Two colleagues have recently asked for my input on two CAP investment questions that I believe to be related. The first question involved an “investment warranty” program offered by an insurer; the second focused on whether I had any external (i.e. independent) information on an insurer’s statement that “the current 25 fund lineup is just fine”.

Interestingly, both questions involved the same insurer, which offers an investment warranty to indemnify CAP plan sponsor clients from certain claims relating to investment choices. There are several terms and conditions associated with the warranty, chief among them a requirement that the CAP must offer at least 22 investment options across various asset classes.

There is a problem here. A significant body of academic research exists under the category of “behavioural economics” that strongly suggest that 25 (or even 22) funds in an investment lineup would actually impair the ability of most plan members to make meaningful investment choices.

An often cited authority in behavioural economics research is a paper entitled When Choice is Demotivating: Can One Desire Too Much of a Good Thing? This paper cites compelling experimental results that people will choose from a limited product offering (6 choices is cited), but they will not choose from a much larger offering (24 or 30 choices cited).

Another foundational paper, Naive Diversification Strategies in Defined Contribution Savings Plans focuses on investor behaviour when faced with investment fund choices. This paper concludes that it is a common strategy for 401(k) members to naively choose to diversify across all investment choices available to them. This is actually quite common behaviour which is readily exhibited in plans that offer funds across traditional asset classes together with asset allocation funds (the latter category encompassing balanced funds, “target-risk” funds and “target-date” (lifecycle funds). Many members will choose to invest in one or more asset allocation funds as well as across traditional asset classes, thus defeating the purpose of utilizing an asset allocation fund.

A more recent paper, The Adequacy of Investment Choices Offered by 401(k) Plans looks more closely at the issue of the number of investment choices. Some key aspects of this paper are as follows:

• In a U.S. context, investment options need span only 8 “research-based” indices, specifically 4 domestic equity (value, growth, large cap, small cap), 1 international equity, and 2 domestic fixed income (1 encompassing government, corporate and mortgage-backed, the other high yield) and 1 international fixed income.
• Of the 680 plans surveyed, the median number of investment choices was 8, with only 12% of plans offering 4 or fewer choices and 11% offering 13 or more&#8212only 4.56% offered more than 16 fund choices (inclusive of money market and GIC options).
• Sufficient diversification can be achieved through offerings of as few as 2 funds&#8212of the plans offering 8 funds, more than half had sufficient diversification in their offerings (excluding money market and GIC options).

The paper concludes that some plans should have more investment choice in order to allow investors to construct their own efficient frontier portfolios. A fundamental problem in practically applying the conclusions of this paper is that very few CAP members are capable of constructing their own efficient frontier portfolios even if their plan’s fund offerings are sufficient to such purpose.

The main overall conclusion to be drawn from this body of research is that most plan members do not cope well with too much choice and will trend towards investing in either a default fund, or across all funds. This may explain why America’s favourite ice cream flavour, by a very wide margin, is vanilla.

The academic research has contributed to a meaningful public policy response in the U.S. “Safe harbor” rules for 401(k) plans were changed in 2007 to require every plan to have a “Qualified Default Investment Alternative” (or QDIA), which is defined to be a lifecycle fund, an asset allocation fund or a balanced (diversified) fund. This ensures that those who cannot make a choice when faced with too many options will default to a fund with a reasonable level of diversification.

Circling back to the original questions, I first offer a comment on the investment warranty. Under the warranty’s terms, in order for it to apply, a minimum of 22 funds must be offered which span specific asset classes and management styles, and plan sponsors must (among other things) “evaluate the needs and abilities of the Plan and its participants and tailor the investment options available under the Plan to those needs and abilities…” The research cited in this column would indicate that these two requirements represent an irreconcilable conflict.

On the second question, we reviewed the actual investment allocations of members in the plan with 25 funds. We found that roughly 80% of the assets in the plan spanned 2 balanced funds, one being the current default fund and the other the previous default. Q.E.D.