How a Simpler Approach to Retirement Savings Can Make You Richer
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When it comes to the fund options in your retirement savings plan, it turns out less is more.
Using the choices offered at a large nonprofit institution, two professors at the University of Pennsylvania's Wharton School of Business looked at what happened when nearly half the funds were eliminated, and the remaining options were structured in a way that made them easier for employees to understand.
Within six months, simplification had helped employees make smarter decisions about retirement, the researchers found. Faced with fewer choices, they opted for funds with lower fees, saving an average of $470 a year.
The streamlined portfolios also "held significantly less equity and exhibited significantly lower risks," the report noted. The funds had lower turnover rates too, which reduces transaction costs and likely results in a larger nest egg at retirement, said Olivia Mitchell, one of the study's co-authors—a change that benefits men in particular. "Prior studies have found that men trade stocks more aggressively than do female investors and waste money churning," Mitchell noted.
The longer-term impact was positive as well. Eighteen months after the change, the risk level of participants' portfolios remained stable, even for those who had reallocated their funds. The researchers projected that reducing the number of available funds in the company's retirement plans would yield a savings of about $9,400 per employee over 20 years.
It might seem counterintuitive that offering fewer fund options within retirement savings plans would save employees money. But the study's conclusion is backed by previous research in behavioral finance, which found that people can get overwhelmed—and, ultimately, make poor decisions—when presented with too many choices.
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As irrational as it might seem, for example, given a choice of scores of funds listed alphabetically, people often just pick the first few they see, without realizing that they might be among the riskiest available options. "With information overload, people tend to just pick something quickly and get it over with," Mitchell said.
Mitchell and study co-author Donald Keim, a Wharton finance professor, recommend that employers—who are legally bound to manage plans in the best interest of employees—periodically review their offerings to see if there's any opportunity to pare them down or reorganize them.
If you're confused by the funds offered in your company's 401(k) plan, Mitchell advises that you start by looking at funds with the lowest fees. And less knowledgable employees should consider target-date funds, which allocate your retirement savings based on your age and projected retirement date.
Another approach? Check your employer's plan for the funds that Money recommends in its annual list of the 50 best mutual and exchange-traded funds.