1

Individual Account Investment Options and Portfolio Choice:

Behavioral Lessons from 401(k) Plans

2

The Growing Importance of Asset Accumulation

U.S. is witnessing a shift toward increasing self-reliance in retirement planning Shift from DB to DC pension plans Potential for personal accounts as part of Social Security

Individual accounts put more emphasis on creating financial wealth for retirement, rather than relying on a formula-based pension approach

Portfolio choice one key determinant of retirement wealth (allocation, location, expenses)

3

Plan Design and Behavior

Plan design can have important effects on retirement wealth accumulation in cross section Default options for participation

Madrian & Shea (2001); Choi, Laibson, Madrian, & Metrick (2002)

Number and type of investment options available Benartzi & Thaler (2001)

Match Policy Benartzi (2001); Brown, Liang, & Weisbenner (2006)

4

Differing Views on Value of Large Number of Options

Standard economics view: “More options are good, or at worst, unnecessary” Constraints are either not binding or bad, never good Portfolio theory: only need one risky asset (the “market”

portfolio) and one riskless asset Behavioral view: “More choice is potentially bad”

Information overload if too many options Huberman, Iyengar, & Jiang (2007); Agnew & Szykman (2004)

5

Our Focus

Does the share of investment options in a particular asset class influence portfolio allocations to that asset class?

More specifically, how has growth in actively-managed equity funds affected 401(k) allocations?

6

What Do We Add?

Our data enable us to exploit both cross-sectional AND time-series variation in the number and type of options offered to identify how retirement-plan parameters affect portfolio allocations

Enables us to control for sorting effects that may confound cross-sectional results

7

Key Findings

1. Evidence that both plan parameters and firm-level heterogeneity important

2. Mix of options across equities and bonds is a strong determinant of allocations across these asset classes

3. Growth in number of actively-managed equity funds (with high expenses) leads to a smaller share of assets in low-cost index funds, resulting in higher expenses and worse performance

DATA

9

Retirement-Plan Data

11-k filings with the SEC is the key data source Filed by firms with 401(k) plans that offer employer

stock as an investment option (and it is deemed new equity issuance)

Detailed information on specific plan investment 1993-1998 information on contributions and balances for

each plan option (some firms report 1991 & 1992 data in 1993 report)

1999+ reporting requirements change, only statement of end-of-year balances provided for each plan option (contribution data reported by just a few firms)

Convergent Communications Services, Inc. 401(k) Plan Line 27a - Schedule of Assets Held For Investment Purposes as of December 31, 1999 - -------------------------------------------------------------------------------- <TABLE> <CAPTION> Description of Investment Including Maturity Date, Identity of Issue, Borrower, Rate of Interest, Collateral, Current Lessor, or Similar Party Par or Maturity Value Cost Value - ------------------------------------------- ----------------------------------- ------------ ----------- <S> <C> <C> <C> Guaranteed Certificate Fund Term of 36 months $ 109,618 $ 109,618 Guaranteed Certificate Fund Term of 60 months 17,452 17,452 Guaranteed Certificate Fund Term of 84 months 5,722 5,722 Maxim Bond Index Mutual Fund - Bonds 14,759 14,721 Maxim Loomis Sayles Corporate Bond Mutual Fund - Bonds 37,862 38,737 Maxim U.S. Government Mortgage Securities Mutual Fund - Bonds 57,238 57,351 Maxim Global Bond Mutual Fund - Bonds 14,972 14,410 Maxim Short-Term Maturity Bond Mutual Fund - Bonds 10,028 10,162 Maxim Money Market Mutual Fund - Stocks 380,424 390,877* Maxim Index European Mutual Fund - Mix 123,575 140,641 Fidelity Advisor Overseas Mutual Fund - International Stock 46,713 61,024 Maxim INVESCO ADR Mutual Fund - International Stock 9,241 10,969 Maxim Index Pacific Mutual Fund - International Stock 184,557 235,397* Putnam Global Growth Mutual Fund - International Stock 181,192 258,592* AIM Charter Mutual Fund - Stocks and Bonds 181,751 212,899 Orchard Index 500 Mutual Fund - Stocks 387,931 430,162* Maxim Founders Growth & Income Mutual Fund - Stocks 99,938 112,639 American Century Ultra Mutual Fund - Stocks 978,116 1,261,494* AIM Weingarten Mutual Fund - Stocks 310,832 382,073* Maxim Growth Index Mutual Fund - Stocks 557,367 659,822* Fidelity Advisor Equity Income Mutual Fund - Stocks and Bonds 137,663 139,356 Fidelity Advisory Growth Opportunities Mutual Fund - Stocks and Bonds 206,645 210,516 Putnam Fund for Growth & Income Mutual Fund - Stocks and Bonds 152,808 148,622 Maxim Value Index Mutual Fund - Stocks 110,056 115,483 AIM Constellation Mutual Fund - Stocks 278,111 378,346* Maxim T. Rowe Price Mid-Cap Growth Mutual Fund - Stocks 104,429 123,789

Convergent Communications Services, Inc. 401(k) Plan Line 27a - Schedule of Assets Held For Investment Purposes as of December 31, 1999 - -------------------------------------------------------------------------------- <TABLE> <CAPTION> Description of Investment Including Maturity Date, Identity of Issue, Borrower, Rate of Interest, Collateral, Current Lessor, or Similar Party Par or Maturity Value Cost Value - ------------------------------------------- ----------------------------------- ------------ ----------- <S> <C> <C> <C> Profile Series I Mutual Fund - Mix 1,219,247 1,442,344* Profile Series II Mutual Fund - Mix 953,310 1,084,627* Profile Series III Mutual Fund - Mix 301,322 334,413* Profile Series IV Mutual Fund - Mix 44,467 47,540 Profile Series V Mutual Fund - Mix 29,356 30,451 Orchard Index 600 Mutual Fund - Stocks 84,859 94,084 Lord Abbett Developing Growth Mutual Fund - Stocks 78,133 95,003 Maxim Ariel Small-Cap Value Mutual Fund - Stocks 28,861 28,002 Maxim Loomis Sayles Small-Cap Value Mutual Fund - Stocks 75,182 76,677 Company Stock** Stock 4,416,458 6,110,257* ----------- ----------- $11,930,195 $14,884,272 =========== ===========

Convergent Communications, Inc. 401(k) Plan Statements of Changes Net Assets Available for Benefits with Fund Information for the year ended December 31, 1998 - -------------------------------------------------------------------------------- <TABLE> <CAPTION> American Maxim Century - Small-Cap Guaranteed Twentieth AIM Orchard Maxim Growth Aggressive Certificate Century Constellation Index 600 Index Growth Fund Ultra Fund Fund Portfolio Portfolio Portfolio <S> <C> <C> <C> <C> <C> <C> Additions to net assets: Investment and interest income: Net appreciation (depreciation) in fair value of investments $ -- $ 45,053 $ 12,498 $ 1,337 $ 33,086 $ 1,126 Investment and interest income 424 -- -- -- -- -- Participant contributions 10,137 209,836 74,024 26,394 161,455 43,192 Employer contributions -- -- -- -- -- -- Transfers in 91,369 1,783 442 -- 12,511 -- ---------- ---------- ----------- --------- ---------- ---------- Total additions 101,930 256,672 86,964 27,731 207,052 44,318 ---------- ---------- ----------- --------- ---------- ---------- Deductions from net assets attributable to: Transfers out -- (229) (167) (184) (193) (240) Distributions -- (8,824) (2,422) (1,129) (3,850) (955) ---------- ---------- ----------- --------- ---------- ---------- Total deductions -- (9,053) (2,589) (1,313) (4,043) (1,195) ---------- ---------- ----------- --------- ---------- ---------- Net change 101,930 247,619 84,375 26,418 203,009 43,123 Net assets available for benefits at: December 31, 1997 1,090 52,242 14,795 1,371 10,754 10,361 ---------- ---------- ----------- --------- ---------- ---------- December 31, 1998 $ 103,020 $ 299,861 $ 99,170 $ 27,789 $ 213,763 $ 53,484 ========== ========== =========== ========= ========== ========== </TABLE>

Continued - 3 - <PAGE> Convergent Communications, Inc. 401(k) Plan Statements of Changes Net Assets Available for Benefits with Fund Information for the year ended December 31, 1998 - -------------------------------------------------------------------------------- <TABLE> <CAPTION> The Lord Maxim Maxim Abbett Maxim U.S. Investment Maxim Putnam Short-term Developing Government Grade Corporate Global Maturity Growth Mortgage Corporate Bond Governmental Bond Fund Securities Portfolio Portfolio Income Fund Portfolio Additions to net assets: <S> <C> <C> <C> <C> <C> <C> Investment and interest income: Net appreciation (depreciation) in fair value of investments $ 205 $ 213 $ 36 $ 656 $ 915 $ 8 Investment and interest income -- -- -- -- -- -- Participant contributions 1,783 11,548 4,272 23,413 5,087 1,618 Employer contributions -- -- -- -- -- -- Transfers in -- 7,114 -- 442 7,114 -- ---------- ---------- ----------- --------- ---------- ---------- Total additions 1,988 18,875 4,308 24,511 13,116 1,626 ---------- ---------- ----------- --------- ---------- ---------- Deductions from net assets attributable to: Transfers out -- -- -- -- -- -- Distributions -- (272) (271) (185) (249) (338) ---------- ---------- ----------- --------- ---------- ---------- Total deductions -- (272) (271) (185) (249) (338) ---------- ---------- ----------- --------- ---------- ---------- Net change 1,988 18,603 4,037 24,326 12,867 1,288 Net assets available for benefits at: December 31, 1997 -- -- -- 2,168 1,466 -- ---------- ---------- ----------- --------- ---------- ---------- December 31, 1998 $ 1,988 $ 18,603 $ 4,037 $ 26,494 $ 14,333 $ 1,288 ========== ========== =========== ========= ========== ========== </TABLE>

Continued - 4 - <PAGE> Convergent Communications, Inc. 401(k) Plan Statements of Changes Net Assets Available for Benefits with Fund Information for the year ended December 31, 1998 - -------------------------------------------------------------------------------- <TABLE> <CAPTION> Fidelity Advisor Maxim Maxim Growth AIM Small-Cap Mid-Cap Maxim Opportunities Orchard Weingarten Value Growth Blue-Chip Fund Index 500 Fund Portfolio Portfolio Portfolio Additions to net assets: <S> <C> <C> <C> <C> <C> <C> Investment and interest income: Net appreciation (depreciation) in fair value of investments $ 7,561 $ 7,873 $ 11,378 $ 1,930 $ 4,806 $ 464 Investment and interest income -- -- -- -- -- -- Participant contributions 52,710 62,290 53,563 16,728 35,670 13,942 Employer contributions -- -- -- -- -- -- Transfers in 442 22 -- -- -- -- ---------- ---------- ----------- --------- ---------- ---------- Total additions 60,713 70,185 64,941 18,658 40,476 14,406 ---------- ---------- ----------- --------- ---------- ---------- Deductions from net assets attributable to: Transfers out -- -- -- -- (262) -- Distributions (1,593) (1,219) (235) -- (165) (213) ---------- ---------- ----------- --------- ---------- ---------- Total deductions (1,593) (1,219) (235) -- (427) (213) ---------- ---------- ----------- --------- ---------- ---------- Net change 59,120 68,966 64,706 18,658 40,049 14,193 Net assets available for benefits at: December 31, 1997 8,434 9,111 9,764 13,516 -- -- ---------- ---------- ----------- --------- ---------- ---------- December 31, 1998 $ 67,554 $ 78,077 $ 74,470 $ 32,174 $ 40,049 $ 14,193 ========== ========== =========== ========= ========== ========== </TABLE>

Continued - 5 - <PAGE> Convergent Communications, Inc. 401(k) Plan Statements of Changes Net Assets Available for Benefits with Fund Information for the year ended December 31, 1998 - -------------------------------------------------------------------------------- <TABLE> <CAPTION> Fidelity Maxim Putnam Advisor Putnam Maxim New AIM Value Fund for Equity Global England Charter Index Growth and Income Growth International Fund Portfolio Income Fund Fund Equity Additions to net assets: <S> <C> <C> <C> <C> <C> <C> Investment and interest income: Net appreciation (depreciation) in fair value of investments $ 3,998 $ 1,990 $ 5,140 $ 2,426 $ 8,951 $ 71 Investment and interest income -- -- -- -- -- -- Participant contributions 22,275 30,901 51,798 32,793 53,616 2,054 Employer contributions -- -- -- -- -- -- Transfers in -- -- 442 -- -- -- ---------- ---------- ---------- ---------- ---------- ---------- Total additions 26,273 32,891 57,380 35,219 62,567 2,125 ---------- ---------- ---------- ---------- ---------- ---------- Deductions from net assets attributable to: Transfers out -- (141) -- (22) (11,310) -- Distributions (2,439) (3,008) (2,425) (910) (2,777) -- ---------- ---------- ---------- ---------- ---------- ---------- Total deductions (2,439) (3,149) (2,425) (932) (14,087) -- ---------- ---------- ---------- ---------- ---------- ---------- Net change 23,834 29,742 54,955 34,287 48,480 2,125 Net assets available for benefits at: December 31, 1997 6,330 4,865 10,666 2,160 12,319 -- ---------- ---------- ---------- ---------- ---------- ---------- December 31, 1998 $ 30,164 $ 34,607 $ 65,621 $ 36,447 $ 60,799 $ 2,125 ========== ========== ========== ========== ========== ========== </TABLE>

Continued - 6 - <PAGE> Convergent Communications, Inc. 401(k) Plan Statements of Changes Net Assets Available for Benefits with Fund Information for the year ended December 31, 1998 - -------------------------------------------------------------------------------- <TABLE> <CAPTION> <S> <C> <C> <C> <C> <C> <C> Fidelity Orchard Orchard Maxim Advisor Index Index Money Overseas Pacific European Market Profile Profile Fund Fund Fund Fund Series I Series II Additions to net assets: Investment and interest income: Net appreciation (depreciation) in fair value of investments $ 945 $ 347 $ 1,389 $ 4,794 $ 53,066 $ 46,258 Investment and interest income -- -- -- -- -- -- Participant contributions 13,821 5,264 17,721 330,055 400,947 290,003 Employer contributions -- -- -- -- -- -- Transfers in -- -- 3,062 11,786 3,615 25,753 --------- -------- --------- -------- --------- --------- Total additions 14,766 5,611 22,172 346,635 457,628 362,014 --------- -------- --------- -------- --------- --------- Deductions from net assets attributable to: Transfers out (111) -- -- (8,569) (47,318) (66,735) Distributions (2,414) -- (314) (8,137) (34,255) (1,714) --------- -------- --------- -------- --------- --------- Total deductions (2,525) -- (314) (16,706) (81,573) (68,449) --------- -------- --------- -------- --------- --------- Net change 12,241 5,611 21,858 329,929 376,055 293,565 Net assets available for benefits at: December 31, 1997 7,870 219 474 8,624 125,957 118,653 --------- -------- --------- -------- --------- --------- December 31, 1998 $ 20,111 $ 5,830 $ 22,332 $338,553 $ 502,012 $ 412,218 ========= ======== ========= ======== ========= ========= </TABLE>

Continued - 7 - <PAGE> Convergent Communications, Inc. 401(k) Plan Statements of Changes Net Assets Available for Benefits with Fund Information for the year ended December 31, 1998 - -------------------------------------------------------------------------------- <TABLE> <CAPTION> <S> <C> <C> <C> <C> <C> <C> Profile Profile Profile Company Series III Series IV Series V Stock Fund Unallocated Total Additions to net assets: Investment and interest income: Net appreciation (depreciation) in fair value of investments $ 12,220 $ 348 $ 185 $ 207,446 $ -- $ 478,719 Investment and interest income -- -- -- -- -- 424 Participant contributions 109,849 10,150 4,932 -- -- 2,183,841 Employer contributions -- -- -- 1,049,872 -- 1,049,872 Transfers in -- -- -- -- -- 165,897 ---------- --------- -------- ---------- ----------- ---------- Total additions 122,069 10,498 5,117 1,257,318 -- 3,878,753 ---------- --------- -------- ---------- ----------- ---------- Deductions from net assets attributable to: Transfers out (30,399) -- -- -- (11,995) (177,875) Distributions (5,305) -- -- (84,174) -- (169,792) ---------- --------- -------- ---------- ----------- ---------- Total deductions (35,704) -- -- (84,174) (11,995) (347,667) ---------- --------- -------- ---------- ----------- ---------- Net change 86,365 10,498 5,117 1,173,144 (11,995) 3,531,086 Net assets available for benefits at: December 31, 1997 17,256 107 1,070 271,856 11,995 735,493 ---------- --------- -------- ---------- ----------- ---------- December 31, 1998 $ 103,621 $ 10,605 $ 6,187 $1,445,000 $ -- $4,266,579 ========== ========= ======== ========== =========== ==========

18

Our Sample(s)

Collect data on employee contributions and balances across five asset classes (company stock, domestic equity, international, fixed income, and balanced funds)

This sample primarily covers the period 1993-1998 891 firms in the sample just over 3 years on average

Broad cross section Represent roughly 1/3 of 401(k) assets/contributions of

publicly-traded firms in 1998 Good representation across industries About 1/5 belong to S&P 500

19

Our Sample(s)

We later augment this earlier-period data by following the firms that filed an 11-k in 1998 over next 4 years (1999 – 2002) Limited to looking at asset balances (not

contributions)

Background:Number of

Mutual Funds and 401(k) Options

Total Number of Mutual Funds, 1990-2004

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Number of Equity Funds Number of Non-Equity Funds

Average Number of Investment Options in Sample 401(k) Plans, 1993-2002

0

2

4

6

8

10

12

14

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Number of Equity Funds Number of Non-Equity Funds

Average Number of Investment Options in Sample of 401(k) Plans, 1993-2002

0

2

4

6

8

10

12

14

16

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Number of Equity Index Funds Number of Actively-Managed Equity FundsNumber of Non-Equity Funds

Mix of Options and Allocation of Contributions

Composition of Plan Options and Employee Contributions in 401(k) Plans by Fund Type, Pooled Sample 1991-2000

Mean 10th Percentile

25th Percentile Median 75th

Percentile 90th

Percentile Share of Options (in percent)

Company Stock Fund 15 8 11 14 20 25

Domestic Equity Funds 38 20 29 38 50 56

International Equity 8 0 0 8 14 17

Bond Funds 31 17 20 29 40 50

Balanced / Life Cycle 9 0 0 8 15 20

Share of Employee Contributions Allocated to Fund Type (in percent)

Company Stock Fund 19 3 7 14 26 43

Domestic Equity Funds 44 20 31 45 58 68

International Equity 4 0 0 1 7 13

Bond Funds 26 8 14 22 35 48

Balanced / Life Cycle 7 0 0 2 12 21

Employer Stock

5

10

15

20

25

30

4 5 6 7 8 9 10 11 12 >12

Total Number of Funds Offered in Plan

Perc

ent o

f Tot

al

Opt

ions

/Con

trib

utio

ns

Share of Fund Options Share of Contributions

Domestic Equity Funds

20

30

40

50

60

4 5 6 7 8 9 10 11 12 >12

Total Number of Funds Offered in Plan

Perc

ent o

f Tot

al

Opt

ions

/Con

trib

utio

ns

Share of Fund Options Share of Contributions

Fixed Income Funds

15

20

25

30

35

40

4 5 6 7 8 9 10 11 12 >12

Total Number of Funds Offered in Plan

Perc

ent o

f Tot

al

Opt

ions

/Con

trib

utio

ns

Share of Fund Options Share of Contributions

International Funds

02468

1012

4 5 6 7 8 9 10 11 12 >12

Total Number of Funds Offered in Plan

Perc

ent o

f Tot

al

Opt

ions

/Con

trib

utio

ns

Share of Fund Options Share of Contributions

Regression Analysis: Relating Allocation of Contributions to Mix

of Options

Regression of Share of Contributions Against Share of Fund Options, Pooled Cross-Sections

Share of Contributions in:

Company Stock Fund

Domestic Equity Funds

International Equity Funds

Bond Funds

Balanced Funds

Share of Fund Options in Asset Class

0.850***

(0.129) 0.703*** (0.048)

0.533*** (0.069)

0.265*** (0.050)

0.494*** (0.117)

Co Stock Match Required?

0.070*** (0.014)

-0.021* (0.011)

-0.005 (0.005)

-0.032*** (0.012)

-0.029*** (0.009)

Past 5 Year Return on Company Stock

0.005* (0.003)

-0.003*** (0.001)

0.001* (0.001)

-0.002 (0.002)

-0.000 (0.001)

Std Dev of Co. Stock -0.467*** (0.156)

0.089 (0.140)

0.133* (0.073)

0.328** (0.155)

0.022 (0.130)

Market-to-Book Ratio

0.013*** (0.005)

-0.003 (0.005)

-0.002 (0.002)

-0.009*** (0.003)

-0.007*** (0.002)

Other firm controls? Yes Yes Yes Yes Yes Year Fixed Effects? Yes Yes Yes Yes Yes Firm Fixed Effects? No No No No No Adjusted R2 0.272 0.477 0.271 0.321 0.244 # of Observations 1,935 1,900 1,045 1,911 1,065 *, **, and *** denote significance at the 0.10, 0.05, and 0.01 level respectively.

32

Firm-level Heterogeneity

Concern with any cross-sectional regression is that correlations obtained may reflect differences across firms in unobserved characteristics (such as risk tolerance of workers) that manifest themselves both in pension plan parameters and participant investment decisions

SOLUTION: Exploit the panel data!

Regression of Share of Contributions Against Share of Fund Options, Firm Fixed Effects

Share of Contributions in:

Company Stock Fund

Domestic Equity Funds

International Equity Funds

Bond Funds

Balanced Funds

Share of Fund Options in Asset Class

0.269***

(0.093) 0.452*** (0.053)

0.317*** (0.109)

0.452*** (0.060)

0.443*** (0.121)

Co Stock Match Required?

0.023 (0.019)

0.024 (0.016)

-0.010 (0.008)

-0.037** (0.017)

-0.003 (0.020)

Past 5 Year Return on Company Stock

0.005*** (0.002)

-0.003*** (0.001)

0.001 (0.001)

-0.001 (0.001)

-0.001 (0.001)

Std Dev of Co. Stock -0.144 (0.228)

-0.062 (0.246)

0.095 (0.173)

0.180 (0.264)

-0.002 (0.230)

Market-to-Book (q)

0.024*** (0.007)

-0.014*** (0.005)

-0.002 (0.004)

-0.008* (0.005)

-0.003 (0.003)

Other firm controls? Yes Yes Yes Yes Yes Year Fixed Effects? Yes Yes Yes Yes Yes Firm Fixed Effects? Yes Yes Yes Yes Yes Adjusted R2 0.875 0.868 0.808 0.828 0.797 # of Observations 1,935 1,900 1,045 1,911 1,065 *, **, and *** denote significance at the 0.10, 0.05, and 0.01 level respectively.

34

Economic Magnitude

Coefficient on share of equity options is 0.45 From 1993 to 2002 the share of equity options in

the average 401(k) plan increased from 0.35 (2.0/5.7) to 0.53 (7.4/13.9)

This implies that contributions to equity funds increased by 8 percentage points (0.45*0.18)

Nearly all of this increase in equity funds was the result of the explosion of actively-managed funds in 401(k) plans

35

Interpretation

Even after controlling for firm-fixed effects (i.e., relating changes in plan parameters to changes in contributions) the composition of equity and bond funds still “matter”

Two Possibilities (Jiang and Huberman, 2006; Benartzi and Thaler, 2001; Holden and Vanderhei, 2001)

1. As number of options increases, each investor more likely to spread assets over greater number of funds

2. Each investor concentrates assets in small number of funds; as increase number of options, likelihood of concentrating investment in any one fund decreases

36

Another Result

However, firm-level heterogeneity appears to be important in the context of company stock investment Firms that match with company stock or that offer few

investment options may do so because their workers have a preference for company stock

Inertia in response to plan parameters may also be important

37

Does Type of Equity Mutual Fund Matter for 401(k) Participants?

Do participants “find” the index fund offered in the plan (if any)?

Or are participants just as likely to contribute to an high-cost actively-managed fund as they are a low-cost index fund?

Relation Between Contributions to Equity Funds and Number of Equity Funds

Share of Contributions in: Domestic Equity Funds

(1) (2) (3) (4)

Share of Fund Options that are Equity Funds

0.45*** (0.05)

0.46*** (0.05) 0.45***

(0.04)

Have Equity Index Fund? -0.01 (0.01)

Share of Fund Options that are Equity Index 0.45***

(0.07)

Share of Fund Options that are Actively-Managed Equity 0.45***

(0.05)

Ratio of Index Funds to Total Equity Funds 0.01

(0.02)

Year Effects? Yes Yes Yes Yes Firm Effects? Yes Yes Yes Yes Standard error of coefficient estimate in parentheses. *, **, and *** denote significance at the 0.10, 0.05, and 0.01 level respectively.

EXTENSION: INDEX vs.

ACTIVELY-MANAGED FUNDS

40

Game Plan

Augment contribution-based 11-k data used earlier with data from the 1999-2002 period

Link mutual fund names to Morningstar database

Examine characteristics (i.e., expenses, fund return, Morningstar percentile ranking) of the equity funds in the 401(k) plan

Nearly 18,000 fund-year observations and nearly 4,000 firm-year observations

Average Number of Investment Options in Sample of 401(k) Plans, 1993-2002

0

2

4

6

8

10

12

14

16

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Number of Equity Index Funds Number of Actively-Managed Equity FundsNumber of Non-Equity Funds

Share of New Options Added to 401(k) Plans, 1998-2002

ACTIVE EQUITY66%

INDEX EQUITY8%

International13%

Balanced6%

Fixed Income7%

Average Number of 401(k) Plan Options Across Fund Types, 2002

0

1

2

3

4

5

6

7

Co. Stock ACTIVEEQUITY

INDEXEQUITY

International Balanced Fixed Income

Num

ber o

f Opt

ions

Share of Options & Assets Across Fund Types, 1999-2002

0

5

10

15

20

25

30

35

40

45

Co. Stock ACTIVEEQUITY

INDEXEQUITY

International Balanced FixedIncome

Perc

ent

Share of Options Share of Assets

Share of Equity Assets in Index Funds, Plans with One Index Fund

0

5

10

15

20

25

30

35

40

45

50

55

2 3 4 5 6 7 8 9 10+

Total Number of Equity Funds (Index and Acively-Managed)

Perc

ent

Why do we care?Performance of Equity Funds Offered in 401(k) Plans

10

11

12

13

14

15

16

17

Average GROSS Return Over Past 5 Years

Perc

ent p

er Y

ear

Active Equity Funds Index Equity Funds

Why do we care?Performance of Equity Funds Offered in 401(k) Plans

10

11

12

13

14

15

16

17

Average GROSS Return Over Past 5 Years Average NET Return Over Past 5 Years

Perc

ent p

er Y

ear

Active Equity Funds Index Equity Funds

Morningstar Performance Ranking within Objective

50

55

60

65

70

75

Active Equity Funds Index Equity Funds

Perc

entil

e

Difference in Performance of Actively-Managed Funds Relative to Index Funds in 401(k) Plans, 1991-2002

Controls

Past Five-Year Gross Return

(before expenses)

Past Five-Year Net Return

(after expenses)

Morningstar Percentile Ranking within Objective (based on past 5-year net returns)

None -0.61 (0.51)

-1.37** (0.54)

-9.4*** (2.7)

Year and Firm Fixed Effects

-0.08 (0.30)

-0.72** (0.31)

-8.3*** (2.3)

Year and Firm Fixed Effects and Equity-Style Controls

-0.27 (0.43)

-0.81* (0.43)

-8.6*** (2.6)

Standard error of coefficient estimate in parentheses. *, **, and *** denote significance at the 0.10, 0.05, and 0.01 level respectively.

Regression of Expenses and Performance of Equity Allocations within 401(k) Plans by Fraction of Equity Funds in the Plan that are Actively-Managed, 1991-2002

Firm-level average expenses

for equity funds in plan (in percent)

Firm-level average Morningstar Percentile

Rankings for performance over the next year

for equity funds in plan (in percentage points)

Unweighted Weighted by Assets Unweighted Weighted

by Assets

Fraction of Equity Funds that are Actively Managed

0.40*** (0.06)

0.30*** (0.06)

-12.9*** (3.9)

-13.2*** (3.9)

Year and Firm Fixed Effects and Equity-Style Controls? Yes Yes Yes Yes

Standard error of coefficient estimate in parentheses. *, **, and *** denote significance at the 0.10, 0.05, and 0.01 level respectively.

51

Does it Matter?

Consider a worker who starts at age 22 earning $30,000 per year and experiences 4% nominal annual earnings growth until they retire at age 62.  Suppose this worker saves 6% of salary per year in a 401(k) and receives a matching contribution equal to 3% of salary. 

52

Does it Matter?

If this individual earns an 8% nominal net return on their investments, she would have $1.142 million at retirement.  If, instead, this individual received nominal annual net returns that were 35 basis points lower than this, or 7.65%, she would receive roughly $80,000 less. 

In short, due to the power of compounding, a 0.35% per year difference in annual returns accumulates to a nontrivial 7.5% difference in terminal wealth at retirement.

54

Bottom-Line Conclusions

“Design Matters” – individuals are clearly influenced by the choice set in ways that are not explained by standard models

Behavioral response coupled with influx of high-cost actively-managed funds into 401(k) plans leads to worse performance on average (i.e., increasingly harder for participants to find that one index fund)

55

Plans Sponsors Starting to “Get It”, Gov’t Still “A Step Behind”

Roughly 20% of 401(k) plans have the default that you are in the plan (many of these are setting the default to something riskier than the money market fund) Reflects understanding by plan sponsors of the crucial role

of plan design and inertia

Recent government mandates for pension plans seem to lack this understanding

56

Policy Implications of Research

Pension Protection Act (2006) Employee contributions to company stock must

be immediately diversifiable Employer contributions to company stock must

be diversifiable after three years

What is likely result of legislation?

57

401(k) Fair Disclosure for Retirement Security Act of 2007

Plans that allow workers to control their investments would have to offer at least one market-based index fund

What will be the likely result of this legislation if passed?