Do you know what you own in your 401(k)? I’m not a gambler, but I think it’s safe to bet that most of us don’t. At some point we were given a list of investments from which to choose. Maybe you kept the default option your employer chose, maybe you chose funds with appealing names or decent returns, or maybe you put the list up on a dart board and let fate decide. Absent the help of an employer-provided financial wellness program or advisor to consult with, you were probably flying blind. Considering your 401(k) is likely to be your largest investment asset throughout your life, I think it’s time we take off the blindfold and figure out how to make wise investment choices in our retirement plans. Consider this your 101 on 401(k)s.
We’ve all heard that you shouldn’t put all your eggs in one basket but following that advice without understanding the goal of diversification may lead us astray. When we receive the list of investment options for our 401(k), we might think choosing a handful of different funds is a sufficient means to spreading our eggs around. Not always true. If the funds we choose are very similar and own the same types of companies, what we’ve done is make multiple purchases of the same thing. All that achieves is higher costs, not diversification.
Simply put, diversification is reducing risk by owning a variety of assets that are likely to perform differently in various market conditions. Some market environments will favor large companies over small ones; others will favor international companies over domestic; and when stocks are going down, bonds tend to be the favorite. A portfolio with a little of each of these will have lower risk than one concentrated into a single part of the market. When choosing from your employer’s list of options, pay attention to the asset class. The asset class, for example large US, will tell you what the fund holds, enabling you to choose multiple different asset classes to build a truly diversified retirement plan.
Target the Right Funds
Managing a retirement portfolio can be quite simple with an all-in-one fund. These funds, called target date or lifecycle funds, usually have a year in the title, such as the Vanguard Target Retirement 2050 fund. The reason they are appealing is that they take the work out of allocating and diversifying your portfolio. Instead of picking funds with different asset classes, a single target date fund provides a ready-made mix of different types of bonds and stocks. The higher the year in the name, the more allocated to stocks (and thus the more aggressive) the portfolio will be. The allocation to stocks is automatically reduced as the year gets closer, naturally reducing your risk as you near retirement. Owning one target date fund is equivalent to owning many individual funds, so in this case one basket might be a fine place for all your eggs to be.
The challenge with target date funds is that they vary widely from one fund company to another. You might reasonably expect that all 2050 funds would be similarly invested and totally appropriate for you if you plan to retire in 2050. In truth, two 2050 funds can be very different, so you can’t rely entirely on the year in the title to indicate the fund is right for you. Ideally, you would determine how much stock you want to own and then look for the target date fund with that allocation. In the absence of help from an advisor, you can start to figure out how much stock to have with this questionnaire.
Mind your Fees and Q’s
A typical list of investment options for a 401(k) or 403(b) gives you a few funds to choose from in each asset class. There might be three different large US company funds available. From a diversification standpoint, they may be very similar. That doesn’t mean that all three funds are equally suitable for your portfolio. Of the funds you can choose from in each asset class, the fees can vary tremendously. Every cent you pay in fees reduces your overall return, so avoiding punitive costs on your retirement plan investments is critically important and can have a significant impact on how much you wind up with at retirement.
Mutual funds have three common types of fees. The first is the expense ratio. This is the cost the fund charges to run the mutual fund. All mutual funds have this fee, but they can range anywhere from .03% to 3.00% per year. Look for funds with a lower expense ratio to maximize your return.
The other two fees are up-front or back-end commissions called loads. A front-end load is paid when you buy the fund and a back-end load is paid when you sell the fund. They are deducted from your investment, so it’s easy to miss them, even though these fees can be as high as 6%. A $100 investment with a 6% front-end load means that the day you buy the fund your $100 becomes $94. You then must earn more than 6% just to get back to even!
The good news? There are plenty of no-load funds that have neither type of commission, though it’s not always obvious which ones do and don’t. The pro-tip to identifying fee-laden funds is to look for the letter ‘A’ or ‘B’ after the fund name. In most cases an ‘A’ or ‘B’ fund will have a front or back-end load respectively. To check the fees on mutual funds offered in your 401(k), go to Morningstar and enter in the ticker symbol.
Get on It
My last tip? Don’t wait to apply this information! Before rushing off to your next email, task or project, ask yourself if any of those things are as important as improving the odds of achieving your financial goals. Take some time, review your options and turn that 401(k) to a 401-yay!