What you know about retirement plan investment menus might be wrong, as a recent piece of research from Chicago-based Morningstar seems to stand conventional wisdom on its head.
For years, retirement experts have urged defined contribution plan sponsors to limit the number of funds on their plan’s investment menus, as it was thought a larger number of choices could confuse participants and lead to paralysis instead of enrollment in the plan and investment in an appropriate asset allocation. But the opposite is true, according to “Bigger is Better,” a white paper coauthored by David Blanchett, Morningstar’s head of retirement research.
“A larger menu can do two things,” said Blanchett. “It can draw you to it like a massive tray of desserts, you just want all of them, or it can be a menu of 100 options that leaves you unsure of what to do, so you just go with whatever is easiest, which in the case of retirement plans, means the default investments.”
Blanchett and his co-researchers studied more than 500 retirement plans to determine the relationships between the size of a plan’s core investment menu and two participant investment choices: Whether or not they chose the plan’s default investment options, and whether or not self-directed investors were creating more efficient portfolios.
According to Blanchett, the same phenomenon that previously led experts to worry about participant paralysis when enrolling and investing now actually works in a plan’s favor. But rather than prevent participation altogether, choice overload now leads participants to select the default investments.
“We have an engrained perception that a smaller fund menu is better, based off of research done a decade ago before the mass introduction of default investments,” Blanchett said.
Morningstar looked at plans with 10 to 30 funds on their core investment menu (not counting target-date fund lineups). For each additional fund offered on its core menu, the rate of participant acceptance of default investments increased by 0.7%—an effect large enough to have an economically significant impact on retirement outcomes for participants, according to the study.
While 74% of participants in plans with 10 funds on their core menu accepted the default investment option, 87% of participants in plans with 30 funds on their core menu accepted the default option.
But a broader menu of funds also helps self-directed participants create better portfolios because investors in plans with larger menus tend to have more funds in their portfolios, Blanchett said. Participants in plans with 10 funds had an average of 4.4 holdings in their portfolios, while participants in plans with around 30 funds had an average of 8.6 holdings. Risk-adjusted performance increases by an average of 3.6 basis points for each additional fund included in a portfolio, according to Morningstar.
The study didn’t establish an ideal or optimal number of funds for plan menus. According to Blanchett, the average retirement plan fund menu currently has 18 investment options .