The 401(k) plan, a close U.S. cousin of Can-ada’s defined-contribution pension plan, has in the past 10 years become the dominant retirement savings tool of American workers.

The 401(k) plans are much different, however, from those of the past, when U.S. employers hired professionals to manage pension plans, determine savings rates to meet guaranteed benefits and to outline investment policy. With a 401(k), all the responsibility now falls on workers, not all of whom possess the tools to do the job.

A recent study by New York University professors Martin Gruber and Edwin Elton and Fordham University professor Christopher Blake found that many such company pension plans don’t offer employees an adequate set of investment choices. Workers also lack the right type of funds to build a truly diversified portfolio.

In fact, almost two-thirds of the 401(k) plans the authors studied resulted in substantially lower returns over time.

Using statistics from Moody’s Investors Service Inc. and the University of Chicago’s Center for Research, Gruber and his colleagues analysed more than 400 401(k) plans, studying the characteristics associated with adequate investment choices, including an analysis of the impact of company stock, plan size and the use of outside consultants.

For each plan, they collected data on the funds offered, the historical returns and the characteristics of the firms offering the plans. They found that most of the larger 401(k) plans — those offering at least 13 mutual fund choices — presented enough options for investors to create diversified portfolios. Smaller plans, however, were especially lacking in the number of choices offered for adequate diversification.

Another interesting finding of the study was that 401(k)s that offered company stock as an option did not offer plan participants inferior choices.

Furthermore, the inclusion of company stock and its selection by participants in moderate amounts didn’t hurt performance and might have even improved it. The authors noted, however, that the tendency of participants to load up on company stock could clearly increase risk and hurt performance.

Too many investment choices, meanwhile, can cause information overload, resulting in greater use of the default option — which is often a money market fund — and even declines in participation rates, say Gur Huberman and Wei Jiang, professors at Columbia University.

In a study published earlier this year, they found 401(k) participants generally choose to invest their retirement savings in a small number of funds — usually no more than three or four — regardless of the number of funds offered.

They found that the median choice was three funds and that 95% of participants used no more than seven funds. In addition, a sizable percentage of investors chose to invest their money equally among their selected funds.

The distribution of dollars in plans remains fairly concentrated in a subset of the investment options. When there are numerous choices available, the size of the subset does not increase proportionately with the increase in total funds offered.

For example, the study found that in plans offering 10 investment choices, 75% of the dollars were concentrated in five funds. In plans with 60 choices, 75% of the dollars were concentrated in 11 funds. In other words, there was an increase in the number of funds used, but the growth was not commensurate with the increase in funds offered.

A third study, by researchers at The College of William & Mary in Virginia examined the relationship between individuals’ financial knowledge and their behaviour relative to the number of investment options. That study found that the number of funds had a greater impact on individuals with above-average financial knowledge than on those with below-average investment savvy.

In particular, high-knowledge employees reported increased feelings of information overload as the fund choices jumped past six. As a result, more opted for the default investment portfolio. Lower-knowledge employees, on the other hand, reported greater overall levels of overload, regardless of the number of funds, and their level of overload did not increase by a statistically significant amount when the number of funds increased.

The results of all three studies emphasize the importance of pension plan design, especially the careful selection of default options and the need to improve the financial literacy of participants. IE