Employer-sponsored retirement accounts are a great way to end up with more money when you’re ready to retire. 401(k) plans are the most common type, but there are also 403(b) plans for the public sector and non-profits, 457 plans for government employees, the Thrift Savings Plan for federal employees, and a few other choices. Beyond the huge tax advantages, these plans have much higher contribution limits than an IRA and the possibility of employer matching contributions. Sometimes, the only way to save enough for retirement (e.g., 15-20% of your income) is to use an employer-sponsored plan in addition to an IRA. Unfortunately, many plans have limited investment options with higher expenses.
This guide’s goal is to help you pick funds in your employer plan by following the /r/personalfinance (or Bogleheads) investment philosophy. If anything here confuses you, hit the background materials at the end of this post.
Our overall approach is to optimize fund choices across several competing factors. These are in rough order of importance, but sometimes these factors are going to conflict with each other. We want:
- Employer matching (as much as possible)
- A diversified portfolio consisting of stocks and bonds
- Mostly domestic stocks and some international stocks
- Reduced costs by choosing funds with lower expense ratios
- Passively managed index funds rather than actively managed mutual funds
Know When to Punt
There is one additional tool at our disposal: most people have the ability to open an IRA with similar tax advantages and good fund choices. So, in some cases, we’re going to decide to skip one or two investment types and acquire those separately in an IRA.
So, if you find yourself with a bad option or two when going through these steps, don’t panic. Do the best you can and the last step discusses how to fix problems.
Costs (Expense Ratios)
The expense ratio (ER) of a fund is the total percentage of your investment used each year for administration and other costs. The “net” ER is the number that matters because that’s the amount you’re actually being charged.
What makes a good ER for a fund? For domestic stock funds in the US, an ER below 0.1% is great, below 0.25% is good, below 0.5% is fair, and below 1% is sometimes the best you can manage in an expensive plan. If you find yourself much above 0.2% then once you’ve maximized your employer matching, you should probably max out your savings in an IRA before you max out your 401(k). This being said, even if you are limited to expensive funds above 1% ER, it’s still almost always a better choice to max out your IRA and 401(k) before using a taxable account. Beyond the enormous tax advantages, you can always move your money after leaving your job and your employer plan may also improve in the future.
Generally speaking, cheap international funds tend to have ERs about 3x higher than domestic funds and small-cap and bond funds tend to be about 1.5-2x higher in ER than large-cap stock funds. Expensive funds tend to have an ER around 0.75% to 1.5% regardless of the type.
Finally, try very hard to avoid funds that have transaction fees or sales charges (also known as loads or commissions).
1. Research your plan options
Get a complete list of the funds available in your plan. You will need the fund name, the ticker symbol (a five letter code), and the ER for that fund in your plan. You may have to read the prospectus or search on the Internet to find out more about each fund if the fund names are not descriptive enough.
SIDEBAR: TARGET DATE FUNDS AND BALANCED FUNDS
If your plan offers target date funds with an expense ratio that is comparable to or better than the other options in your plan, you should consider using it as your sole investment in your plan to lower your costs and/or keep things simple. Target date funds allocate across both domestic and international stock markets. They also include a bond allocation that slowly increases over time as you approach the target date (of retirement). They’re intended to be the only fund you use within a plan.
Two very good target date fund families are the TSP Lifecycle funds and the Vanguard target date funds. The TIAA-CREF Lifecycle Index Series is also good. Other target date funds tend to be more expensive and/or include actively managed funds, but they might still be the best choice in some plans.
There are also balanced funds that may be worth considering because they are diversified like target date funds although they don’t increase the bond allocation over time. Some good options include:
- Fidelity Four-in-One Index Fund is similar to a target date 2035 fund
- Vanguard LifeStrategy Growth Fund is similar to a target date 2030 fund
- Vanguard LifeStrategy Moderate Growth Fund and Vanguard Balanced Index Fund are similar to a target date 2020 fund
- Vanguard LifeStrategy Conservative Growth Fund is similar to a target fund for someone in retirement
Most other balanced funds tend to be more expensive and/or include actively managed funds.
If you haven’t selected a target date fund or a balanced fund, continue on below.
2. Decide on your Bond Allocation
You need to decide what percentage you want to hold in bonds and what percentage in stocks. This is a complex topic, but a simple approach is this: If you’re a conservative investor, subtract your age from 100 or 110 and allocate that percentage to stocks. If you’re an aggressive investor, subtract your age from 130 or 120 and allocate that percentage to stocks (cap at 100). The remainder is your bond allocation. While some young and aggressive investors do decide to leave out bonds, note that most target date funds always include at least 10% bonds even for investors very far from retirement.
If you’re uncertain about your bond allocation, take the Vanguard Investor Questionnaire and use the resulting bond allocation recommendation.
We ideally want to allocate the entire bond allocation to a Total Bond Market index fund with a low expense ratio. Here is a rough ranking of the various options to consider for this:
- Total Bond Market index fund
- The lowest cost intermediate-term bond fund
- The lowest cost bond fund
Note that a money market or sweep account is not a suitable alternative. Those options won’t earn enough interest to keep up with the rate of inflation.
4. US Stocks
This is going to be the largest percentage of your overall allocation.
Take your stock allocation and multiply it 70%. We ideally want to allocate this amount to a US Total Stock Market index fund with a low expense ratio. Here is a rough ranking of the various options to consider for your US stock allocation:
- US Total Stock Market index fund
- A mix of index funds that approximate the US Total Stock Market
- A good large-cap index fund (e.g., an S&P 500 index fund)
- The lowest cost US mutual fund choice(s), ideally averaging out to Morningstar large size category and the Morningstar blend style category.
If you end up on the last option and your plan only has growth and value funds, you can approximate a blend style fund by combining equal proportions of growth and value. Because large-cap stocks constitute about 80% of the US stock market, you also want to try to only use small-cap and mid-cap funds for about 20% of your US stock allocation.
5. International Stocks
Take your stock allocation and multiply it by 30%. We ideally want to allocate this amount to a Total International Stock Market index fund with a low expense ratio. Here is a rough ranking of the various options to consider for this:
- Total International Stock Market index fund
- A mix of index funds that approximate the Total International Stock Market (75% developed and 25% emerging is reasonably close)
- A good developed markets international index fund
- The lowest cost international mutual fund choice(s)
In a worst-case scenario, it’s acceptable to fall short of 30%, but see the “Fixing Problems” section below first.
6. Fixing problems
Now, if you have a great employer plan, you’re basically done at this point. If, however, some of the funds that you had to pick weren’t index funds, had high expense ratios, or weren’t quite right, then consider following these steps:
- Open an IRA if you don’t already have one. Good options include Vanguard, Fidelity, and Schwab.
- Take the worst fund from your 401(k) and leave it out of your 401(k).
- Replace that fund with a better choice from your IRA.
- Repeat #2 and #3 if needed.
Ideally, you want to do this while preserving the overall allocation you want, but sometimes that will be difficult. If the fund you’re trying to replace is a US stock fund, it’s likely that you’ll only be able to partially replace it because US stocks are the largest percentage of our allocation. Do your best and just contribute as much to both an IRA and a 401(k) as you can. It doesn’t have to be perfect.
If your income exceeds the limit for deductible contributions to a Traditional IRA then it may be disadvantageous to use this approach if it would mean contributing less to your 401(k) plan because it might increase your taxable income.
When fixing problems via a separate IRA, there are two big things that you don’t want to do:
- Leave employer match on the table.
- Contribute less to retirement than you wanted to contribute before running into bad choices. In virtually all cases, tax-advantaged savings trumps poor choices.
If you are totally lost, please study the background materials before going through this guide again. If you’re still stuck, make a post to /r/personalfinance. Include the full list of funds offered in your plan including the fund names, ticker symbols, and (net) expense ratios in your plan. Also include your proposed allocation, information about any other investment accounts, your age, and your gross income.
- Bogleheads investment philosophy videos
- “I Have $[X] … What Do I Do With It?!”
- Your 401(k) and You: Basic Information