Bookmark This: A Step-by-Step Guide to Choosing 401(k) Investments

By Damian Davila on 21 September 2017 0 comments

It's no secret that 401(k) fund options are notoriously opaque. While target-date funds provide convenience to investors, they often come with higher fees than alternative investment vehicles, have highly variable returns, and aren't a good fit for many retirement savers. Let's simplify things, and review a low-stress strategy for building a solid two-to-three-fund portfolio for your 401(k).

The downsides to target-date funds

Designed to gradually adjust your investment mix as you approach retirement age, target-date funds have exploded in popularity since their designation as qualified default investment alternatives by the 2006 Pension Protection Plan. The upsides of target-date funds are that they're easy to select (96 percent of Vanguard plans make it the default investment option), they automatically rebalance, and they offer appropriate investment diversification. (See also: What You Need to Know About the Easiest Way to Save for Retirement)

However, all that convenience comes at a high price. A 2015 review of over 1,700 target-date funds by FutureAdvisor determined that their average expense ratio (the annual fee charged to shareholders to cover operating expenses) was a relatively high 1.02 percent, meaning that you'd pay $51 every year for every $5,000 in your balance. Assuming an average investment return of 7 percent per year, you would miss out on an extra $4,998 in retirement savings over a 30-year period.

On top of high fees, some target-date funds' returns barely cover their high annual expense ratios. The same review of 1,700 target-date funds pointed out that the lowest five-year average annual returns were 2.9 percent. (Returns are expressed net of expense ratios.) As of September 2017, 2.9 percent is not that much higher than the rate of a five-year CD at a credit union.

Here's a better alternative to target-date funds.

Your guide to choosing your 401(k) investment options

In his 2013 letter to Berkshire Hathaway shareholders, Warren Buffett (aka The Oracle of Omaha) provided an investment strategy that would "be superior to those attained by most investors who employ high-fee managers." Buffett recommended putting 90 percent of one's investments in a very low-cost S&P 500 index fund, and the remaining 10 percent in short-term government bonds. This is the same advice that he has set in his will. (See also: The 5 Best Pieces of Financial Wisdom From Warren Buffett)

More and more 401(k) plans are offering passively managed index funds that track a benchmark, such as the S&P 500. And for good reason: The Vanguard 500 Index Investor Shares Fund [Nasdaq: VFINX] has an annual expense ratio of 0.14 percent, just a $7 annual fee for a balance of $5,000. That's $44 in annual savings when you compare it to a target-date fund with a 1.02 percent annual expense ratio.

Worried that this approach doesn't provide you enough diversification? Think again: An index fund tracking the S&P 500 is investing in 500 large-cap companies. That's as diversified as you can get. (See also: How Too Much Investment Diversity Can Cost You)

Let's use Buffett's advice to build your 401(k) plan's portfolio.

Step 1: Check your plan for a U.S. equities index fund

There is a good chance that your 401(k) plan offers a low-cost S&P 500 index fund. Buffett personally recommends an S&P 500 Vanguard index fund. Vanguard is an investment management company known for having very low fees compared to competitors, especially on its index funds. In 2016, close to 60 percent of Vanguard plans offered an index core giving you access to broadly diversified index funds for U.S. stocks. In truth, you can do just as well with other index funds tracking the S&P 500, such as the Fidelity 500 Index Investor [Nasdaq: FUSEX] and the Northern Stock Index [Nasdaq: NOSIX].

In the event, that you don't have access to a low-cost index fund tracking the S&P 500 through your workplace 401(k), you have two action items. First, see if your plan offers another large cap index fund (one investing in large U.S. companies based on a market index). This type of fund normally invests at least 80 percent of its assets in securities within its benchmark index, such as the Fidelity Large Cap Stock Fund [Nasdaq: FLCSX] and the Vanguard U.S. Growth Fund [Nasdaq: VWUSX]. Second, contact your plan administrator and request adding a low-cost S&P 500 index fund.

Step 2: Check your plan for a fund of short-term investment-grade bonds

Just like there are index funds for investing in equities, there are also index funds for investing in bonds. For example, there is the Vanguard Short-Term Investment-Grade Fund [Nasdaq: VSFTX], which has an annual expense ratio of 0.20 percent, or $10 in fees for a balance of $5,000.

Don't have access to such a fund? Look for a low-cost fund giving you the most exposure to high- and medium-quality, investment-grade bonds with short-term maturities, including corporate bonds, pooled consumer loans, and U.S. government bonds. Why short-term maturities? Short-term bonds tend to have low risk and low yields, ensuring that one portion of your nest egg remains stable at all times — something you'll really benefit from during any recessions.

Then, request that your plan administrator add a low-cost index fund for domestic bonds.

Step 3: Allocate 90 percent to the equities index fund and 10 percent to the bonds index fund

Now you're ready to rebalance your portfolio. Using your online portal, look for an option that says "exchange funds" or "transfer money between funds" to move your nest egg dollars from your existing investments into the equities index fund and bonds index fund. (Note: Depending on your plan rules, including vesting rules, you may not be able to move 100 percent of your balance until a certain date. In that case, move everything that you can and the remaining once it becomes eligible.)

Exchange your entire 401(k) balance and allocate 90 percent of that amount to the equities index fund and 10 percent to the bonds index fund. Confirm your transaction.

Step 4: Adjust your future contributions

To keep future contributions going into the right place, adjust your paycheck investment mix so that 90 percent of withholdings go to the equities index fund and 10 percent go into the bonds index fund.

If your 401(k) offers an automatic rebalance feature, opt-in for it so that your portfolio is automatically readjusted to the 90/10 without you moving a finger. If your 401(k) doesn't offer that feature, plan to manually rebalance your account once a year.

Step 5: Revisit the 90/10 allocation at important life changes

Marriage. Birth of your first child. Purchase of your first home. Being able to start making catch-up contributions. Reaching age 59 1/2. These and more critical milestones in your life may require you to adjust your 90/10 allocation. As you get closer to retirement age, you should gradually shift from a growth strategy (selecting funds that exhibit signs of above-average growth) to an income strategy (picking funds that provide a steady stream of income) so that you hold fewer stocks and more bonds. The beauty of a target-date fund is that is does all of this for you automatically as you age. Without one, you'll need to stay on top of this occasional rebalancing yourself.

The bottom line

One of the main reasons that your 401(k) will perform better is that you're minimizing fees. If you were to allocate 90 percent of a $5,000 401(k) balance into the Vanguard 500 Index Investor Shares Fund [Nasdaq: VFINX] and 10 percent into the Vanguard Short-Term Investment-Grade Fund [Nasdaq: VSFTX], you would just pay $7.30 in annual fees. That's $43.70 in annual savings over putting the entire $5,000 in a target-date fund with a 1.02 percent annual expense ratio. It doesn't sound like a large amount of savings, but compounded over the years it can add up to thousands of dollars more in your retirement fund.

Like this article? Pin it!

A Step-by-Step Guide to Choosing Investments

5
Average: 5 (1 vote)
Your rating: None
ShareThis

Disclaimer: The links and mentions on this site may be affiliate links. But they do not affect the actual opinions and recommendations of the authors.

Wise Bread is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to amazon.com.