Inefficient Choices in 401(k) Plans: Evidence from Individual Level Data

This paper investigates how individual characteristics, such as age, salary, job tenure, and gender, influence an individual’s decision to over-invest in company stock and follow naïve diversification rules. Using a new and unique data set from one 401(k) plan with over 73,000 eligible employees, the results suggest that individual characteristics do influence company stock holdings. Ordered probit regression results indicate that the probability of over-investing in company stock for the average participant is greater for males, decreases with salary, increases with past company stock performance and is related to the participant’s division of employment. In addition, the paper investigates if individuals tend to follow a simple diversification rule, the 1/n heuristic. According to this rule, some 401(k) investors will choose to divide their contributions evenly among the n options available regardless of the type of investment vehicles offered. While the percentage of individuals who follow the 1/n heuristic in this study is lower than that found in previous studies, it still represents 5% of the sample. Probit regression analysis results suggest that the probability of following the 1/n heuristic decreases with increases in job tenure and salary. Finally, consistent with the mental accounting literature, participants demonstrate a tendency to treat company stock as a separate “account”. The evidence from this study indicates that over-investing in company stock and practicing naïve diversification strategies may be occurring frequently in 401(k) plans and that certain individuals are more prone to make these decisions than others. Given the pivotal role 401(k) savings play in individuals’ retirements, this research may help plan sponsors design plans and train participants to make better-informed decisions.