401(k) plans provide a wide range of investment options to choose from. Perhaps the most rewarding—but also the most daunting—aspect of managing your 401(k) plan is deciding how to allocate the contributions you’re making to your account.
The investments you select play a crucial role in determining how quickly your account balance may grow or shrink in value, as well as the income your plan will generate after you retire.
How to choose suitable investments for your 401(k)?
A 401(k) is an employer-sponsored retirement account that enables employees to allocate a percentage of their pre-tax salary toward retirement savings. Your employer, acting as the plan sponsor, chooses a financial services firm to serve as the plan provider. Subsequently, the sponsor selects the investment options to be offered in the plan from those available through the provider.
At a minimum, you can expect to find three distinctly different investment options in your 401(k) plan, each designed to work differently and expose you to varying levels of risk.
Typically, a 401(k) plan offers at least ten investment funds, although some programs may provide dozens of options. However, before making your selections, 401(k) participants should consider a few essential factors:
- Long-term returns: Evaluate the fund’s profitability over 5- and 10-year periods, as well as since its inception.
- Expense ratio: Understand the annual cost of maintaining the fund, expressed as a percentage of the money invested.
While there are no strict rules governing which types of funds or investments to choose, the least risky options in a 401(k) typically include money market funds or U.S. government bonds. However, it’s important to note that these investments often offer very low rates of return and may struggle to keep pace with inflation.
What the choices are?
In practice, most 401(k) plans provide a range of choices across three categories, each with distinct investment objectives and characteristics. For instance, you might find six stock fund options focused on various aspects, such as companies of different sizes, international firms, growth companies, and value companies.
Some of these funds may be passively managed index funds that track specific market indices, such as the Standard & Poor’s 500 Index or the Russell 2000 Index. Additionally, there may be balanced funds that hold a mix of stocks and bonds, with the relative proportion of stocks to bonds detailed in the fund’s prospectus.
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Some plans also offer a range of target-date funds. You can select a fund with a date—such as 2020, 2025, 2030, 2035, 2040, or 2045—that aligns with your expected retirement year. These funds allocate your contributions to a diversified portfolio of individual funds tailored to your time horizon for accumulating assets. Over time, the fund’s mix is gradually adjusted, shifting from a focus on growth to one centered on providing income.
Additionally, you may encounter target-risk funds, which combine various stock and bond funds to expose you to a specific level of risk—aggressive, moderate, or conservative—thereby offering the potential for corresponding returns.
Doing Double Duty
Offering a variety of investment choices helps your employer fulfill its fiduciary obligation to provide a menu that serves your best interests. By ensuring you have access to a range of suitable investment options, employers limit their legal liability for the outcomes you achieve. If the portfolio you select underperforms relative to your expectations, the responsibility ultimately rests with you, as you had the opportunity to make different choices.
What kinds of investments are in a 401(k)?
A company’s plan determines the investment choices available to employees. The most common investment options include:
- Stock Funds: Stock funds have historically delivered more substantial investment returns compared to other types of funds.
- Bond Funds: When you invest in a bond fund, you purchase shares in the fund, similar to investing in a stock fund. The fund manager then invests that money by acquiring bonds issued by corporations, governments, or government agencies.
- Target-Date Funds: Target-date funds help you diversify your portfolio by allocating your 401(k) contributions across various asset classes, including large-company stocks, small-company stocks, emerging-market stocks, real estate stocks, and bonds. These funds are particularly appealing as they alleviate the stress of making individual investment decisions. They also provide professional management and a commitment to adjust the allocation over time, following the guidelines outlined in the prospectus.
Additionally, these funds offer transparency, allowing you to review a fund’s prospectus for details on its investments, the schedule for reallocating assets, and associated fees.
However, there may be drawbacks to consider. The fees for target-date funds are often higher than those associated with a self-selected combination of individual funds due to the added layer of management.
Additionally, the principal value of target-date funds is not guaranteed at any time, including on the target date. As a result, you could end up with less than you anticipated—or need—at retirement.
Stable Value Funds: A stable value fund guarantees the value of your initial investment, or principal, while promising a fixed rate of return. For instance, a stable value fund may invest in U.S. Treasury securities, corporate bonds, and interest-bearing contracts from banks and insurance companies. Alternatively, the fund’s assets may be entirely allocated to Guaranteed Investment Contracts (GICs).
What is the automatic (default) 401k investment?
If a plan sponsor automatically enrolls employees in a 401(k), it selects a default investment for all participants. This default investment must be one of the following options: a set of target-date funds, a balanced fund, or a managed account.
As an automatically enrolled participant, you have the option to either remain with the default investment or select different investment options from those available in the plan. The same applies to your contribution rate; while many automatic enrollment plans set an initial default percentage of 3%, you may prefer to contribute a higher or lower amount. Typically, employers require a minimum contribution—often around 1%—to participate in the plan. In some cases, there may also be upper limits on contributions, such as 15%.
What are common investing mistakes in a 401(k)?
A 401(k) account can be one of the most effective ways to save for retirement. However, many individuals inadvertently undermine their potential returns by making a few common mistakes. Here are the most frequent 401(k) investing missteps to avoid:
1. Wasting Opportunities for Matching Funds
If your employer offers matching contributions, it’s wise to contribute enough to maximize this benefit. Typically, employers may match 50% of your contributions, up to a maximum of 5% or 6% of your salary, though these plans can vary.
2. Leaving the Company Before You Are Vested
While the money you contribute to your 401(k) is yours immediately, employer contributions may be subject to a vesting period. This means you need to work for your employer for a specified amount of time—often up to six years—to retain those contributions upon leaving or retiring. Understanding your employer’s vesting schedule is crucial, especially if you’re considering a job change.
3. Investing Exclusively in Company Stock
Putting all your money into company stock can be highly risky. If the company faces difficulties, it could jeopardize both your job and your retirement savings. A diversified portfolio is essential for mitigating this risk.
4. Misallocating Your Portfolio
Proper asset allocation is critical for managing risk. Different asset classes do not always move in the same direction; therefore, spreading your investments across various types can help stabilize your returns.
5. Leaving Old 401(k)s Open
You may be making a mistake if you leave a job but keep your 401(k) account with your former employer. Rolling over your 401(k) into a traditional or Roth IRA often provides better growth potential and more control over fees than leaving it in an old account.
6. Paying Too Much in Fees
401(k) costs and expenses generally fall into three categories, as defined by the U.S. Department of Labor: plan administration fees, investment fees, and individual service fees. Paying attention to these fees can help you keep more of your savings.
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