Steve Utkus, Principal and Director of Vanguard Center for Retirement Research
The phenomenon of choice overload—that individuals find too
many choices perplexing and demotivating—is one of the most popular ideas in
behavioral economics. Choice overload came to the forefront with Sheena
Iyengar’s well-known study of chocolates and jams in a grocery store—too many
options made shoppers disinclined to like or buy. The concept has also made its
way into 401(k) investment lineups. Professor Iyengar and coauthors found that
too many fund choices reduced plan participation and encouraged participants to
gravitate toward familiar options like money market funds. (The 401(k)
research, coincidentally, was made possible by a collaboration between Vanguard
and Iyengar.)
Choice overload offered a strong critique of a central
organizing principle of 401(k) plans—that an extensive list of investment
options is the best way to maximize welfare for workers, and the larger the
list, the better. Other research (including our own) showed that while some
participants made reasonably effective use of extensive choice sets, a large
group made erratic portfolio decisions—investing either at extreme asset
allocations or with high levels of concentration or idiosyncratic risk.
Sponsors designed complex menus under the hypothesis that participants had
strong preferences for, say, investment contracts over stock index funds,
mid-cap value managers over long bonds, and so on. In reality, most did not.
It’s still common today to talk about DC menu options in
terms of choice overload. Yet, we’d argue that the time has come to retire the
concept, given the growth of automatic enrollment and target-date funds in DC
plans. As of year-end 2015, 78% of new entrants into Vanguard recordkept plans
were in professionally managed allocations—either a single target-date fund (76%)
or traditional balanced funds and managed accounts (2%). Among all
participants, half (48%) were in a professionally managed allocation, either a
single target-date fund (42%) or balanced and managed account options (6%).
If this trend continues, we anticipate that over two-thirds
of all Vanguard participants will be in a professionally managed strategy,
mostly a single target-date fund, by 2020. For these participants, there is no
problem of choice overload. The process of choosing has been delegated to the
target-date money manager or other advisor running an all-in-one portfolio.
What is underlying this change? The obvious explanation is
the strong default effect of automatic enrollment. Automatic enrollment is
increasingly common, and the most prevalent choice of a default fund for
automatically enrolled participants is a target-date option. Because of
inertia, participants stick with that option.
The other explanation, which has received less attention, is
a streamlined choice effect. Many plans still offer voluntary enrollment,
whereby participants must choose both a contribution rate and investment
option. In these plans, the presence of target-date funds, particularly in the
first tier of a menu, has radically streamlined the decision-making process for
participants. Participants in these cases gravitate toward a single target-date
option because it reframes investment choice from a complicated portfolio
construction process to a single question: In what year do I expect to retire?
It’s a sign of the shifting choice architecture of U.S. DC
plans. A default and a streamlined choice effect have trumped the problem of
too much choice.
In this environment, as we argue in our paper on DC plan
design,¹ the fundamental design principle underlying DC investment menus has
changed. Given that many investors are no longer making active choices (either
because of a default or streamlined choice effect), the menu becomes a decision
aid, a way to frame choices, for the motivated investor. This is the small group
of participants who have strong investment beliefs and who want to deviate from
a professionally managed, all-in-one portfolio option.
To us, the end of choice overload in DC plans signals a new
era. It marks the emergence of a more desirable model of decision-making than
the “more choice is better” model of the traditional 401(k) —one in which more
participants end up in professionally designed portfolios while allowing a
smaller group with strong convictions to create their own way.
¹
Frank Chism, Kelly N. McShane, and Stephen P. Utkus, 2016. Constructing a
defined contribution investment lineup: Four best practices. Valley Forge, PA:
The Vanguard Group.
About Steve Utkus
Mr. Utkus is a
principal and director of Vanguard Center for Retirement Research. The Center
conducts and sponsors research on retirement savings in the United States, with
an emphasis on private defined contribution retirement plans. Its work is
designed to assist employers, consultants, policymakers, and the media in
understanding developments in the U.S. retirement system. Mr. Utkus’s research
interests also include behavioral finance and the role of psychology in
household financial decisions. Mr. Utkus earned a B.S. from the Massachusetts
Institute of Technology and an M.B.A. from The Wharton School of the University
of Pennsylvania. He is a member of the advisory board of the Wharton Pension
Research Council and is currently a visiting scholar at Wharton. Mr. Utkus is a
member of the board of trustees of the Employee Benefits Research Institute in
Washington, D.C.
