Feb 24 (Reuters) - When you're trying to build toward financial security in retirement, complexity is the enemy.
That message came through loud and clear in an opinion delivered last month by the U.S. Supreme Court in a case brought by employees against Northwestern University. The plaintiffs alleged that the university’s retirement plan had too many investment choices and excessively high fees.
Retirement plan sponsors have a fiduciary duty to monitor and control plan costs. Northwestern operates a 403(b) plan - a sibling of 401(k)s used by public schools and universities, nonprofits and churches. At the time in question, the Northwestern plan had more than 400 investment choices, and the high court ruled that offering workers a broad range of choices did not shield employers from claims that some of the funds on the menu were imprudent selections because of their high fees. The high court disagreed with a lower court ruling, and sent it back for further consideration.
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A Northwestern spokesperson expressed disappointment with the ruling, and denied that the university had violated its fiduciary duty.
But no matter how the case is resolved, it serves as a reminder of the complexity of many of the retirement systems we have built in the United States, and the increasing burden we put on the individual to navigate a myriad of choices.
Over the past four decades, employers largely have shifted from defined benefit pensions to 401(k)s. In the old system, the employer contributed to your plan and managed it - at retirement, a regular check started arriving in the mail, and it did not stop until you died.
Today, most employees navigate the world of self-directed 401(k)s. You are left to your own devices when it comes to figuring out how to turn your portfolio into an income stream in retirement. And the average large plan offered 28 investment options in 2018, according to a report issued last year by Brightscope and the Investment Company Institute. If you subtract target date funds, which offer automatic reallocation of the mix of stocks and bonds according to investors’ age profiles - the average number of options was 21.
That is more choices than most people can navigate successfully. So how much should the menu be shortened?
“The ideal menu length for me would be a series of target date funds, a couple stock funds and one or two bond funds,” said John Rekenthaler, a Morningstar columnist and member of the firm’s investment research department. Beyond that, he argues, the differences between funds are very small - and sophisticated plan participants looking for more investment choices can always find them outside their 401(k) plans, he notes.
In the early days of mutual fund investing, a wide array of choice in retirement plans was seen as a plus, but that really appeals only to a small percentage of investors, Rekenthaler argues. “For the vast majority of people, giving them more choices does not make them happy. It's not like television, where giving people a thousand stations is fine because people like TV and don’t mind browsing. They don’t want a thousand mutual fund choices, because they don’t like investing. For most people, it’s a painful process.”
The Northwestern plaintiffs also charged that the university failed to take advantage of lower-cost institutional-class mutual funds identical to the more expensive retail funds in the plan. In some plans, such a failure can be related to the size of the investment menu, since the dollars invested must cross a certain threshold to qualify for the cheaper institutional options. That has been a particular problem in 403(b) plans, which tend to have larger menus than 401(k) plans.
“You’re spreading dollars across more funds, and that means there’s less in each one of those funds and less likelihood that you cross that threshold,” said Rob Austin, head of research at Alight Solutions, an employee benefit and human resources consulting company.
Complexity of this type has a couple side effects. Research on the psychology of choice shows that too much choice produces paralysis: confronted with too many options, we simply freeze. And even when we do manage to make choices, we are less satisfied with what we have picked, because we imagine alternatives that might have been better.
Most workplace retirement plans have been moving toward greater simplicity in recent years. The two key innovations have been widespread adoption of index funds, which let you invest in huge chunks of the stock market without trying to sort out winners from losers, and target date funds, which take care of the task of keeping your portfolio balanced between stocks and bonds as retirement nears. Use of target date funds has grown rapidly over the past decade: six out of every ten dollars contributed to a 401(k) plan managed by Vanguard in 2020 went into a target date fund.
Wouldn’t it be great if we could also simplify the other big questions we all face in figuring out retirement? When to file for Social Security. What to do about long-term care insurance. How to hire a trustworthy financial planner.
Or, consider my favorite poster child for complexity: Medicare, a once-simple social insurance system that we have mucked up with marketplace-driven choices for prescription drugs, managed care and supplemental insurance. The sheer number of choices can be intimidating - and even Medicare’s own data suggests most people shy away from the recommended regular coverage check-ups.
And who can blame them? Do you know anyone who actually likes thinking about health insurance? I thought not.
The opinions expressed here are those of the author, a columnist for Reuters.
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