Optimal Number of 401(k) Investment Categories Between 12 and 20 Study Says

Any 401(k) plan that has fewer than 12 and more than 20 investment categories is an outlier, according to the 401(k) Portfolio Study of Investment Categories by ERISApedia.com.

The study report says that offering fewer than 12 categories may mean that participants are not being given sufficient opportunity to diversify. Offering more than 20 investment categories could lead to lower average investment in each fund, which may cause higher fees. An overly large number of investment categories may also contribute to participant confusion.

The ERISApedia.com Market-Based Portfolio Model (EMBP) provides a model to help establish investment lineups in 401(k) plans. It is not based on any formal academic principles but instead relies on market data at the investment category and the fund level to provide guidance to investment fiduciaries and financial advisers. EMBP involves a two-step process for establishing investment lineups in 401(k) plans. First is to determine the core investment categories to offer (including the number categories and the specific categories to include), and second is picking the individual fund or funds within each investment category. Based on the EMBP, the optimal number of investment categories is between 12 and 20.

The study finds the top five investment categories ranked by number of plans is Large Blend, Large Growth, Intermediate-Term Bond, Large Value and Target-Date. The top five ranked by average balance per plan are Target-Date, Stable Value, Large Blend, Large Growth and Intermediate-Term Bond.

However, there appears to be a fair amount of investment category variance among all plans. On average there are about 5.8 missing investment categories (the absence of categories in the top 20) and 4.0 extraneous categories (inclusion of categories not in the top 20) per plan for a total variance of 9.8. Much of the variance is concentrated in plans with less than $10 million in assets, which the study report says could be an indication that smaller plans do not have the resources to design a rational investment lineup.

Overall, the study finds that fund redundancy is relatively low, as only about 20% of all plans have fund redundancy in excess of six. However, the amount of fund redundancy increases as plan size increases. Fund redundancy most frequently is four for plans with more than $500 million in assets.

The report notes that there may be good reasons for relatively high fund redundancy. For example, an investment fiduciary may wish to provide an actively managed and passive fund for each of several of the major investment categories.