Investment Menu Simplification: The Case for Consolidation
By: Jared Martin, CFP®, AIF® and Austin Cleveland
Retirement readiness significantly challenges plan sponsors. Plan sponsors have a responsibility to design retirement plans that maximize participation, minimize fees, and provide participants with investment options that meet the diverse needs of their participants.
In building an investment menu, plan sponsors may be inclined to utilize a “bigger is better” approach. They offer more investment options to give participants greater optionality. However, plan sponsors must be aware of the risks of building an excessively large investment menu. These risks must be evaluated from both a participant and fiduciary perspective to understand them holistically.
Participant Considerations
Participant psychology is a crucial piece of investment menu design. Studies have shown that plan participants can exhibit choice paralysis when presented with too many options. One recent US Department of Labor study found that retirement plan enrollment decreased by 1.5-2% for every 10 funds added to a 401k plan.
Plan sponsors have begun to recognize the benefits of investment consolidation. Fidelity Investments reported that the average number of investment options offered in their largest 401(k) plans has decreased from 26.3 in 2010 to 15.4 in 2020 (a full target date series is considered as one fund). Target date funds have created a streamlined and professionally managed solution for participants who do not desire to manage their own portfolios.
The availability of extensive investment funds may also provide a false sense of diversification as funds may overlap in their underlying holdings. For example, Fidelity Blue Chip Growth and Harbor Capital Appreciation include 11 of the same stocks within their top 20 holdings as of March 31, 2024. Significant overlap can lead to highly correlated investment performance and risks.
Fiduciary Considerations
Plan sponsors have the responsibility to monitor all investments offered in their plans. Increasing the number investment offerings creates additional administrative burden with each added fund, making it incumbent on fiduciaries to ensure that the benefits outweigh that obligation. Qualitative considerations, like shifts in investment philosophy or process or changes to the portfolio management team, can be especially difficult to monitor for a larger investment menu as they require more time and detailed attention.
Plan sponsors also must be conscious of the expense ratios of the funds offered to participants. Investment management fees typically make up the largest portion of defined contribution plan expenses. In an investment menu comprised of numerous options offered in each asset class, participants might miss out on the benefits of the economies of scale that result from consolidation.
Participants could save 1% or more per year in fees if plan sponsors replace high cost “retail” share classes with institutional share classes. To demonstrate the impact of expense ratios, let’s compare two participants who save the same amount of money for the same amount of time and both invest in an S&P 500 index fund. The only difference is how much investment management expenses are paid: one invests in a fund with an expense ratio of 0.04% and the other has an expense ratio of 0.95%. Over 40 years, investing in the lower cost index fund would lead to $878,943.60 in additional savings at retirement. The impact of fees, since they are paid as an annual percentage of assets, compounds just like the value of a participant’s account.
Assumptions: Both participants save $5,000 per year for 40 years, savings compound every year by the average annual return for the S&P 500 since 1928 (11.66% according to data from Aswath Damodaran, NYU) minus the expense ratio for each fund, participant one invests in an S&P 500 index fund which costs 0.04% per year, and participant two invests in an S&P 500 index fund which costs 0.95% per year. Expense ratios are from two real index funds.
Plan sponsors hold a responsibility to provide participants with investment options that allow for sufficient levels of diversification for various risk tolerances and investment time horizons. However, there is a tipping point. Finding the right number of options to maximize plan participation and diversification is key. From a participant perspective, an excessive number of investment options can create choice paralysis and may give a false sense of diversification. From a fiduciary perspective, excessive investment options can be difficult to monitor effectively and can prevent participants from accessing lower cost share classes or separate accounts.
Consolidation should be done thoughtfully, so as to not remove a fundamental asset class or investment style completely. It is important for fiduciaries to communicate the purpose and value of consolidation as to not confuse participants or cause them to believe that their choices for retirement savings are being reduced or eliminated. But when consolidation is carefully considered and artfully implemented, plans and participants will benefit.