Beneath the surface of every decision we make — save or spend, apple or orange — is a rich intersection of our values, culture and personal experiences. We prize our freedom of choice; more is better. Or is it? Abundant choice may not always be a good thing, management professor Sheena Iyengar reveals in her recent book, The Art of Choosing (Twelve Books/Hachette Book Group, March 2010). “We frequently pay a mental and emotional tax for freedom of choice,” Iyengar says. In the following excerpt, she examines how some of the most important decisions in our lives — those involving retirement and healthcare — can come undone by too many options.
In 1978, a new class of retirement plans, known as the 401(k), became available to American workers. Whereas traditional pension plans were funded by the employer, these “defined contribution” plans encouraged the employee to invest a portion of his own salary in a range of mutual funds, the earnings of which would become available after retirement. They solved many of the problems of pensions, which were often underfunded and couldn’t be transferred if the employee switched jobs, and they offered the employee more control over his financial future. Today, the 401(k) is the dominant form of retirement investing in the United States: Almost 90 percent of the people who have some form of retirement plan are covered solely or in part by defined contribution plans.
Like other long-term investments, 401(k)s reap the benefits of compound interest. Prices may fluctuate wildly in the short term, especially in the stock market, but booms and recessions balance out in the long term and produce dramatic cumulative returns. Even after the stock market lost about 40 percent of its value in 2008 — the worst loss since the Great Depression — the 25-year annual average return of the S&P 500 stock index was still about 10 percent. At those rates, if a 25-year-old employee contributed just $1,000 to the S&P each year, by the time he retired at age 65, his total contribution of $40,000 would have become $500,000. These numbers don’t account for inflation, but since inflation affects savings just as much as it affects investments, 401(k) plans still have more than a tenfold advantage over stockpiling money in a bank account.
In addition, your contributions to the plan and the returns earned are both tax-exempt until you retire and begin to withdraw money. For the average American, this is equivalent to contributing an additional 20 percent to the fund as compared to investing in the market with the same amount in after-tax dollars. Moreover, most employers match employee contributions with money of their own. The match percentage and cutoff vary by company, but dollar-for-dollar matching up to several thousand dollars is not uncommon. This means that our young employee’s $1,000 yearly contribution effectively becomes $2,000, turning him into a millionaire by retirement. Given these incentives, if you know nothing about investing, randomly picking funds for your 401(k) is still a better financial move than not participating at all. So why doesn’t everyone sign up?
In 2001, I received a call from Steve Utkus, the director of the Center for Retirement Research at the Vanguard Group, one of the largest mutual fund companies in the country. He told me that an analysis of the retirement investment decisions of more than 900,000 employees covered by Vanguard had revealed something disturbing: The percentage of eligible employees participating in 401(k)s had been in steady decline and was currently down to 70 percent. Concurrently, the average number of funds in each plan had been gradually rising. He had recently read my paper on the jam study and was wondering if these two trends might be related. Were the employees suffering from too much choice?
With my colleagues Gur Huberman and Wei Jiang, both professors of finance [at Columbia Business School], I examined the investment records in order to answer his question. We found that an increase in the number of options did have a significant negative effect on participation. As the graph [below] shows, participation rates quickly fell from a high of 75 percent for the smallest plans, which had four funds, to 70 percent for the plans with 12 or more funds. This rate held until the number of options exceeded 30, at which point it started to slide again, reaching a low just above 60 percent for plans with 59 funds.
More Choice, Worse Decisions
In 401(k) plans, the more funds a plan has, the lower the participation rate. Participation is highest at 75 percent with the smallest plans, which have four funds, and drops to 70 percent in plans with 12 or more funds. That rate holds until the number of options exceeds 30, at which point it starts to slide again, reaching a low just above 60 percent for plans with 59 funds.
It’s unlikely nonparticipants muttered that there were too many choices and then actively opted out of their 401(k)s. Rather, quite a few of them probably intended to enroll as soon as they’d done some research and figured out which funds were best for them. After all, it’s easy to sign up on the spot when you have only five choices, but when you have 50 it seems reasonable to mull things over for a while. Unfortunately, as you keep delaying the decision, and days turn into weeks, and weeks into months, you might forget your 401(k) altogether.
Okay, so some employees were overwhelmed by the number of options and didn’t participate. Clearly, having a lot of choice did not work in their favor. But what about the people who did participate? They were perhaps more knowledgeable and confident about investing, and maybe they were able to take advantage of all those options.
However, when Emir Kamenica, an economics professor at the University of Chicago, and I examined the funds that participants had chosen, we found that this was not actually the case: More choice had, in fact, led to worse decisions. Stocks composed the largest category of funds in these 401(k)s, and as the total number of funds in a plan went up, the plan became increasingly stock-heavy. Given these facts, we expected that even if people were picking funds out of a hat, they would be investing more in stocks as their options increased. But the exact opposite was true: For every set of ten additional funds in a plan, 2.87 percent more of the participants avoided stocks completely, and the rest allocated 3.28 percent less of their contributions to stocks, preferring bonds and money markets instead.
Why were we troubled by our findings? Well, 401(k)s are designed for long-term investing, and that’s where stocks shine. Looking at 25-year averages, stocks reliably outperform bonds and especially money markets, which may not even keep up with inflation. Yet in our study, even the employees in their late teens and early twenties, who could afford more risk, gave short shrift to stocks as the number of funds in their plans increased. It seems that learning about all the funds was too complicated, so people tried to reduce the options by pushing the largest category — stocks — to one side. In doing so, they may have compromised their future financial well-being. They did make one exception: They bought more stock in the companies where they worked, perhaps due to familiarity or loyalty. But this is generally a risky move, because if your company goes bankrupt, you lose both your job and a good portion of your nest egg, as any former Enron or Lehman Brothers employee can tell you.
Let’s consider the possibility that people don’t take advantage of choice for retirement investing because even though it is an important decision, it’s one that doesn’t have any immediate impact on the chooser. Without a tangible payoff in the present, you may simply not be motivated enough to carefully and thoroughly assess your options. But perhaps you’d work hard to reap the benefits of more choice in a domain that’s equally important and affects your current well-being? Unfortunately, even when it comes to health insurance, we don’t seem to handle choice too well.
Remember President George W. Bush’s push for Medicare reform? It resulted in the addition of a program called Part D to the federal health insurance program for senior citizens. Part D was created in December 2003 to compensate for the increasing role and cost of prescription drugs in modern healthcare by subsidizing them. Seniors choose from a variety of coverage plans offered by private companies, and the government reimburses the companies for the costs. In particular, Bush lauded the increase in choices provided by the program as a cure-all for Medicare’s ills. “A modern Medicare system must offer more choices and better benefits to every senior— all seniors,” he asserted. “The element of choice, of trusting people to make their own healthcare decisions, is essential.” The logic behind offering a wide variety of plans held that “The more options a senior has to choose from, the more likely it is that the benefit is going to be tailored to his or her needs.”
For many participants, Medicare Part D has led to a 13 percent reduction in out-of-pocket costs, and according to one study, an increase in the purchase of prescribed medication. These benefits are considerable, but the program has fallen short in other ways. As with the 401(k)s, many of the people who stood to gain from enrolling failed to do so. The initial enrollment deadline for Medicare beneficiaries, March 15, 2006, came and went, and 5 million of the 43 million eligible seniors had not enrolled. All was not lost as they could join at a later date, but they would have to pay higher monthly premiums for the rest of their lives.
Still, you might say, nearly 90 percent of the seniors had enrolled. Isn’t that success? In fact, almost two-thirds were enrolled automatically by their insurance providers, with many randomly assigned to plans that did not necessarily meet their prescription drug needs. Of the people who had to choose, 12.5 million enrolled and the remaining 5 million did not. Enrollment rates were dismal for those who most needed Part D — the low-income individuals eligible for full prescription drug coverage at no personal cost. If they enroll now, they’ll incur late penalties they can ill afford; if they don’t, many will have to forgo medication that they can’t pay for on their own. Either way, they’re in trouble.
Seniors were supposed to be able to benefit from choosing their own plans, and from the increased variety available to them, but the choice itself became a major obstacle to enrollment. There were dozens of plans, ranging from 47 in Alaska to 63 in Pennsylvania and West Virginia, and elderly people, many of them with poor eyesight and limited computer skills, had to go online to find the list of attributes for each plan. Then they had to figure out how the plans differed from one another, which seemed to require superhuman puzzle-solving abilities. Plans varied in multiple ways: drugs covered, generic drug policy, co-payments, monthly premiums, annual deductibles, and on and on. Different companies offered plans with the same characteristics but at different prices, and these characteristics could change from one week to the next.
Marie Grant, a retired nurse from Cleveland, recalls her frustration with Part D: “I never understood the whole mess. … I’m so mad. All these different plans.” Martha Tonn, a retired teacher from Wisconsin, “felt it was too much, too overwhelming.” They’re in good company, because 86 percent of seniors and over 90 percent of doctors and pharmacists agree that Part D is much too complicated. A substantial number of seniors trying to enroll in Medicare couldn’t even discern which option offered the same benefits they already had, let alone which plans would be an improvement or how they could tailor any of them to fit their own needs. To be sure, any attempt to compare 63 options will test our cognitive limits — but there’s more to the story than just our ability to process the different choices. Bush and other architects of the program focused primarily on quantity, but unfortunately, in doing so, they paid far less attention to the quality of choices included, and whether these choices were meaningful in terms of improving people’s lives. When it comes to making challenging and consequential decisions like how to invest in a 401(k) plan or how best to take advantage of the Medicare Part D subsidy, we’ve seen that a focus on simply increasing the available choices can backfire and lead to decisions that harm rather than help.
From the book The Art of Choosing Copyright © 2010 by Sheena Iyengar. Reprinted by permission of Twelve Books/ Hachette Book Group, New York, NY. All rights reserved.