The Efficiency of Pension Plan Investment Menus: Investment Choices in Defined Contribution Pension Plans

Abstract

Few previous studies have explored whether defined contribution retirement saving plans offer sufficiently diversified investment menus, though it is likely that these menus significantly shape workers' accumulations of retirement wealth. This paper assesses the efficiency and performance of 401(k) investment options offered by a large group of US employers. We show that most plans are efficient compared to market benchmark indexes. Three performance measures underscore the fact that these plans tend to offer a sensible investment menu, when measured in terms of the menus' mean-variance efficiency, diversification, and participant utility. The key factor contributing to plan efficiency and performance has to do with the types of funds offered, rather than the total number of investment options provided. The Efficiency of Pension Plan Investment Menus: Investment Choices in Defined Contribution Pension PlansDefined contribution (DC) plans have become a central financial investment vehicle for retirement saving; in the US, for instance, there were 42.4 million active participants involved in almost half a million 401(k) plans with assets totaling almost $2 trillion (EBRI, 2005).Moreover, assets in 401(k) plans represent the sole source of retirement funding for a substantial fraction of 401(k) participants (Poterba, Venti and Wise 2007). There is a rich literature on participants' investment decisions in 401(k) plans, but much less attention has been paid to plan menus. 1 This paper uses a rich new dataset on over 1,500 plans provided by Vanguard to study the characteristics and efficiency 2 of 401(k) investment menus and investigate factors that affect plan performance.Although plan sponsors have substantial freedom in setting up 401(k) investment menus, the 1974 Employee Retirement Income Security Act requires that they take responsibility for offering participants investment options with appropriate risk and return features, and monitoring the investment vehicles to make sure they continue to be appropriate. Thus it is useful to investigate the characteristics of various 401(k) plans, to evaluate whether they are satisfactorily offering employees such "appropriate" investment opportunities. It has also been noted that, over time, employers have added investment options to 401(k) plans. 3 Therefore the question arises, as to whether adding more funds is necessarily better. To address this question, we explore factors that influence the efficiency of 401(k) plans, to see whether plan sponsors might enhance plan performance by adding investment choices. Additionally, recent proposals have suggested introducing individually-managed accounts into the U.S. Social Security system (Cogan and 1 For example, Madrian, and Shea (2001) and Choi, Laibson, Madrian, and Metrick (2001) show that automatic enrollment increases 401(k) participation rates and participants tend to stay with the default contribution rate and fund allocation; Ameriks and Zeldes (2004) and Agnew, Balduzzi, and Sunden (2003) document inertia in...

Retirement savings investment decisions: evidence from Malaysia

“…Also, as the number of choices increased, and choices become more similar, participants experienced 'information overload' and were more likely to stay with the default as they 'choose not to choose' (Agnew and Szykman 2005). Tang and Mitchell (2008) discovered that adding investment choices might not necessarily improve the 401(k) plans efficiency and performance. Most important was the particular set of investment funds offered.…”

Determinants of Pension Governance: A Survey of Pension Plans in Kenya

“…Additionally, communication in large organizations becomes expensive and ineffective thus leading to information asymmetry amongst the members of the organization (Teisseire, 2009). The information asymmetry impacts on the effectiveness of the members in contributing to decision making and running of the pension plans.…”

“…According to Clark and Urwin (2009) honest sharing of information ensures proper utilisation of pension plan authority, avoidance of conflict of interest and promotes transparency and openness in decision making. An effective CEO, according to Teisseire (2009), represents the interest of the pension plan in the board of the sponsoring company. Appropriate pension leadership is performance-oriented and maintains independent performance measurement systems (Ambatchsheer et al 2008).…”

“…Effective pension plan leaders engenders trust in investment managers to such an extent that full discretion in investment decisions can be granted to these managers. This leads to investment and administrative efficiencies according to Tang and Mitchell (2008), Bikker andDreu (2009) andChan-Lau (2005). Against this background, it is important that leadership in pension plans be enhanced, to reap the mentioned benefits.…”

Evaluating the Financial Performance of Pension Funds

“…An alternative measure of efficiency is tied to the rates of return received on pension funds. For example, a DC plan could charge low fees but be inefficient because of the lack of diversification provided by the offered investment menu (Tang and Mitchell 2008).…”