Defined contribution savings plans give individual employees more responsibility for their investment decisions-are they up to the task?
Research by Richard H. Thaler
What mix of fixed income and equity funds should companies offer in their 401(k) savings plans to prevent participants from investing too conservatively or too aggressively? How should plans deal with differences in risk aversion across the participant population? Should plans offer different funds based on the age of participants, allowing young employees to select aggressive, stock-rich portfolios of funds and older employees to gravitate toward fixed-income funds?
The array of funds offered to plan participants can strongly
influence the asset allocation individuals select-especially
given the growing popularity of defined contribution savings
plans where investment decisions are made by plan participants.
In the study, "Naive Diversification Strategies in Defined
Contribution Savings Plans," Richard Thaler, a professor
at the University of Chicago Graduate School of Business,
and Shlomo Benartzi of the Anderson School of Management at
UCLA demonstrate that many investors hold naive notions about
diversification and a pronounced lack of sophistication about
portfolio asset selection.
To a great extent, participants choose their asset allocations
based on the overall makeup of the funds in the plan. For
a number of years, TIAA-CREF, the world's largest defined
contribution saving plan, offered two investment options,
TIAA (bonds) and CREF (stocks), and found about half of plan
participants split their allocation right down the middle.
"It's particularly common for the proportion of assets
invested in stocks to depend on the proportion of stock funds
the plan offers," says Thaler. There is no shortage of
data to back him up.
Putting Money on the Line
Using actual data from the Money Market Directories (MMD)
covering 170 retirement savings plans with annual contributions
of $3.23 billion and assets of about $50 billion, the authors
found that 61.76 percent of the available investment options
in the plans were equity options, and that the mean allocation
to equities, defined as the combined allocation to company
stock, domestic equity, and international equity, was 62.22
Plan sizes ranged from 100 participants to 237,500 participants.
The database included a list of the investment options available
to participants in each plan, and provided information about
each investment option, including its investment style (i.e.,
money market, bonds, domestic equities), its assets as a percentage
of the plan assets, and the year it was added to the plan.
Turning to a simple categorical analysis, Thaler and Benartzi
used the relative number of equity funds to categorize the
retirement savings plans in the database into three equal-size
groups: low, medium, and high. In the low group, 37 percent
of the options were equities; in the medium group, 65 percent;
and in the high group, 81 percent. Calculating the mean allocation
to equities, they found that the low group had an allocation
of 48.64 percent, the medium group 59.82 percent, and the
high group 64.07 percent.
"Participants will choose mostly stocks in a plan predominantly
offering stock funds, and mostly bonds in a plan primarily
featuring fixed income funds," says Thaler.
were then evenly divided across the number of options, resulting
in a portfolio that had 75 percent of the total allocation
in stocks. Over a 20- to 30-year time frame, however, such
naive allocation strategies could prove costly.
First, investors might not choose from the best available
alternatives, and secondly, they might choose the wrong risk-return
tradeoff. The first type of error is not likely to cause too
much damage, because even a naive allocation strategy will
result in a well-diversified portfolio.
By contrast, picking the wrong risk-return tradeoff can be
exceedingly costly. For instance, for someone with minimal
risk aversion, investing too little in equities can lead to
large "ex ante welfare costs," i.e., the anticipated
costs of making a decision before the outcome is known.
The Bottom Line
To place the significance of the effects of naive investment
behavior in context, Thaler and Benartzi found that a rational
investor would increase his or her equity exposure from 50
percent to only 53 percent as the proportion of equity funds
increased from 33 percent to 87 percent.
"This implies that the shifts in equity exposure are
much more strongly influenced by the array of funds in the
plan than would be expected," says Thaler.
One potential flaw in this analysis is the possibility that
companies choose the fund options in their plans to reflect
the desires of their plans' participants. Thus, the underlying
risk preferences of the plan participants would drive the
observed association between the relative number of equity
funds and asset allocation, the authors note.
To test the likelihood of that possibility, the authors used
a time series analysis of changes in the asset mix within
plans. They obtained data from a pension consulting firm on
one mid-size company that had twice changed the array of funds
it offered during a four-and-one-half-year sample period.
There were two opportunities to observe how employees' asset
allocations responded to the changes.
As the company made additional stock fund options available
to employees, the allocation to stocks increased. A later
elimination of a bond fund also increased equity allocation.
Food for Future Thought
The results of Thaler and Benartzi's research suggest that
the surge in private plan retirement funds invested in equities
over the past decade may have much to do with the numbers
of new equity funds added to these plans. That trend could
continue, based on the ease of differentiating equity funds
by firm size, style, industry or sector, and country or region,
compared with the relative difficulty of differentiating fixed-income
funds by anything other than maturity and risk. Their findings
also have implications for the design of both public and private
retirement savings plans.
While economists designing plans may worry about ex ante
welfare costs, public or private plan administrators may also
worry about ex post regret-the after-the-fact costs of a decision.
"A plan that by design encourages investors to put an
unusually large or small proportion of assets in equities
may suffer later if returns differ from historical norms,"