The mainstream media has often commented on the shift from defined benefit plans to defined contribution plans over the last few decades (see PBS FRONTLINE report). But there has also been a shift within defined contribution plans from “trustee” directed “pooled” accounts to “participant” directed “individual” accounts.

Years ago it was commonplace for employers to sponsor a “pooled profit sharing” plan. Each year the employer would determine how much to contribute and these contributions were held in a single account. The employer would appoint a trustee and/or investment manager to determine how to invest the contributions on behalf of all participants.

Then came the rise of the 401(k) plan. For some reason in a 401(k) plan it was decided that participants ought to choose their own investments. At the meetings I attended where sponsors contemplated adding a 401(k) provision, the logic went something like this: because participants would see the money come out of their paychecks they will want to be (and perhaps ought to be) more involved in the investment decisions.

We have moved from a situation where employees didn’t have to make any decisions, or have any choices, about retirement savings (e.g. the traditional DB plan) to a situation where employees have all the decisions, and have perhaps too much choice (e.g. today’s typical 401(k) plan).

Is this good or bad? As with any most questions, there isn’t a simple answer. However, some additional background might be helpful.

As most HR professionals know, getting participants to pay attention to their retirement plans can be tough. Aside from the few people glued to the web watching their account balance go up and down, the majority are not very involved. Why?

Deloitte conducts an annual  401(k) benchmarking survey. In these surveys, employers consistently report that the biggest barrier to plan participation is a “lack of employee understanding.” Similarly, employees most often report “Where to invest/which funds to use” and “How Much to Save for Retirement” as the more confusing parts of their retirement plans. While automatic enrollment features and default investments may alleviate some of these problems, they are not perfect solutions (see a related blog post on automatic enrollment).

So what about the participants who do get involved? How well do they perform?

Unfortunately, the answer is that they do not perform well. The Michigan Retirement Research Center published a working paper in which they analyzed a rich set of participant account data from Vanguard. They found that most “real-world” participants make mistakes by investing inefficiently and not diversifying their investments enough. In fact, participant investment mistakes account for the majority (76%) of their poor investment performance. These investment mistakes have a significant impact on retirement savings, reducing wealth by 1/5^th over a 20 year career.

Given that many participants don’t want to manage their own retirement accounts, and those that do often make big mistakes, why would an employer give control to participants?

Unfortunately, some retirement plan providers told employers that by handing over investment choices to participants they rid themselves of fiduciary responsibility. While correcting this fallacy is beyond the scope of this post, you should know that the employer can never entirely eliminate their fiduciary responsibility.  In fact, improperly transferring control to participants can even lead to greater responsibility.

Does this all mean that participant choice is a bad idea? Yes, many times it is. However, for many employers taking away this choice is just not feasible. If you must offer participants a choice, do it right:

• Have a well chosen list of investment options covering all asset classes.
• Use no more than 9-12 funds (studies show having more funds can lead to more investment mistakes).
• Consider having participants select between pre-mixed model portfolios instead of individual mutual funds.
• To the extent you provide investment education, focus on answering the basic questions: How to enroll in the plan?, How much to save? and Where to invest?
• Provide employees easy to use savings guidelines when they enroll in the plan (try the FPA Journal – National Savings Rate Guidelines for Individuals).
• Periodically review participant asset allocation, individual investment performance, and retirement readiness. You can’t manage what you don’t measure.

Kevin Boercker is a credentialed member of the American Society of Pension Professionals and Actuaries (ASPPA) and holds the Qualified Pension Administrator (QPA) designation. Prior to joining Spectrum, Boercker graduated with Phi Beta Kappa Honors from Washington University in Saint Louis with a bachelor’s degree in Applied Mathematics.