I recently started a new job, which meant reviewing the multi-page booklet of investment options for my new 401k. It gave me flashbacks to a time when I first started working. The jumble of options, percents, ratios, and expenses looked more frightening than my differential equations homework.
It is like going out for ice cream in a foreign country: you have hundreds of flavors and toppings to choose from, some delicious and some terrible, and the menu is in a different language. Except now your financial future is on the line. The pressure is on to meticulously craft the perfect sundae while other life obligations rush you like people impatiently waiting in line.
Disclaimer: I am not a financial professional. This post details my personal strategy for choosing my own investment options. Do your own research before making investment choices.
Back to the 401k Basics
When I asked Mr. Mechanic what he knew about 401ks, he said:
- Um… you’re supposed to have one.
- I don’t know where you get one.
- You should max them or something?
- Your company will match some money or something like that.
Yes, you should enroll in your 401k. It is a great vehicle for saving for retirement because money can grow tax-free. You get a 401k through your employer; many companies auto-enroll their employees, but some people will need to opt in.
There are other employer-sponsored retirement accounts such as 403(b) plans for the public sector and non-profits, 457 plans for government employees, and the Thrift Savings Plan for federal employees, but the 401k is more ubiquitous.
The max contribution limit for a 401k is $18,500, higher than a personal IRA at $5,500. Many companies offer contribution matching, which is not counted towards the limit. The exact amount will vary company to company, but the end result is the same: extra money funding that sweet retirement life.
My first employer offered a 6% match. A percent match means that your employer will match you dollar for dollar on contributions up to that percent of your annual salary. If I hypothetically made $40,000, and contributed 3% ($1,200), my company would have matched my 3% and put in $1,200, for free! If I had instead contributed 6% ($2400), or more, my company would have added $2,400, an even better deal. Some companies offer other conversion rates, like fifty cents on the dollar, usually capped at a certain percentage of annual salary.
Personally I max out my 401k every year, but of course whether or not this is achievable depends on your salary and expenses. Reference the ultimate flowchart for the order of contributions to debt, 401k, IRA, HSA, etc.
Now that we’ve covered the basics of what a 401k is and how it works, there are 4 steps to simplify the process of choosing your funds.
Step 1 – Consider Expense Ratios
One of the first places to start is taking a look at the expense ratios. An expense ratio is a fee the fund will charge from your account annually for upkeep and management costs. The fees associated with your investments can drag on your portfolio over time. A great expense ratio would be below 0.1%, a good rate below 0.5%, and a poor rate nearing or surpassing 1%.
Let’s start with an example. Here are Morningstar’s 401k options as of 2015:
The difference between the least expensive fund in our list of options (0.04%) and the most expensive (1.20%) might seem negligible, but the cost to you overtime is huge. Consider an example assuming an initial investment of $10,000 and an annual addition of $5,000. With a market return of 7% over 30 years, the more expensive fund will cost $109,093 more than the one with a lower expense ratio.
That is a huge amount swept off the top of your earnings! Since fees are automatically pulled from the account, this factor is easily forgotten. As you can see from the example, favoring low ratio funds is crucial for maximizing your overall return.
Step 2 – Decide your asset allocation
Assets are divided into different categories such as cash, stock, and bonds. Your asset allocation is the percentage you decide to put into each of these categories. For example, your portfolio might be 5% cash, 15% bonds, and 80% stocks. There is no one “right” way to decide the balance. It depends on the time until your retirement and your personal ability to stomach up-and-downs in the stock market. Having more bonds will smooth out volatility as they will often increase while stock prices tumble, but more stocks will often provide better returns in the long run.
When I started investing I was not as informed about asset allocation and by default valued a less-risky portfolio that was bond heavy. However, leaving my money in bonds meant losing out on a lot of growth from stocks. I have since flipped completely to a 90/10 split of stocks/bonds because I have plenty of time to ride out a market correction. I think I have the fortitude to watch my investments drop as much as 30-50% in a market crash, strengthened by the knowledge that I am investing for the long term. It might be easier said than done; we will see how that pans out in the next market correction!
There are some well-known rules of thumb for determining your asset allocation:
- Use your age as the percentage of bonds in your portfolio. So if you are 30, you would have a portfolio of 30% bonds and 70% stocks.
- More recent guidelines suggest more aggressive investment in stocks, by subtracting your age from 110 (or 120) for the amount of stocks. So a 30 year old would do 110-30 = 80% in stocks, 20% in bonds.
If you’re still uncertain about your bond allocation, take the Vanguard Investor Questionnaire and go from there.
When you choose your 401k allocation, keep in mind the investments you may have in an IRA or other retirement accounts to make sure your entire retirement portfolio tracks your chosen allocation.
Next we will consider the funds that make up your allocation.
Step 3a – Prioritize Index Funds
Index funds are a type of mutual fund that track certain groups of stocks, bonds, or other types of investments.
An example are funds like Vanguard 500 Index (VFINX), Fidelity Spartan 500 Index (FUSEX), and Schwab S&P 500 Index (SWPPX) which track the S&P 500, a market index that follows market-leading companies such as Apple, Amazon, Netflix, etc. to determine the market’s overall performance. Index funds are ideal for holdings in retirement accounts as they provide broad market exposure, generally have low expense ratios, and perform better than actively managed funds.
You can tell index funds as they usually have “index” in the name of the fund.
In this case, the index funds are represented by Index and Idx. As you can see, these index funds also have the lowest expense ratio, yay!
Step 3b – Consider a Target Date Retirement fund
Many plans offer a single fund called a “Target Date” fund that automatically handles allocations and rebalancing for you. They contain domestic and international stocks and become bond heavy as the fund approaches its target year, which is included in the name of the fund.
This option is great for those who don’t want to log in and rebalance their portfolios every year. If your plan offers a target date fund with the same (or lower) expense ratio than your other options, consider directing your funds there.
Be wary of target funds that include actively managed funds, as these frequently have high expense ratios and might not be worth the extra simplicity.
You don’t have to pick the exact year you are retiring, either. If you are planning on retiring in 2055 but want a more aggressive fund, you can pick the 2065 option instead as it will be stock-heavier for longer.
If you are considering an index fund or a Target-Date fund, chances are that you are on the right track for making your 401k selections.
Step 4 – Commit to a Decision: Progress over Perfection
If you take one look at the spread of fund options and rash of numbers and feel overwhelmed– you are not alone. It is okay to pick some funds and revisit later. 401k accounts are tax-sheltered, which means you can change your allocation penalty-free. You don’t have to get it perfect on the first try. Do not leave your money plopped in the default money market account struggling to keep up with inflation while you study to become a financial expert. Just choose some funds.
If your company’s 401k options are terrible, don’t worry. Later down the line you can roll the funds into your IRA or a new 401k plan when you leave your current employer.
In the end, these are the funds and allocation I would choose from the Morningstar example:
- 90% Vanguard Inst Index (VINIX)
- 10% Vanguard Total Bnd Mkt Idx (VBTLX)
One might consider adding the Vanguard Int Growth to get some international exposure, but I keep international funds in my IRA since I have more choices in that account compared to a 401k, where I like to keep it simple. Either way, it is better to make a decision to get started.
Everyone tells you how important saving for retirement is, but it is a whole different animal when you face the choices head-on. By taking a systematic approach, you can narrow down your choices to a portfolio you can be proud of.
- Look for options with low expense ratios
- Decide your asset allocation
- Consider index and target date funds
- Commit to a decision: progress over perfection
Armed with these four steps, the selection process is much easier.
To read more, check out The Beginner’s Guide to Investing – For When You Just Want To Be Told What To Do which explores opening and funding an IRA.
How did you choose your 401k funds? What is your asset allocation? Share your experience in the comments!