Many people in the workforce who are saving for retirement by contributing to a 401(k), 403(b) or other similar employer-sponsored programs often are plagued by one not-so-simple question: How do I know what funds to select for investing?
Research shows that some investors contribute equal amounts to all of the funds available. Some investors are so overwhelmed by the number of choices that they elect not to contribute to their plan at all, while other participants use something called alphabeticity to select funds.
Per USA Today:
Using a proprietary database of 401(k) plans, researchers recently showed that alphabeticity – when fund names are listed alphabetically on an investment menu – significantly biases participants’ investment allocation decisions.
This as well as other factors that cause irrational investment in defined contribution savings plans are of great concern, the researchers concluded in their paper, “Alphabeticity Bias in 401(k) Investing.”
“The paper confirms what many would suspect,” says Stacy Schaus, the founder and CEO of Schaus Group, a retirement consulting firm. “Participants choices are often irrational and/or uninformed.”
The research also suggests that a “more strategic ordering of funds could result in favorable outcomes for participants,” wrote Jesse Itzkowitz, a vice president at the Ipsos Behavioral Science Center, who co-authored “Alphabeticity Bias in 401(k) Investing.”
For instance, if funds were listed in ascending order by expense ratio rather than alphabetically, then the plan design feature would help reduce investment fees paid by plan participants affected by alphabeticity bias.
In the absence of more strategic ordering of funds by plan administrators and plan providers, how might people in an employer-sponsored retirement plan go about choosing funds?
What matters most?
Itzkowitz says people should sort their choices according to what’s most important to them.
“For example, a prudent strategy is looking for funds with minimal fees,” he says.”
Likewise, if you think that five-year returns are most important, sort by that criteria first.
People can also improve their ability to pick the best option by making sure that they are alert and focused, Itzkowitz says.
“To do that, they should save important decisions, like how to invest their retirement savings, for when they are well rested, after a good meal, and before they do a lot of other difficult decision making,” he says. “Research has shown that when we are tired, both physically and mentally, all of our biases, not just alphabeticity, become more pronounced.”
Stick with qualified default investment alternatives
In some cases, when plan participants are automatically enrolled in a 401(k), they are also placed into what are called qualified default investment alternatives or QDIAs. If that happens to you, consider sticking with them.
There are four types of QDIAs: a lifecycle or target-date fund; a professionally managed account; a balanced fund; and a capital-preservation product such as a stable-value fund.
“We know that defaults can be very helpful,” Schaus says.
Work with a financial planner
QDIAs, however, are targeted to the average worker without regard to their personal needs and circumstances. Given that each person has different goals and resources, what’s needed is more customized and personal advice. And that’s especially true as one gets older, as financial assets increase in value and as financial affairs become more complicated.
“The closer to retirement, the more important comprehensive planning becomes as participants are likely to have more outside assets, varying risk preferences and health considerations,” Schaus says. “Decisions also matter more when the participant has more at risk — accumulated balances and less human capital. Working with a financial planner to tailor the allocation within a defined contribution plan with a comprehensive view and objectives in mind would be ideal.”