Funds listed at the beginning of 401k plan menus receive significantly greater allocations compared to funds listed towards the end of plan menus, according to a new research paper.
Remember how service companies used to give their companies names like “A-1 Plumbing” or AAA Electrical in order to show up at the top of the alphabetically listed Yellow Pages when phone books were still a thing? It worked, and apparently still works when 401k plan participants are considering which funds to include from a menu of options – because those options are typically listed in alphabetical order.
Using a proprietary database of 401k plans, the research paper, “Alphabeticity Bias in 401k Investing,” clearly shows that “alphabeticity” – the order that fund names appear when listed in alphabetical order – significantly biases participants’ investment allocation decisions. While the research shows a larger impact as the number of funds in the plan increases, the bias is strong even when relatively few funds are available in the plan menu.
The findings suggest that a more strategic ordering of funds could result in favorable outcomes for participants.
Rather than having funds arbitrarily listed in alphabetical order, plan sponsors could request that TPAs strategically order funds so the effect of alphabeticity bias results in a favorable outcome for participants. 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.
The paper’s authors took on the topic because they say structural factors that cause irrational investment in defined contribution savings plans are of great concern. The team notes that several factors can preclude DC plan participants from investing rationally: bias, behavioral inertia, framing, and a lack of financial literacy. The first-of-its-kind paper considers a new behavioral bias – alphabeticity – in the context of 401k investing and examines its potential effects on participants’ investment decisions.
The importance of being first
Alphabeticity bias is the phenomena in which early alphabet options are chosen more frequently than others. Investment options within 401k and other DC plans are often listed in alphabetical order. While many investors can access their plans online and may be able to re-order their list of fund choices, individuals generally rely on the default (status quo) list given to them. Because funds are initially listed in alphabetical order, they tend to remain in alphabetical order when participants make fund allocation decisions within the plan.
The paper also says a fund’s position on the plan menu is more important than a fund’s relative location in the alphabet. “For example, if a 401k plan offers only Vanguard funds (each starting with the word Vanguard), then the Vanguard 500 Index fund is likely to be listed first. However, if a 401k plan offers Vanguard funds as well as funds from other families, then the Vanguard 500 Index fund is likely to appear towards the end of the list.”
The research also found the same fund appearing in multiple plans in the sample receives a significantly higher allocation when it is listed closer to the top of the plan menu, further supporting alphabeticity bias.
You might think that professionals in certain fields would be less susceptible to alphabeticity bias when making plan allocation decisions, but according the authors’ findings, that’s not the case. Even when larger companies and top TPAs provide additional resources to help participants in the decision-making process, alphabeticity bias still occurs. “Our results support the hypothesis that all participants, on average, display the bias equally. Interestingly, this is even true for professionals employed in the financial sector,” the paper states.
Customizing how plan menus are presented
For those who are prone to alphabeticity bias, the same factors that biased their allocation decisions could lead them to select fund options that improve their overall investment outcomes. And this change would not impact plan participants that are unaffected by alphabeticity bias.
While behavioral interventions were shown to have limited effect, changing the informational environment can remedy irrational investment.
The authors found that TPAs are beginning to offer plan sponsors the flexibility to customize how plan menus are presented to employees, making the results from the paper’s analysis especially pertinent to plan sponsors.
Per the paper, “One alternative sorting strategy might be listing fund options in ascending order based on expense ratio. This simple change could have considerable impact. Assuming an alphabetized list of plan menu options, the average expense ratio of the top four equity funds in plan menus of our sample is 90 basis points. But, if we order equity funds in ascending order based on expense ratio, the average expense ratio of the top four funds is 62 basis points. This difference in fees is economically significant. Assuming $5,000 annual contributions and a fixed 7% annual gross rate of return over a 30-year period, this difference in fees, all else equal, costs an investor $20,440 in investment income – a loss equivalent to over four years’ worth of contributions.”
Nudging investors towards selecting lower expense ratio funds could also motivate mutual fund companies to include cheaper funds in 401k plan menus knowing their more expensive funds will receive less investment because of being listed later in the plan menu.
Plan sponsors could also employ other strategies to benefit plan participants, such as listing low volatility funds first as low volatility portfolios have been shown to outperform higher volatility portfolios over the past several decades.
The 58-page research paper (The Financial Review, Forthcoming) was written by Thomas Doellman (Saint Louis University – Richard A. Chaifetz School of Business), Jennifer Itzkowitz (Seton Hall University – Department of Finance and Legal Studies), Jesse Itzkowitz (Ipsos Behavioral Science Center), Sabuhi Sardarli (Kansas State University – Department of Finance). It can be downloaded at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3295400.