Is more investment choice actually good for DC plan members?
While previous research has indicated that defined contribution pension plan members benefit from a limited number of core investment options because it reduces choice overload, is this still true now that automatic enrolment and default funds are becoming more common?
According to new research by Morningstar Inc., more investment options in a DC arrangement could lead to better results for plan members because it could prompt them to simply choose the default fund more often.
The research, which studied 500 U.S. DC plans with core investment menus featuring between 10 and 30 options, found the use of the default fund increased 0.7 per cent for each additional investment choice.
“While we do not have concrete data on why default acceptance increases with the size of the menu, we believe it is, at least partially, attributable to choice overload,” noted the paper. “Larger plan menus may overwhelm a participant and, thereby, make selecting the default investment decision less mentally taxing. Again, higher default acceptance would generally be in the participant’s best interest, given the relatively poor performance of participants who self-direct their portfolios.”
Further, a larger number of investment options could benefit plan members who manage their own investments, since the increased choice leads them to invest in a wider variety of funds, thus gaining more efficient portfolios, the report found.
It found the average number of funds in portfolios increased from about 4.4 among plans with about 10 options, to 8.6 for plans with around 30 to choose from, and, on average, risk-adjusted performance increased by 3.6 basis points for each fund in the portfolio. “Therefore, increasing a fund menu from 10 funds to 30 funds, which would result in an average increase in holdings of approximately three funds per participant, would result in an estimated increase of alpha of 11 basis points for those participants self-directing their accounts.”
When considering both the increased use of the default fund and the more efficient portfolios of self-directed members, the report found raising the investment choices from 10 to 30 in a core menu would result in an aggregate increase of expected alpha for the plan of approximately 10 basis points.
“While this may not seem material, it represents a relatively easy way for plan sponsors to improve likely retirement outcomes for participants,” the report said. “While there are additional administrative and monitoring costs that need to be considered when maintaining a larger core menu, those costs are likely significantly lower than the expected benefits.
“Overall, large core menus appear to have the dual benefit of nudging more participants to use the default investment and then enabling self-directed participants to build more-efficient portfolios. When it comes to core menus, ‘bigger is better.’”