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Friday, June 7, 2013

Behavioral finance techniques really work in 401(k)s

LifeHealthPro:
JUNE 6, 2013 • REPRINTS





... I’ve written about the problem of choice overload and the detrimental effect it has on 401(k) plans (see, “4 Proven Strategies to Reduce Choice Overload in 401(k) Plans,” FiduciaryNews.com, June 4, 2013). Behavioral finance has been a “hobby” of mine ever since I started my own firm in the mid-1990s. I like it because it’s true. It’s true when it comes to picking stocks. It’s true when it comes to buying mutual funds. And it’s especially true when designing 401(k) plan investment menu options
...[Here's] the real problem with choice overload – it can be the reason why a 401(k) plan fails its annual nondiscrimination test. ... As the name implies, it’s caused by there being too many choices for the participant to process. Instead of making a decision on which fund or many funds to pick, the employee makes an even easier decision – the employee chooses not to participant. ... 
Unfortunately, as we all know, nonparticipation has a dark side for the plan sponsor. It increases the likelihood of failing the nondiscrimination test. ...
Along comes behavioral finance to the rescue. Studies show there are plenty of reliable ways to boost participation and leading providers and their plans are employing them with success (see, “How Plan Sponsors Can Restructure a 401(k) Investment Menu to Increase Participation,” June 5, 2013). The most obvious solution is to simply cut the number of options. 
The best solution, however, requires us to rethink the way we approach the plan itself. Almost since its very inception, the 401(k) plan has been investment-centric. ... The increasing problem, though, has been as investments become more complex, more employees are tuning out their 401(k) plans. Product salesman can regale – and sometimes even confirm – 401(k) plan sponsors to include the latest bells and whistles of alternative investments, annuities or target-date funds, but, to the average employee, that’s all nothing but a bunch of mumbo-jumbo. 
This trend has begun to reverse. We see more and more 401(k) plans adopting the idea of offering a menu of “employee categories” rather than a menu of “investment options.” Sure, in a lot of cases, they contain the same mutual funds (although the total number is well below the industry average). The difference is how the menu is worded. Gone are the catch-phrases of Modern Portfolio Theory (e.g., “asset class,” “style box” or “___-cap” anything) and in are the easy-to-understand personality descriptions like “Do-It-Yourself” and “Do-It-For-Me.” Gone is the concept of “asset allocation” and in is the idea of “aggressive,” “moderate” and “conservative.” 
Again, these new phrases may lead to the same funds, but the end is not the purpose, the journey is. We want more employees to participate – to make the journey. It doesn’t really matter what fund choice they make (well, except for money markets or other fixed income vehicles). The average asset allocation is not very different than the optimal asset allocation in terms of performance. Starting to invest earlier, more often and in greater amounts has a far greater impact on meeting your retirement goal than any particular investment a fiduciary would recommend (and, we all know, only fiduciaries should make those recommendations, but that’s another story).
I’ve seen first-hand the fruits of this new finance – this behavioral finance – reap benefits for companies using it. If you’d like to see a real-life example of a new improved 401(k) investment menu, you can find it here “Adding Categories: A Sample of a New and Improved 401(k) Investment Option Menu,” FiduciaryNews.com, June 6, 2013). Go ahead. Use it. If you like it, you can thank me by buying my book.
About the Author
Chris Carosa
Chris Carosa
Christopher Carosa, CTFA, is chief contributing editor for FiduciaryNews.com, a leading provider of essential news and information, blunt commentary and practical examples for ERISA/401(k) fiduciaries, individual trustees and professional fiduciaries. With three decades of experience in the investment industry, Carosa has helped create or found a number of financial products and firms including mutual funds, common trust funds, registered investment advisers as well as a billion-dollar trust company. He is also the author of the new book, "401(k) Fiduciary Solutions." Follow Fiduciary News on Twitter and LinkedIn.


Originally published on BenefitsPro. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

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