I am often asked for help by friends and family when it comes to making investment choices inside their 401(k) plans. Unlike IRAs, many company 401(k) plans have very limited investment choices. To make matters worse, most of these choices are actively managed funds that charge very high fees. This makes it much tougher to give any recommendations to people who are looking for help. Sometimes all one can do is make the best of the situation because the benefits of a 401(k) plan are too good to pass up. Here are some of the things I look for when the choices are limited:
- Index funds that charge low fees: The Vanguard S&P 500 Exchange Traded Fund (NYSEARCA:VOO) now charges only 0.06% per year. This is incredibly low compared to S&P 500 funds just five years ago. Also, compared to the average actively managed fund expense ratio of 1.5%, the Vanguard ETF is an amazing deal. Using our free calculator called Compare Investment Fees, I came up with the following: A $100,000 investment over a 20 year period in the actively managed fund, not taking into account any investment return, would cost you nearly $25,000 more in fees than the Vanguard ETF. Looked at another way, 25% more of your money will go to the fund company in 20 years compared to the Vanguard ETF. Needless to say, investing in funds with low expense ratios is one of the easiest ways to increase your overall returns. The very first thing I look for when sifting through choices in a 401(k) plan are the investment choices that are not actively managed and have the lowest fees.
- Life-cycle funds: These funds are designed to remain appropriate for investors in terms of risk as the investor ages. Accordingly, the funds automatically change the allocation among U.S. stocks, bonds, and international exposure as the investor grows older. These types of funds can be very useful for three reasons: First, they are on autopilot and can help save many people from having too much exposure to risky assets as they approach retirement. Second, they usually have reasonable expense ratios and are sometimes the best choice in a limited 401(k) plan. Lastly, I have seen many 401(k) plans that offer no way to gain exposure to bonds that have superior credit. Many times the only way to gain exposure to a high quality bond fund is through a life-cycle fund.
- Emerging market exposure: If the investor is young, it makes much more sense to take on more risk via emerging markets. If you are going to pay for actively managed funds, it’s more palatable when those funds at least access emerging markets where the potential return is much higher. For those who have access to multiple ETFs, I am a big fan of the Wisdom Tree Emerging Markets Equity Income Fund (NYSEARCA:DEM), which now has a dividend yield of nearly 7%.
Younger investors should be taking most of their risk in their retirement portfolios, which they likely won’t touch for decades, and less risk in their non-retirement portfolios where they have more investment choices and can find less risky funds with very low costs.
It is also important to rebalance your 401(k) plan annually, unless you plan on putting everything into a life-cycle fund which will rebalance for you. It likely also goes without saying that investors should always put at least enough money into their 401(k) plans so they get every possible dollar of company matching available. Using our 401(k) Benefits calculator I determined that a young person with 40 years left until retirement making $70,000 a year will forego over $250,000 if he or she cuts their 401(k) contribution by just 1%. This assumes a typical 50% company match, a maximum match of 5%, and a total return of 6% per year.
Company contributions to 401(k) plans are free money and a risk-free return added to your portfolio over time. Those kinds of deals are very tough to come by.
Disclosure: I am long DEM.