Note: this post has been updated with content current for 2019.
We’re commonly asked by our Custom Portfolio clients to make recommendations for their 401(k) investment alternatives. Over time, we’ve identified a few common 401(k) pitfalls which minimize the effectiveness of their investment strategy. Those pitfalls are presented as questions below.
How many and which kinds of funds should I own?
Just because your 401(k) plan offers 20 funds doesn’t mean that you should invest 5% of your money in each one. Yet we often see investors doing that. Selecting the right asset allocation is pretty straightforward: beginning with a stock fund, your expected volatility and return decline increasingly as you add more bonds. Start with a core large company U.S. stock fund, add a bond fund as you see fit, and then – if you would like to increase your return potential – swap some of your large company fund for exposure to a U.S. small company fund and an international fund.
What about target date funds?
Target date funds apply the strategy outlined above within a single fund, and adjust the allocation to stocks downward as your projected retirement year gets closer. A target 2020 fund will have a much lower allocation to stocks than a 2050 fund. These funds can be a decent, low cost alternative to many funds in a 401(k) plan. On the other hand, ask yourself if you’re 30 years old, does it really make sense to own even 10% bonds? Also, consider the reallocating risk of these funds in light of the current stock market conditions.
For example, suppose you owned a target date fund that lowered the stock allocation and increased the bond allocation on March 1, 2009 – a few days before the bottom of the 2008 – 09 bear market. The effect would have been to diminish return potential for years to come.
Should I use index funds?
If you have index funds available in a 401(k), they may be the best alternative. Many 401(k) plans are sold by financial advisors distributing product for specific fund companies. This can have the effect of limiting investment choices to only a small set of funds approved by the financial advisor. Because active mutual funds can be expensive, an index fund may be the best alternative. Although, just because a fund follows an index, it doesn’t mean that it is also low cost. For example, take a common 401(k) offering, the Principal Small Cap S&P 600 Index R1 fund (PSAPX). The fund invests in the holdings of the Standard & Poor’s SmallCap 600 Index, but the expense ratio is 1.04% per year. As a comparison, the i-Shares Core S&P Small-Cap ETF (IJR) which tracks the same index only charges 0.07%. Maybe it’s a privilege to invest in Principal’s mutual funds? Who knows.
What about employer matching?
Many, but not all, 401(k) plans offer participants an added benefit of a matching contribution. For example, an employer might match 100% on the first three percent and 50% on the next three percent of a participant’s contributions. The choice to not save money for retirement is a problem in and of itself. But it’s an absolutely terrible idea to miss an employer matching contribution by not saving yourself. Truly, it’s the same thing as passing up free money.
A few features common to many 410(k) plans make them relatively less attractive: high mutual fund fees and poor fund selection being among the worst. However, by using important disciplines – like selecting a simple & effective asset allocation – investors can still profit from the benefits these plans have to offer: tax-deferred saving, and the possibility of “free money” from employer matches.