Financial Sophistication and Conflicts of Interest in 401(k) Pension Plans

Abstract

Defined contribution pension plans transfer the risks and responsibility for retirement outcomes to plan participants, while exposing participants to agency conflicts in the design of investment options. We analyze the role financial sophistication of participants and plan governance in reducing conflicts of interest in 401(k) plans. Pension plans of finance firms with an external independent trustee invest less in sponsoring company equity and options affiliated with the trustee than pension plans of non-finance firms and of finance firms that serve as own trustees. The changes in options on the investment menu offered by finance firms with an external trustee are more sensitive to past performance and their participants benefit from the removal of underperforming mutual funds. The evidence implies that greater financial sophistication among plan participants can improve the investment allocations, but only when it is accompanied with an independent governance structure.

Keywords: 401(k) pension plans, trustee, mutual funds, financial literacy.

JEL Classification: G11, G23, G28, G40, G53, H55.