Head to head: Is too much choice an issue in DC plan investment options?

As a member of the College of Physicians and Surgeons of Ontario’s pension committee, I believe in offering more investment choices in a defined contribution pension plan as part of an overall retirement savings plan.

Four key factors contribute to this view. First, plan members’ individual financial circumstances and tolerance to risk may vary. An employee who has accrued savings through their defined benefit plan from a previous employer may wish to take on more risk in their DC plan — investing in equities, for example. More choice would also allow employees to take their spouse’s investments into consideration.

Read: Is more investment choice actually good for DC plan members?

Also, to have a best-in-class DC plan, employers are expected to be aware of best practices and new developments in the investment industry, offering fund options that reflect modern trends. For example, two years ago, CPSO elected to add low volatility and infrastructure funds to its DC plan’s investment choices. CPSO also periodically reviews the investment industry to determine whether changes are required for plan members.

In addition, a diverse lineup helps mitigate risk, both from a fee and a performance perspective. Offering a choice between passively and actively managed funds will help meet the needs of both employees seeking low-priced investments and those seeking growth. Active fund managers should be considered in asset classes where there’s consistent outperformance of the benchmark. And, from a performance perspective, more choice lowers the risk of a single fund manager’s underperformance.

But mostly, it’s the desire to meet the needs of a do-it-yourself investor versus those who are less hands-on. For example, target-date funds are a simple solution for those who want to delegate their investment decisions to experts. Conversely, the other single asset class funds offer more experienced investors the ability to tailor their investments to their specific needs
and risk tolerances.

Roman Kosarenko, director of pension investments at George Weston Ltd.:

There are no legal barriers preventing plan sponsors from offering a single investment fund in a DC plan. The Saskatchewan Pension Plan, for example, had just one fund for more than 20 years; today, it offers only two. Indeed, modern portfolio theory requires, at a minimum, only two assets — market portfolio and a risk-free asset.

Read: How default investment funds are becoming smarter

Plan sponsors usually offer a far greater choice. This is often explained by variability in plan members’ risk tolerances, asset levels, retirement needs and even prior investment beliefs. And unfortunately, plan sponsors are often led to believe fiduciary responsibility is minimized when member choice is maximized, because no investment decisions are made at the plan level.

Plan sponsors can’t avoid fiduciary responsibility by avoiding investment decisions. For employers with highly engaged workforces, investment education may be the answer, or maybe access to outside investment advice. Yet a typical DC plan member would prefer simple, cost-effective solutions, where someone else makes the decisions for them. This is one of the reasons target-date funds are so dominant.

Research in behavioural finance demonstrates that excessive choice can lead to real financial harm. Plan members cut corners and invent silly rules of thumb just to take the choice down to a manageable level. For some people, excessive choice leads to decision paralysis, and that can be devastating in the long run.

Read: Plan sponsors urged to brush up on science of financial markets, human behaviour

A minimal set of carefully designed investment choices can work around behavioural biases. It can also significantly reduce the plan’s operating costs, due to lower management expense ratios and investment oversight costs, as well as cheaper to deliver, more effective education.

Finally, when investment advice is provided at the plan level, the cost is shared by all members (think robo-advisors). Member-specific advice is always more expensive and can’t
be easily scaled up.