What's the Right Number of Investment Options in an HSA?

Does the size and design of the investment menu affect how many Health Savings Account owners invest a portion of their balances?

The number of Health Savings Accounts with invested balances and the total value of investments continues to climb. At the end of 2022, about 7% of accounts, or a total of more than 2.6 million, had a portion of their balances invested in various equities. These 2.6 million accounts held investments totaling $33.8 billion, or just under one-third of total Health Savings Account assets. Investments are projected to grow to $59 billion, representing 40% of assets, by the end of 2025.

What is the ideal number of investments? Recent work published by Devenir Research summarizes the market today and offers insight into design strategy. It found that the average number of investment options increased from 15 in 2012 to 21 in 2017, where it stands as of the end of 2022. That's a healthy increase, but a small absolute number that has remained flat for five years.

Is 21 the right number? Would more investment choices increase the percentage of assets invested? Are there other barriers holding most account owners back?

Barriers to Investing

Why don't more Health Savings Accounts contain balances invested in mutual funds, stocks, bonds, ETFs, and other financial instruments to increase projected long-term returns? Below are some thoughts. The first is documented. The others are more speculative.

• Insufficient balances. Devenir's 2022 end-of-year report shows that 62% of all Health Savings Accounts have balances less than $1,000 and 73% less than $2,000. Those figures are important because most administrators require a minimum cash balance of $1,000 or $2,000 before owners can invest. And even without these thresholds, owners who want liquid balances to reimburse their next qualified expense are unlikely to commit a portion of their funds to equities.
• Knowledge. Many Health Savings account owners, particularly newer ones (5.3 million new accounts were opened during 2021 and 2022 combined), don't know that they can invest.
• Friction. Investing often involves setting up an investment account, perhaps finding the link to a separate investment account, and establishing credentials. That level of work may discourage marginal investors - ones who are interested in, but not dedicated to, building their balances.
• Confusion. Experts speculate that far too many younger workers retain too much of their retirement savings in default money-market funds paying minuscule interest because they don't know how to invest. Faced with an overwhelming menu of choices, they fall victim to what's called paralysis by analysis - the tendency to avoid something that looks too complicated.

Changes that affect any of these variables positively are likely to increase the percentage of accounts with invested balances.

Health Savings Account Investment Options

Many Health Savings Account providers offer no investment options other than simple interest because they're financial institutions that offer a Health Savings Account that's no more than a standard checking account with different paperwork. They simplify the investment decision by removing all options except a certificate of deposit. On the other hand, these owners lose purchasing power every year that they retain their balances. Financial institutions typically pay a rate of interest far below general inflation, and medical inflation over time runs at about twice the rate of general inflation.

Fortunately, these administrators manage a small percentage of total accounts. The market leaders offer a range of investment options. These offerings generally fall into one of two categories (or a hybrid of the two).

Limited menu. This approach is designed to slay paralysis by analysis. Owners typically have access to a couple dozen mutual funds from different fund families that include all major asset classes (large, mid-size, and small companies; growth, blend, and value stocks; bonds; and international funds). Owners who want to invest can determine how they want to allocate their funds among these classes of investments, then identify the fund corresponding to each target investment. This approach is straightforward for someone who knows a little about investing. But it's not satisfying to more knowledgeable investors.

Broad menu. To appeal to more sophisticated and active investors, some administrators link their Health Savings Account to a brokerage account, allowing owners to choose from anywhere between several funds and the entire universe of domestic stocks and mutual funds. This approach attracts active investors who have specific stocks or funds - rather than classes - in their crosshairs. But it's not appropriate as the only option for an owner who lacks knowledge about how to invest for long-term growth.

Health Savings Account administrators - like their retirement-account counterparts - must strike the right balance in appealing to sophisticated investors, who hold much of the $33.8 billion invested at the end of 2022, while encouraging less confident investors to begin to allocate a portion of their balances to equities. Some do so by combining the two approaches, offering both a limited menu and perhaps some model portfolios as well as a brokerage account.

The Ideal Approach

The best solution is to offer approaches that make it easy for owners, regardless of their level of investment knowledge, to invest their balances for long-term growth. The ideal approach should include the following elements:

1. A single sign-on for the Health Savings Account and the investment portal. This simple step reduces friction.
2. A simple investment set-up process - perhaps answering two or three questions.
3. Instructions using various media - written, video, interactive - to convey information necessary to invest.
4. Sweep and rebalancing options. A sweep option allows an owner to direct all future contributions above the cash threshold into investments that she has chosen, in proportion to her desired allocation (for example, 50% into Fund A, 25% into Fund B, and 25% into Fund C). This system puts investing on autopilot. A rebalancing tool allows the owner to set the interval (quarterly, semi-annually, annually) when the investments will automatically be reallocated to the targeted percentage. For example, if Fund A grew to 60% of the portfolio and Fund C shrank to 15%, the rebalancing tool would automatically sell enough of Fund A to bring it back to 50% of the portfolio and simultaneously purchase enough to Fund C to bring it back to the 25% level.
5. Model portfolios. An easy way for less sophisticated owners to invest is to show packages that appeal to certain owners, using factors like age to retirement and tolerance for risk. This approach would give the account owner confidence that she's allocating her balances in a tried-and-true formula, rather than guessing or, worse, procrastinating.
6. Target funds. Most retirement accounts now include target funds. These options are easy to understand. If you plan to retire in, say, 2050, you place your balances in the Target 2050 account. The account manager automatically adjusts investments over time to shift from high-growth to lower growth with preservation of balance. Target funds fall under some criticism since investors pay two sets of administrative fees - the fees charged by the managers of the mutual funds in the target fund and the expenses that the target-fund manager extracts to manage the portfolio. But they've proven their value in retirement accounts as a means of reducing among novice investors the fear that often produces paralysis by analysis.
7. Brokerage accounts. More sophisticated investors - the ones most likely to build large balances and actively invest them in equities - want choice. It's not enough for them to select from one or two options in each investment class or a model portfolio. They may want to follow how Berkshire Hathaway is building its portfolio, buy certain stocks in depressed sectors (think financial stocks in the days immediately after three recent bank failures in March), or best part of their balance on emerging technology. An administrator that fails to satisfy their needs will forfeit an important segment of the market. But an administrator that offers nothing but a brokerage account will do a disservice to average owners who need some guidance and a limited set of options.

Another service that some administrators offer is financial advice from a licensed investment professional. For example, an owner would complete a questionnaire to establish an investment profile (aggressive, conservative) and a time frame. The program would then recommend an asset allocation. It might go further by offering an option to professionally manage the account. Owners pay for these services via a percentage of total assets, typically on a quarterly basis. Thus, if the fee is 0.25% per quarter (1% annually) and the account balance is $500,000, the fee is $1,250 quarterly, or $5,000 annually (in addition to the administrative fees charged by the mutual funds, which can range from minuscule for an index fund to 1.5% to 2% for more actively traded funds).

The Bottom Line

The construction of the investment portfolio isn't the only factor limiting investment. Too few HSA-eligible individuals open a Health Savings Account. Of those who do, most manage their account like a Health FSA, distributing nearly as much as they contribute each year. But as balances continue to grow, administrators have an opportunity to encourage more account owners to invest their balances to achieve returns that exceed medical inflation. The design of the investment program - education, ease of access and use, range of options - plays a key role in determining how many owners invest how much of their balances.

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The content of this column is informational only. It is not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.