Defined-contribution savings plans sometimes permit participants to select their
retirement savings investments. Many plans offer investors numerous funds,
ideally allowing them to maximize their utility as measured by individual risk
and return preferences. The authors survey employees at two organizations to see
if they prefer the retirement portfolio asset mix they selected for themselves
over other mixes. They find that retirement plan participants do not prefer
their own portfolio when presented with various options, indicating that choice
alone does not help them make an optimal allocation. Possibly, participants do
not have enough knowledge of investments or of their own preferences to make
optimal choices.
Defined-contribution savings plans often let participants determine for themselves how to
invest their retirement savings. Such plans as 401(k)s and 403(b)s are popular in the
United States, and similar programs are being introduced in other countries. These plans
typically offer several investment funds for the participants to choose among when
allocating their savings; one plan in Sweden, at an extreme, allows investors to select
from 450 investment options. The authors want to know if these choices allow investors
to maximize their utility by creating optimal portfolios for themselves; they also want
to know if the portfolios selected maximize the participants' return relative to the
risk taken.
To find out how choices affect utility, the authors surveyed employees at two
institutions—the University of California at Los Angeles (UCLA) and
SwedishAmerican Health Systems. At UCLA, the authors compiled information about the
aggregate investment choices of the plan participants and then projected the range of
retirement income from each participant's portfolio, from the portfolio with the average
allocation of all plan participants, and from the median portfolio, based on the
standard deviation of returns of all plan portfolios. They asked participants to rate
each portfolio using the projected range of retirement income, not knowing which
portfolio was their own.
Regardless of their personal risk preferences, most participants preferred the median
portfolio to their own. The median portfolio was selected by 62 percent of those
surveyed as the best, as opposed to 21 percent who selected their own portfolio.
The authors conducted a different survey at SwedishAmerican, where a consulting firm
recommends portfolios for participants based on basic demographic information,
especially age, but not risk preferences. Participants are alternatively allowed to
select their own investment allocation. The authors asked those who opted out of the
recommended plan to rate the attractiveness of three portfolios—the person's own
portfolio, the average allocation of all participants in the plan, and the portfolio
recommended by the consultant for the participant. The results are similar to those at
UCLA: A full 61 percent of those surveyed preferred the recommended portfolio to their
own.
The authors examine why those surveyed did not like their own portfolios. Reasons might
include the failure to select efficient portfolios, differences of opinion about future
stock market performance, unrealistic assumptions about the equity risk premium, changes
in preferences from the initial plan enrollment, and mistakes in the initial asset
allocation. It is this last explanation that the authors favor. In other words,
defined-contribution retirement plan participants do not have the skill or the
understanding of their own preferences to select appropriate investment portfolios.
Furthermore, their choices can be skewed by the offerings given to them. In a plan
offering many equity options, participants will disproportionately choose equity funds
over fixed-income alternatives regardless of their true risk preferences. The authors
conclude that choice by itself may not benefit retirement plan participants and may
cause them to act against their own interests.