Research finds a bias toward funds appearing first in alphabetical menus of retirement-plan options
This really is the ABCs of retirement planning: New research suggests that 401(k) plan participants are more likely to invest in mutual funds at or near the top of alphabetical listings.
Investment choices on the websites that investors in 401(k) and other defined-contribution plans use are often organized by asset class (e.g., equities, bonds, balanced), with the funds in each class then listed in alphabetical order. While not all plan participants will choose funds that appear at the top of a plan’s alphabetical menu, on average, participants are biased toward choosing those funds, a paper in the Financial Review suggests.
On average, each of the top four funds on such a list receives 10% more money than it would receive if money was allocated equally among the investment options, the researchers found. Funds in the fifth through 10th places on a plan’s list receive 5% less investment than they would if money was allocated equally, while each fund appearing after the 10th position contains 10% less investment allocation, the researchers found.
“It’s absolutely amazing how powerful this effect is and how much it is really distorting what’s being invested in,” says Jesse Itzkowitz, one of the paper’s authors.
Dr. Itzkowitz, a senior vice president of Ipsos Behavioral Science Center, a market-research firm in New York, is joined on the paper by his wife, Jennifer Itzkowitz, associate professor of finance at Stillman School of Business at Seton Hall University; Thomas Doellman, associate professor of finance at Richard A. Chaifetz School of Business at Saint Louis University; and Sabuhi Sardarli, associate professor of finance at the College of Business Administration at Kansas State University.
That powerful alphabet
When choosing between multiple alternatives with different attributes, individuals typically stop searching after they find the first option they deem acceptable even if continued searching could yield a better result, Dr. Jesse Itzkowitz explains.
INVESTING IN FUNDS
It’s a well-known bias that influences many decision processes. Prior research, including a 2016 paper by the Itzkowitzes, has found that
- stocks of companies whose names would place them early in any alphabetic listing have higher trading volumes than those that come later. Prior research has shown that
- politicians with last names early in the alphabet are more likely to be elected; that
- scholars with such names are invited to review papers more often; and that
- alumni with such names donate more than others because they are solicited more.
But the researchers were surprised to find that the effect holds true with data sets as small as the groups of funds offered within 401(k) plans.
“While we show a larger impact as the number of funds in the plan increases, this bias is strong even when relatively few funds are available in the plan menu,” says Dr. Jennifer Itzkowitz.
Behind the research
The researchers examined information on 6,807 defined-contribution plans collected from regulatory filings made with the Labor Department in 2007 and provided by plan-tracker BrightScope Inc. Plans of all sizes and with all types of sponsors were represented. On average, plans had about 20 fund options, and roughly $32.5 million in net assets. While the data used comes from a previous decade, the study’s authors say that this reflects the time-consuming nature of obtaining proprietary data and converting it into a usable format. The data is still representative, they add, as plan menus haven’t changed drastically. While plan menus today do have more fund options, they say, this, in their opinion, would only increase the alphabetical bias.
The primary analysis focused only on U.S. equity funds, which represent the largest proportion of fund options and the largest allocations by plan participants.
The average plan in the study has 10 equity funds, and after controlling for other factors, the researchers found evidence suggesting that moving a fund from the bottom of the plan menu to the top would increase the percentage of plan assets invested in the fund to 11.68% from 9.9%, on average. As the typical plan examined had $32.5 million in assets, the effect would be a $578,500 increase in investment allocation to the fund, they found.
Neither financial education nor greater plan resources appear to help investors overcome the alphabet bias, the researchers found. The 401(k) investment choices made by professional workers—including those in technology, engineering, accounting, law and health care—and those made by workers in larger plans, which might be able to provide the resources or advice to improve decision-making, were similarly biased.
“It’s not like you can think your way out of this,” says Dr. Jennifer Itzkowitz.
Need to reorder?
The findings suggest that ordering 401(k) investment options more strategically—for example, listed in ascending order by expense ratio or listed with low-volatility funds at the top—could improve investment outcomes for plan participants. Starting with those that have the lowest expense ratios, for example, might help reduce the investment fees paid by plan participants, as prior literature has shown that a fund’s expense ratio is a more reliable predictor of future return performance than past performance, the researchers say.
It’s important for 401(k) plan participants, sponsors and administrators to recognize that plan architecture matters, says Dr. Jennifer Itzkowitz. Investors should recognize that they might be biased by the first screen they see, and take a moment to focus on that and do a better job, she says.
“I’d like to see a third-party plan administrator have a first screen that asks, ‘What is more important to you? Is it a
- fund’s expense ratio? Is it
- past performance? It is an
- age-adjusted fund?’
Then the plan could provide results after that initial screen,” she says. “That forces investors to be a part of the process.”
“All the players within this chain can take something away from this,” says Dr. Sardarli. Now might be the time for regulators and plan administrators to come together to work to offer some legal protection to plan sponsors and administrators who seek to alter listings of 401(k) investment options to nudge investors to make better choices, he says. By being a bit more proactive, Dr. Sardarli says, it is possible that plan administrators could ensure that investors are better prepared for retirement.
Eric Droblyen, owner of Employee Fiduciary, a 401(k) plan administrator for small businesses in Mobile, Ala., says that not a lot of thought is going into how 401(k) plan fund options are ordered.
“There’s so much apathy on the participant side, on the sponsor side in the 401(k) world, it drives me nuts,” he says. “What do you do about that? How do you fix it? What’s being paternalistic versus pushing it too far?”