Fifteen Eighty Four

It’s hard to believe, but an increasing number of retirement plans are allowing employees to invest their 401(k) saving in non-conventional assets – including crypto currency funds and meme stocks.  On the one hand, limited exposure to esoteric investments can provide some diversification benefits, on the other hand, the investors who are interested in these vehicles often go all in and become widely undiversified.  Game Stop may become the employer stock of GenZ investors.

For most people with employer-provided 401(k) plans, successfully saving for retirement depends not just on having the discipline to save, but also on making sound investment decisions. Most people find managing their retirement portfolio an intimidating prospect, and mistakes can be costly and compound over time. Employers have a fiduciary duty in menu construction, and employer-curated menus should be designed to encourage sound investment choices, but the law says little about how to bring this duty into practice.  In Retirement Guardrails we tackle the challenge of menu design and show—with real plan data—that plan fiduciaries can and should be proactive in understanding how participants are using plan menus.   Employers should monitor for obvious signs of under diversification, curate the menu to maximize employee success, and—where appropriate—adopt guardrails that limit choice or warn employees that their allocations look suspect. This proactive fiduciary approach would lead to better outcomes and a safer retirement for investors.

Menu design in retirement plans is tricky. Including extensive options increases flexibility for plan participants with unique needs but makes navigating the menu more challenging for the (likely more numerous) set of participants with straightforward financial goals. Streamlining plans to reduce excess options can be beneficial for investors[1] but can also draw the ire of a vocal minority who favor particular investments.

Consider an example: The University of Virginia retirement plan, in which we are both happy participants and we use as a case study throughout Guardrails, formerly offered a fund that tracked the price of gold. Holding a sliver of gold exposure in a portfolio can offer diversification advantages, but gold also attracts eccentric investors who are “stocking up on canned beans and ammo as [they] wait for the apocalypse.”^[2] Whether offering exposure to gold makes sense depends on how investors actually use the fund: a diversifying sliver or a doomsday over-commitment? That’s an empirical question, but one that we have the data to answer.  Only a handful of investors actually held the gold fund at all, but among those who did, 13 percent of the participants invested in the fund had more than 70 % of their portfolio invested therein; and 11 percent had all their plan savings invested in gold.  UVA dropped the gold fund when it redesigned the plan, and doing so may well have left plan participants better off in aggregate, with some investors losing a bit of diversification, but others being steered away from highly questionable choices.

This type of monitoring is straightforward to undertake and but most plan sponsors don’t evaluate whether employees are misusing the plan menu.  Plans have real-time information about allocations and checking for large commitments to sector and regional funds, money market funds (for young investors especially), and other specialty choices is easy.  Using the (pre-streamlining) UVA plan as a proof-of-concept, we show that allocations that suggest investor error are fairly common among the minority of participants who do not allocate their entire portfolio to Target Date Funds (TDFs). With regard to diversification errors, we see that 11.8 percent of non-TDF participants have more than 10 percent of their portfolio invested in a narrow-gauged sector or regional fund, and that a whopping 65.4 percent of non-TDF participants have less than 20 percent of their equities portfolio invested in international stocks. With regard to fee errors, the figure shows that 5.6 percent of non-TDF participants have portfolios with average annual expense ratios in excess of 75 basis points. And with regard to exposure errors, we find that 15.5 percent have equity allocations that fall outside generous age-adjusted glidepath upper or lower bounds. Analyzed jointly, we find that 77.3 percent of all non-TDF participant portfolios make at least one of these four presumptive errors.

Plan sponsors should proactively try to reduce these problems. These sponsors are fiduciaries who have a legal obligation to create plans that protect employees’ retirement investments.  Does this sound paternalistic? Indeed. But the premise of employer-sponsored retirement accounts is that a curated menu can lead to better choices. That’s paternalistic by nature, and—as these plans represent a tax expenditure—we all have an interest in maximizing the return on that investment. There is no public policy reason that retirement savers need to be able to engage in wild speculation with their tax-favored assets.

But intervention need not be too heavy handed. We argue that the current approach to menu design is leaving a powerful tool on the table that could lead to even better outcomes for investors: guardrails.  As currently structured, most retirement sponsors make an all-or-nothing decision: they either include an fund in the menu or drop it.  If the option is in the plan, how much to allocate is entirely at the discretion of the investor, if the option is out, then it’s unavailable altogether.  We propose that plans adopt guardrails that would limit allocations (either a hard limit or a soft warning) that exceed certain thresholds.  With the aforementioned gold fund, a plan could include the fund, but limit allocations to 5 or 10 percent, thus providing an option for diversification while holding the gold bugs at bay. A plan could guardrail a money market fund by warning young investors who overcommit to the low-return investment that they may be taking too little risk to generate the returns needed to retire on time. Guardrails could catch insufficient equity exposure across the portfolio, excessive fees, and other common mistakes. Such limits are not wholly foreign to retirement plans.  Plans that offer company stock often cap the allocation at 10 percent. But guardrails need not be so simple: They could change dynamically with age, they could be relaxed for those who demonstrate financial sophistication or undertake financial literacy training,[3] they could be adjusted for those with substantial outside assets. Guardrails would provide dramatic flexibility currently missing in plan design, and we argue that they are legally permissible within the existing regulatory framework.  Leaving employees to their own devices isn’t working, and simply asserting that menu construction is a fiduciary task, as the Supreme Court has now twice held, isn’t enough. Better menus can make savings easier and help workers retire successfully.

[1] Donald B. Keim & Olivia S. Mitchell, Simplifying Choices in Defined Contribution Retirement Plan Design: A Case Study, 17 J. Pension Econ. Finance 363 (2018).

^[2] N. Gregory Mankiw, Budging (Just a Little) on Investing in Gold, The New York Times (July 27, 2013), www.nytimes.com/2013/07/28/business/budging-just-a-little-on-investing-in-gold.html.

[3] See Jill E. Fisch, Annamaria Lusardi, and Andrea Hasler, Defined Contribution Plans and the Challenge of Financial Illiteracy, 105 Cornell L. Rev. 741 (2020) (proposing mandatory financial literacy training through employers offering plans.)