What’s the right number of funds in a 401(k) plan? – InvestmentNews

It’s a tricky question, and depends on a number of factors such as the profile and mindset of the plan sponsor and its employees.

However, there’s a sweet spot around which advisers and researchers have largely coalesced: no more than 15-20 investment options. (That counts target-date funds as one investment.)

“If you’re getting over 20, you’re not getting any diversification benefits and it starts getting too much for participants to handle,” said Brady Dall, a retirement plan adviser at 401(k) Advisors Intermountain, a Utah-based retirement plan consulting firm.

Of course, some plans may have more, some less, and that’s not necessarily bad. But keep this in mind: Research has proven that too many funds can result not only in more confusion for employees, but also lower plan participation, poor financial decision-making and higher costs.

Too many choices can result in what Joe Ready, the head of Wells Fargo & Co.‘s retirement-plan record-keeping unit, calls “analysis paralysis.”

Indeed, researchers have found that employees’ predicted participation rate drops by 2% for every 10 funds added to a retirement plan.

“While people generally value the ability to choose, it is recognized that having to choose complicates any decision and may even reduce their ability to make rational decisions,” according to a report authored by Shlomo Benartzi, a behavioral economist who co-founded the Behavioral Decision-Making Group at UCLA Anderson School of Management.

Further, spreading assets over a greater number of funds can increase costs: plans aren’t as likely to afford lower-cost share classes of mutual funds, which have certain asset thresholds for investing in institutional versus retail funds, for example.

“If you’ve got your assets spread over 50 funds, it gives you less ability to [drive down costs] than if you have assets spread over 15 funds,” said Chad Larsen, president and CEO of MRP, an advisory firm overseeing more than $3 billion in retirement assets.

A study published in 2016 by the National Bureau of Economic Research found that halving the number of investments in a large nonprofit institution’s retirement plan, from around 90 funds, yielded potential aggregate savings of over $9,400 per participant over 20 years. The average characteristics of the fund menu (expense ratio and risk, for example) remained the same during the streamlining process.

The average 401(k) plan has an average of 21 funds, when adjusted for TDFs, according to a 2016 joint study by BrightScope Inc. and the Investment Company Institute. That’s only slightly higher than the 20 funds seen in 2006.

Plan sponsors technically only need to offer three investment options, with different risk-return characteristics, to get a degree of legal protection under federal retirement law, said Marcia Wagner, principal at The Wagner Law Group. One is a capital-preservation fund; the other two must be “sufficient for plan participants to create a portfolio to suit their risk-return goals,” usually a bond and equity fund, she said.

Mr. Dall thinks about constructing a typical 401(k) menu this way: with an intermediate-term and multi-sector bond fund; a capital preservation option, like a stable-value fund; an international or foreign bond fund; one growth, blend and value fund each for the large-cap, mid-cap and small-cap sectors; diversified international and emerging markets equity funds; a suite of default funds such as target-date funds; and perhaps a sector fund like real estate. Collectively, that yields a count of 17 funds.

He tries to limit the number of funds in a single asset class, because participants often exhibit poor financial decision-making, such as splitting contributions among all of the funds available in the asset class, or allocating to the one with the best historical performance.

However, it’s not necessarily a cookie-cutter calculation — there’s some room for finesse, experts say. A professional services firm — such as a law office or medical practice, whose professionals may be more financially sophisticated and higher-earning — may be well-served with an active and passive strategy in each investment style and a self-directed brokerage window, for example, said Mr. Ready of Wells Fargo.

And, some company executives have “pet” funds they don’t want to remove, said Mr. Larsen.

Sometimes, though, just broaching the conversation with clients can help change plan sponsors’ mindsets, advisers said.

“A lot of them quite honestly haven’t really thought through it,” said Mr. Dall.

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