Too few choices in employee 401(k) plans have many investors reaping inferior returns because they're not properly diversified, according to a recent academic study published by three New York finance professors.

In a research paper entitled "The Adequacy of Investment Choices Offered by 401(k) Plans," New York University Nomora Professors of Finance Martin Gruber and Edwin Elton, along with Christopher Blake, professor of finance at Fordham University, argue that the lack of diversification of investment options in 401(k) plans will "significantly decrease participants' terminal wealth."

A 300% Difference in Wealth

In their survey of 417 401(k) plans that invest in mutual funds with at least five years of monthly total return data, the trio found that 62% of the plans offered inadequate choices to investors, suggesting that the plan participants would be better off with additional investment choices. Over a period of 20 years, the academicians calculated, this would make a difference in terminal wealth of more than 300%.

"Since for more than one half of plan participants, a 401(k) plan represents the participant's sole financial asset, the consequences are serious," the report said.

In assessing return and risk characteristics of mutual funds held by plans, the professors found that the plans select funds that show negative performance, but the performance is still better than had they been selected at random. "That difference was almost exclusively due to a difference in fees," Gruber said in an interview. The same goes for risk in that the plans have slightly less risk than one would find in a random selection of funds.

The study also found that investors participating in 401(k) plans with a greater number of assets under management will achieve higher returns because the plans are more likely to offer more investment choices, as well as more sophisticated diversification models. Larger plans are also more likely to use outside consultants, the report said.

"There is a strong correlation between the number of investment choices a plan offers and size," according to the report. Among the 401(k) plans they studied, 12.5% of them had four or fewer investment choices, which clearly is not a sufficient number of options for an investor to be diversified. However, there is, at best, weak evidence that the use of consultants and sophisticated strategies leads to better performance.

Another finding the study showed was that plans that offer company stock provide the same number of mutual fund options, on average, as plans that do not offer company stock. But it does not have a major positive or negative impact on the allure of the investment choices offered to participants.

The data, culled from a survey conducted by Moody's Investor Services, is based on a statistical analysis of the plans taking into account the type and quality of the funds in each portfolio. The reason for using this type of statistical analysis is to determine if the investor could be better off with a different set of choices or more choices, Gruber said.

The funds were compared against a series of research-based benchmarks, both stocks and bonds, spanning all categories of the style box. For stocks, they used four Wilshire indexes. In the case of bonds, they put together a general bond index, including government and corporate bonds, a mortgage-backed index and a high-yield index.

In their findings, the professors noted that while a lot of attention has been paid to participant choice in previous academic studies, no attention has been paid to the relevancy of the choices offered to participants.

"If investors are given an inferior set of choices in their plan, the effectiveness of their choice is severely constrained," Gruber said. "No matter how good you are, if you don't have the right options, you can't make the right decisions."

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