How many investment options are too many?

Last week we received a call from an AIF designee who was working with a plan that had over 75 investment options available for participants to choose from. He knew it was too many, but asked for our help in putting together a compelling case as to why too many options is not a good thing and what a reasonable number might be.

In the Prudent Practices handbooks, most of Step 2 instructs on designing an optimal asset allocation strategy based on the portfolio's goals and objectives. And in our classroom program, we include considerations of the “1/n” phenomenon, where investors divide equally among investment options available, as well as participants who will go to the opposite extreme and select a single investment option. These common behaviors illustrate why careful management of the number and type of investments offered in a participant-directed plan are critical plan design considerations.  A particularly helpful slide suggests an order for adding asset classes to a portfolio based on factors such as the size of the portfolio, the investment expertise of the fiduciary, the ability of the fiduciary to properly monitor the number and variety of options considered, and the sensitivity of the fiduciary to investment expenses.

Other than this guidance that the number of investment options should be based on facts and circumstances, we don’t offer any kind of formula or benchmark as to the specific number of options. To try to find more specific information, I turned to research to find how the number of investment options available can affect either investment behavior or portfolio performance.

First, a study from the Journal of Finance found investors tended to choose a small number of funds to invest in, no matter how many were offered, and that they tend to invest roughly equal amounts in each of the funds they select. So, at least in this one study, a large number of options does not correspond in participants taking advantage of them.

So what's the harm in making a large number of options available? The negative effects are most felt in investor behavior. A study from Columbia University found that when the number of investment options went up, enrollment went down, all the way to just 60% participation when the number of investment options approached 60.  (This study and others are cited in an Executive Summary from Vanguard on the subject).

Not only does the number of options affect participation rates, it can also affect how investors make their choice. One study from AllianceBernstein shows that as the number of investment options go up, so does the conservative nature of the funds chosen. The only factor that should be influencing selection should be which options help the beneficiary achieve their end goal.

Another important factor to consider is the number of options within a certain asset class.  In a review of its own state employee retirement system plan, the state of Missouri found that offering too many similar options was contributing to overlap and therefore improper diversification. It also found that by decreasing the number of options available and introducing target-date funds, it would be able to save on management fees and, potentially, administrative costs to the plan.

But perhaps the best case study I found demonstrating an effective and thorough process for selecting asset classes and investment options came from an investment option review by the Federal Thrift Savings Plan. The review found the plan to be comparable to peer plans with 10 available options.  The TSP review also includes great insight into their evaluation of investment options and why the individual asset classes either were or were not included among available options, and why some asset classes had only one option versus multiple options. You may find the 80+ page report excessive to reproduce for your own needs, but it demonstrates the type of thought process and documentation that a plan should be considering when building a prudently built portfolio of fund options that suits the goals and objectives of the end beneficiaries.

Other Resources:

• Plan design is just one of the metrics measured by Fiduciary Benchmarks, Inc., see this sample report.
• TIAA-CREF put together a research summary on plan investment options and investor behavior.
• Fi360 Tools offers an asset allocation optimizer for building diversified portfolios.

Have you had similar experiences where a plan has excessive investment options, seemingly just for the sake of having a lot of options? How did this affect the plan? Were you able to get the plan to revise their offerings to a more reasonable number? Let us know in the comments section below.

If you have a fiduciary question you need answered or would like to see addressed in a future blog post, let us know in the comments section or send an email to blog@fi360.com. 

Comments

[Steve Smith]

What do folks think about a plan offering only asset allocation choices along a risk and/or target date spectrum and not allowing participants to choose individual funds or design their own portfolios?

[Rich Lynch]

This is the second time we have heard this question this week, which tells us there are a number of plan sponsors that are considering this approach. On the opposite side of the spectrum are the self-directed brokerage accounts or windows, for which we have advised caution for years now, as we feel they are inherently more risky and very difficult to monitor. Moving to a plan that only offers one stop shopping, choices from a select list of risk-based or age-based funds or accounts, will ensure that all participants are at least invested in a diversifed portfolio. For an unsophisticated participant universe, it probably makes sense and we are not aware of any laws, regulations, or case law that indicate this would constitute a fiduciary breech. I suspect, however, that most often there will be some participants that want more choice.

[Alexandr Levin]

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[Gerald Sanford]

Have a manufacturing company client. Majority of employees are hourly production. Since workforce was largely unsophisticated, we suggested they offer 5 risk based funds plus a stable value fund. Have had no complaints from any employee. Simple and easy to explain and most of all the employees are better off than picking funds at random.