keeper. "In terms of the ordering of individual (funds), we have not actually discussed that with them, but we will now," she said. The Hilton plan has $1.8 billion in assets.

While plan sponsors are still for the most part presenting their options in alphabetical order by asset class, some are starting to think of better ways to organize their lineups, according to Mr. Doellman. Vanguard, for example, moved toward a tiered approach that has an embedded alphabetic structure within it. It offers its record-keeping clients three investment tiers, much like T. Rowe Price offers Hilton. Vanguard's tier-two core investments, which consist of five to six stock and bond index funds, are organized in alphabetical order by asset class, while its tier-three "supplemental investments" consisting of 10 to 11 actively managed funds are listed alphabetically, according to Jean Young, senior research associate with Vanguard's Center for Investor Research in Malvern, Pa. Its tier-one option consists of Vanguard target-date funds.

In the study, Mr. Doellman and his co-authors — Jennifer Itzkowitz, associate professor in the finance department of Seton Hall University's Stillman School of Business in South Orange, N.J.; Jesse Itzkowitz, senior vice president and behavioral scientist at the Ipsos Behavioral Science Center in New York; and Sabuhi Sardarli, assistant professor in the finance department of Kansas State University's College of Business Administration in Manhattan, Kan. — suggest that sponsors and record keepers consider listing investments options in ascending order by expense ratio rather than alphabetically or by the level of fund volatility.

Mr. Veneruso supports the idea. "We are definitely helping our clients in terms of how to present the lineup to their participants and alphabetized is not the recommendation at all," he said.

For participants who opt not to go with a target-date fund and take a more hands-on approach, Mr. Veneruso advises plan sponsors to arrange the options according to objectives or along some sort of risk-return spectrum.

Not everyone is on board with switching to a different way of presenting options. Vanguard, for example, is wary of rocking the boat, insisting that any bias is mitigated by the fact that most participants are enrolled in target-date funds.

"Two-thirds of new plan entrants join these plans through automatic enrollment where the default is the target-date fund," Ms. Young said.

Neil Lloyd, head of U.S. defined contribution and financial wellness research at Mercer in Vancouver, British Columbia, also has reservations, saying that listing options by, for example, expense ratios may have unintended consequences. Participants need to consider more than just fees when selecting a fund as fees are just one of many aspects to evaluate, he said.

Mr. Doellman agrees there may be potential unintended consequences, saying that organizing funds by expense ratio, for example, could lead to participant accounts with the same kind of funds in them. However, the goal of the study, he said, is not to "propose any one way of doing this," but rather to get people talking about an important issue. "If we know people are making suboptimal investment decisions and those decisions are largely the result of biased decision-making, then let's start talking about how we might better organize plans or present information to employees," he said. "I think what our study wants to try to do is get this conversation going."