How Retirement Plans Should Protect Employees From Themselves

When it comes to 401(k)s and other retirement plans, employees are often their own worst enemies.

The problem—as we have learned by studying the portfolios of thousands of employees in a large institutional plan—is twofold. First, many employees put their portfolios at risk by failing to diversify their investments. And second, many choose investment options with relatively high fees that eat into their returns.

Overall, we estimate that about 10% of plan participants fell prey to one, or both, of those errors.

What’s more, both the advisers that administer plans and help craft their menus, as well as the employers that offer the plans, often act as enablers for poor investment choices—the advisers because they include high-fee funds that they profit from in plan menus, and the employers because they don’t do enough to protect their workers from making investment mistakes. It’s up to employers to do better.

The gold rush

To get a sense of the problem, consider what happened when the plan we studied offered employees the option of investing in a fund that tracks the price of gold. Of the plan participants who invested in the gold fund, half invested less than 5% of their portfolio in it—not a troubling share of a portfolio for a fund whose returns depend on a single asset, as opposed to, say, a diversified equity fund.

But a worrisome 35% of those who held the fund had more than half their money in it—clearly far too much for a narrowly focused fund, by our reckoning—including 11% who had all of their money in it. Those investors don’t have the cushion that greater diversification, or any diversification, would provide should the price of gold decline.

This failure to diversify sufficiently wasn’t limited to a few zealous gold bugs. Overall, we found that nearly 22% of participants who held any narrow fund held more than half their portfolio in that fund. 

Problematic menus

We also found that the menu itself was part of the problem—an issue that isn’t peculiar to the plan we studied. It made it too easy for employees to invest too narrowly and pay too much in fees.

One issue with menus is that some employers have no idea whether plan participants are making poor choices.

That’s because in those cases the advisers who administer the plan don’t give the employer any information on how individual employees allocate their savings. Employers have fiduciary committees that are given reams of information about the returns of each investment option at quarterly meetings with the advisers, as well as comparisons to the returns of similar funds. But they often aren’t told whether individual participants are misusing the menu by creating unbalanced or expensive investment portfolios.

The fund advisers don’t have any financial incentive to provide such information, or to design plans in ways that would tend to reduce diversification mistakes to begin with. They often create menus that include high-fee, undiversified funds of their own that are attractive to participants who believe they can use such funds to beat the broad market. Plan participants’ demand for these funds helps perpetuate the problem.

Building a safer plan

So, with plan advisers and participants often fueling the inclusion of narrow, expensive funds in retirement plans, and employers often blind to their employees’ mistakes, what can be done to help workers make better choices?

To start, employers’ fiduciaries should ask for better information about how participants are using the plan menu. Armed with this information, they can act to reduce employees’ missteps.

One way to do that is to streamline plan menus by eliminating undiversified funds that participants tend to invest in too heavily. The plan we studied did just this in 2016, eliminating more than 200 funds from its menu, including all its narrow-sector fund offerings—its gold fund among them. Participants’ investments in these funds were transferred by default to the plan’s target-date funds or to broad-based equity indexes. This streamlining substantially improved the diversification of participants’ plan balances. 

But streamlining isn’t the only remedy for menu misuse. Fiduciaries who learn that participants are misusing their menu options should also consider imposing various forms of allocation guardrails. For example, instead of eliminating a gold fund, a plan might cap the percentage of new contributions that can be allocated to gold to, say, 10%. That would protect those who otherwise would have invested too much in gold, while allowing more-prudent investors to continue making moderate investments in this fund. 

Guardrails can actually increase choice overall: Plenty of plans that might balk at offering, say, a cryptocurrency option might find it acceptable to do so and cap its use at 5% of a plan participant’s portfolio. Options like that might keep the menus of employer retirement plans attractive to employees who would otherwise funnel some of their money into riskier brokerage apps. 

Guardrails also are more targeted than streamlining.  Streamlining at the plan we studied affected 30% of its participants, while our analysis showed that guardrails could have produced similar or greater benefits while only affecting the 10% of participants who were making serious allocation errors.

Expect dissent

To be sure, a vocal minority of participants will cry foul if their choices are limited by streamlining or guardrails. But fiduciaries have a legal obligation to design menus prudently. This includes a duty to reduce allocation errors. 

It should also be noted that guardrails already exist in many plans with regard to participants’ ability to invest in one specific asset: their company’s stock. Roughly two-thirds of plans that offer company stock limit participants’ stake in these shares to 20% of their portfolio.

Here’s another way to look at the whole issue by using an analogy outside the investing world: Imagine a product manufacturer that has ready access to information that customers are injuriously misusing its product, and a ready means of reducing the probability of harm, would have a legal duty to redesign that product. Plan providers who have taken on the legal duty of a fiduciary should have an analogous duty, to learn whether participants are misusing their menu and, if so, to act by streamlining the menu or putting guardrails in place.  

Ian Ayres and Quinn Curtis are law professors at Yale University and the University of Virginia, respectively, and authors of “Retirement Guardrails: How Proactive Fiduciaries Can Improve Plan Outcomes.” They can be reached at [email protected].