(The following is the first of a three part series covering the oft-asked question: “How many options should a plan sponsor offer in its 401k plan?”)

F ar too many 401k plan sponsors don’t know how to answer this important question. Of greater concern for 401k investors, far too many 401k plan sponsors fail to even ask the question. Instead, they opt to trust the guidance of their service providers, who may have a pecuniary interest in maximizing the number of offerings. First, let’s examine why this question represents one of the most critical fiduciary decisions a 401k plan sponsor must make when establishing and monitoring a 401k plan.

The clearest reason why this might be important deals with fees. No, not the fees associated with the underlying investments, but the infrastructural costs associated with the mere number of options. Recordkeeperers, third-party administrators and custodians all may charge more for each individual investment option, although typically extra charges are not incurred until the 401k plan has exceeded a certain maximum number of investment options. In addition to these providers, accountants may charge more if their work entails auditing investment transactions. The sheer number of options may simply increase the hours necessary to audit the plan and that can increase costs.

Why are these costs significant? Unlike, say, an indirect fee such as a mutual fund expense ratio, none of these direct fees can offer a positive impact on investment performance. As the DOL states in its commentary on 401k plan fees. a “1% difference in fees and expenses would reduce your account balance at retirement by 28%.” These administrative fees can add up, and adding more investment options can cause them to add up quickly.

But fees aren’t the only reason why 401k plan sponsors might inadvertently hurt 401k plan investors by offering too many investment options. A decade ago, in a study conducted by Shlomo Benartzi and Richard Thaler (“Naive Diversification Strategies in Defined Contribution Saving Plans ,” American Economic Review. March 2001, Vol. 91.1, pp. 79-98.), suggested 401k investors tend to use simple decision making heuristics when picking 401k investment options. These unsophisticated approaches often lead employees to merely split their dollars equally among all investment options.

While Benartzi and Thaler focused on the asset allocation implications of this, a far more meaningful impact was the over-diversification caused by assembling a portfolio of too many mutual funds. In effect, these naïve investors, in seeking greater diversification, may have actually created a de facto index fund, even when the underlying investments were all actively managed funds. The problem arises when one looks at the aggregate expense ratio of all these actively managed funds. This expense ratio tends to be much higher than a comparable index fund and, since the de facto index fund will likely yield a return similar to that comparable index fund, this expense ratio difference can only hurt the 401k investor. This is not an “active vs. passive” argument; it is an argument between high-cost and low-cost index funds.

Benartzi and Thaler touched on the real issue concerning why it’s important for 401k plan sponsors to consider the number of investment options to offer on their plan menu. In 2000, Sheena Iyengar and Mark Lepper, published the article “When choice is demotivating: Can one desire too much of a good thing? ” (Journal of Personality and Social Psychology, 76, 995-1006). Iyengar and Lepper showed, despite the popular idea that the greater the number of choices the better, it turns out the opposite it true – the fewer the choices the better. Later studies, including those like Benartzi and Thaler addressing 401k choice specifically, reached similar conclusions. In 2004 Iyengar, Huberman, and Jiang, “How much choice is too much: determinants of individual contributions in 401(k) retirement plans. In: O.S. Mitchell and S. Utkus, Editors, Pension Design and Structure: New Lessons from Behavioral Finance, Oxford University Press, Oxford, pp. 83-95.) found too much choice actually lowered participation rates.

But all these studies postulated the problem dealt with financial illiteracy, nor pure economic theory. If this hypothesis were true, a greater number of choices would be preferred when presented to an ideally educated work force. A working paper just published by the Harvard Business School (“When Smaller Menus Are Better: Variability in Menu-Setting Ability ,” David Goldreich and Hanna Hałaburda, August 10, 2011) tested this idea. They discovered “in an important economic context 401k pension plans – we find that larger menus are objectively worse than smaller menus” and concluded “this results in a negative relation between menu size and menu quality: smaller menus are better than larger menus.”

What is the real impact of offering too many choices? In another recent study, Iyengar and Emir Kamenica spell this answer out quite precisely. Their study, published in the Journal of Public Economics. looked at data from the Vanguard Center for Retirement Research, including over 500,000 employees in 638 firms. Iyengar and Kamenica conclude for every 10 investment options, equity allocation decreases by 3.28% and there’s a concurrent increase of 2.87% that the participant will allocate nothing to equities. These results are consistent with earlier research that concluded too much choice leads to sub-optimal decisions.

While this latest research doesn’t suggest an optimal number of investment options, it does imply that optimum number is likely less than ten options. It should be noted ERISA Section 404(c) provides a safe harbor to 401k plan sponsors that include at least three “diversified” investment options which have “materially different risk and return characteristics” among other things (29 C.F.R. § 2550.404c-1(b)(3)(i)(B) ). Between academic research and government regulation, it would appear the ideal 401k plan would have anywhere from 3 to 10 investment options.

That seemed simple, didn’t it? Unfortunately, a recent court case seems to have complicated matters. In Renfro v. Unisys Corp. the U.S. Court of Appeals in Philadelphia ruled against plaintiffs suing for breach of fiduciary duty because the plan had high-cost retail Fidelity funds. The fees of the 73 options ranged from 0.1% to 1.21% and the court ruled the participants had sufficient low-cost choices to invalidate their claim. Nothing was said about there being too many funds in the plan. Of course, to be honest, the case really dealt with Fidelity’s duty as a directed trustee, not the number of options in the plan. Still, a few other cases have involved plans with several dozen investment options and neither the courts nor the plaintiffs seemed to have treated this fact as relevant.

Yet.

Be sure to read all the informative installments of this three part series:

Part I: How Many Investment Options Should 401k Plan Sponsors Offer?

Part II: Professional Advisors Sound Off on Ideal Number of 401k Plan Options

Part III: Avoiding Decision Paralysis: How to Create the Ideal 401k Plan Option Menu