Not All Funds are Created Equal: How to Evaluate the Investment Options in your Retirement Savings Plan
By Matthew Jones
Hint: by Retirement Savings Plan we refer to any employer-sponsored plan that allows you to contribute a part of your paycheck to enjoy tax advantages later in life. To name a few, these include 401(k), 403(b) and 457 plans.
In 2012, the average 401(k) plan offered 25 different investment options, including strategies focused on bonds, mutual funds, target date retirements, and index funds.1 My company offers more than 70 different investment options, while my spouse’s employer offers just over 10.
While the number of funds varies for each company – your challenge is to find out what investment options are best for your retirement savings plan. After all, you better have a decent nest egg after grinding it out for so many years right?
To understand what investment options are best, let’s first start with a background.
What is a Retirement Savings Plan?
A retirement savings plan (RSP for short) is any employer-sponsored plan that allows you to contribute a portion of your paycheck to investments that are, to some degree, tax-sheltered. These plans include 401(a)s, 401(k)s, 403(b)s, 457(b), 457(f) plans and the federal government’s Thrift Saving Plan (TSP). A brief explanation of each plan is provided below
You can see more info on each plan in our article here: (link),but for the purpose of this article, you only need to worry about the plan that your employer provides you with.
As we mentioned earlier, the average employer plan offers 25 different investment options. To understand which ones are best for your situation we should review the major types of investments these plans hold, namely: stocks, bonds, index funds, mutual funds, and target date funds.
Ready? Here we go:
A stock is an investment that represents ownership in a publicly traded company. When you buy stock, you literally became a part-owner of that business. As an owner of the business, you can make money from the business becoming more valuable (stock price goes up), or from the distribution of dividends from the company’s revenue. Pretty cool right? Now about being an owner, the amount of stock is different for each company. Apple for example, has over 17 billion shares. So, your piece of the pie – it’s pretty slim.5
Investing in stocks is common because it has a historically high rate of return. Thus, most people (myself included) focus on investing in stocks to growth their nest egg. Now most of you won’t see individual stocks for sale in your employer-sponsored fund (which is fine). Instead, most companies offer a selection of mutual funds or index funds – which hold a diverse set of stocks or bonds. We’ll talk about index and mutual funds later. For now, let’s talk about bonds.
Bonds are investments in which you agree to loan your money to an entity, with the expectation that they will return you money with interest after pre-determined amount of time. Think of buying a house. The banker loans money to the homebuyer with interest, so that the individual can get a home. The bankers happy to make their money grow, while the new homeowner is happy to have a place of their own. With bonds you are the banker, and the homebuyer is the entity that uses those funds.
Bonds are used by companies, governments, and nonprofits to secure funding for current needs like improving their facilities or general expansion. There are many different types of bonds, and the tax benefits vary based on the bond type. If you want a more in depth look at bonds, check this article out (link). What you should know about bonds is that historically, they outpace inflation –but provide a lower rate of return than stocks (5.3% over the long run).6
So, if bonds make less money than stocks, why invest in them? Well they are generally less volatile than stocks so retirees tend to use bonds to get more consistent income in their golden years to fund their living expenses. Like stocks, you won’t see an option in your retirement plan to buy an individual bond. Instead, your employer will provide index funds and/or mutual funds that hold a diverse set of bonds. Buyer beware though, mutual fund fees can devour your bond return.
With that, let’s talk about index funds and mutual funds.
Index funds are investment portfolios, where the primary goal is to match a benchmark’s performance. When you pay into an index fund, your cash is pooled with other investors to buy many different stocks (or bonds) to get instant diversification. Some benchmarks include the S&P500, the Dow Jones (DJIA), and the Russell 2000. You should know that index funds typically focus exclusively on equities or on bonds (though there are exceptions). Index funds have extremely low fees, which is critical for your investment performance. Examples of common index funds include the Vanguard Total Market Bond Fund and the Fidelity Zero Large Cap Index Fund.
Like index funds, mutual funds pool together investor money to buy different stocks and/or bonds. However, the goal of Mutual funds is to outperform the market whereas the goal of index funds is to match the market. In an attempt to beat the market, mutual funds are actively managed and investments are traded regularly on a short term basis. The funds have significantly fees in the ballpark of 1 – 3%. While this may not seem high, consider that investment advisors generally suggest you live off 4% of your nest egg for retirement. That mutual fund is suddenly eating 25% of your pay in retirement. Ouch. Oh and by the way, that 1% fee mutual funds charge is 25 times the fee that Vanguard charges for their total market index fund.7
If you’re like me, the fee still doesn’t seem so bad assuming they beat the market. While this is a fair point, there is significant research that shows that mutual funds rarely do this consistently. For example, the American Enterprise Institute found that the market outperformed 92% of all large cap funds over a 15 year period – and if you’re wondering about small caps they’re even worse at 97% underperforming the market.8 Translation? You’ve got much better chances parking your money in an index fund than an actively managed mutual fund.
Target Date Funds:
Target date funds are a relatively new concept where the goal is to choose your retirement year, and then work towards that. These funds can be comprised of actively traded mutual funds (danger, high fee area) or passive index funds. Target funds are basically a blend of stock and bond funds, where the amount in stocks vs bonds changes based on the target date. At the start, these funds may invest up to 100% of funds in stocks. As the target date approaches, the fund will shift so that investments are predominantly held in bonds. If you don’t want to take the time to adjust your ratio of bonds to stocks, this may be a nice option – but remember nothing is done for free. The expense ratios will be higher for these than their respective index and bond funds.
In general, I like to focus on the following for my investments:
- Which funds have the lowest fees
- Which funds are the most diversified (aka which track the market the most)
With that in mind, I invest in index funds through my employer-sponsored retirement savings plan. Since I am young and have a goal to achieve financial independence early, the bulk of my money is parked in index funds that track the market (think S&P500, Russell 2,000, etc.) and a much smaller portion (<10%) in bond funds.
The ratio of stocks and bonds that is best for your portfolio will be very different than mine based on your individual situation and needs. Before investing, you should make sure you understand the choices you have in your employer-sponsored retirement plan.
The key message here is that in general, a retirement savings plan should be invested in index funds or bond funds with the lowest fees (expense ratios) available. The ratio of stock to bonds will be very different for each person. If you want to learn more about general guidelines for the ratio you should hold in stocks and bonds, then check out this are here: (link). Lastly, mutual funds are not worth their fees, unless they’re your only way to invest in stocks. The majority of mutual funds do not “beat the market”. So why pay them the fee for trying to – and failing?
With that, good luck and happy saving fellow investor!
Everything mentioned in this article is exclusively intended for your education and entertainment – and NOT to be interpreted as investment advice. I am not your investment advisor and have not considered your personal circumstances as your fiduciary. You are responsible for your investing future, and the author of this article is not liable for the results of your investment decisions.