How to Invest in Your 401k
Jay Abolofia, PhD, CFP® is a fee-only, fiduciary & independent financial planner in Waltham, MA serving clients in Greater Boston, New England & throughout the country. Lyon Financial Planning provides advice-only comprehensive financial planning for a flat fee to help clients in all financial situations.
If you’re currently working, it’s likely that your employer offers some type of retirement savings plan, such as a 401k, 403b or 457. These plans provide a means to invest a portion of your earnings in a tax-advantaged retirement account, and often include some level of employer contributions. In what follows, I’ll refer to these plans generically as 401k plans.
With fewer employers now providing traditional pensions, much of the responsibility of saving for retirement has shifted from the employer to the employee. This means you’ll be taking on the important task of selecting investments in your 401k. In what follows, I guide you through this (often arduous) process by describing how your 401k works, and providing straightforward recommendations for how to best invest in and manage your account over time.
Your 401k is an investment account with certain perks and restrictions
Within your 401k Plan is a tax-advantaged Account where you select among a menu of Funds in which to invest the assets and future contributions in your plan (see figure below).
The investment account within your plan is typically held by a brokerage firm which acts as a custodian of your money. Rather than lending out your money and paying you interest like a bank, the brokerage firm provides you with various investment options, including mutual funds or exchange-traded funds. Such funds are collections of tradable stocks or bonds that fluctuate in price based on market conditions. Depending on the type of funds you select, you can expect to earn interest and/or capital gains within the account.
Your 401k account comes with certain tax-benefits, including the ability to make pre-tax contributions via payroll that grow tax-deferred within the account. This means you won’t owe taxes on your contributions or earnings until you withdraw the funds in retirement. (Some plans allow for Roth contributions, which involve making after-tax contributions that grow tax-free.)
How to invest your 401k
Your 401k account likely has several investment options, including various bond and stock mutual funds or exchange-traded funds. Before selecting specific funds, you’ll first need to consider your tolerance and capacity for risk. This will guide you in selecting an overall asset-allocation (i.e., the percentage of stocks and bonds in your account) that you can both tolerate emotionally and afford financially.
Once you’ve identified how much stock to hold in your 401k account, you’re ready to select specific funds. The fundamentals of investing remind us that markets are incredibly efficient and no individual investor has an edge. Data confirms that actively managed funds consistently underperform their respective index benchmarks, after fees. This means the best bet you can make is to buy passively managed index funds that capture broad market returns at lowest cost.
With this in mind, the following steps will help you select the most broadly diversified and low-cost stock and bond funds among your 401k investment options. (Note that historical fund performance is NOT a selection criterion!)
1. Eliminate all actively managed funds
2. Eliminate all funds with expense ratios over 0.30% [1]
3. For the stock portion, select broadly diversified funds [2] to recreate the total world stock market index [3]
4. For the bond portion, select broadly diversified funds to recreate the total US bond market index [4]
How to manage your 401k
Now that you’ve selected specific funds in your account, you’ll need to implement the trades and update your future contributions. This may require selling everything in your account and then buying the newly selected funds. Because the account is tax-advantaged, making such trades is tax-free.
Next, automate your 401k contributions via payroll. In most cases, you’ll want to contribute at least the minimum to get your employer match. If your plan offers no employer match and only expensive actively managed funds, consider contributing to your IRA and brokerage accounts first.
Lastly, as with your other investment accounts, you’ll want to revisit and rebalance your 401k infrequently or when your financial situation changes. This involves keeping your overall asset-allocation in-line with your target, so you can maintain an appropriate amount of risk.
Employ Sophisticated, Simple and Low-Cost Investments
With the decline of traditional pension plans, much of the responsibility of saving for retirement is now on the employee. This makes the work of managing your retirement savings plan a critical task for securing your financial future. To do so, educate yourself about your plan and employ straightforward criteria to select low-cost and broadly diversified investments. With a bit of effort, you’ll be able to construct a sophisticated, yet simple and inexpensive, portfolio you’ll be happy with for years to come.
Footnotes
[1] The expense ratio is the annual management fee charged by the fund as a percentage of assets invested. For example, 0.30% means you’ll pay $30 a year for every $10,000 invested.
[2] Generally speaking, to select broadly diversified funds, look for those with names that include index, total, global, US, international, etc., and avoid those with names that include value, blend, growth, small, medium, large, etc. If needed, use Morningstar to identify a fund’s index benchmark and asset class.
[3] For example, put about 60% of your stock holdings in a Total US Stock Index Fund and 40% in a Total International Stock Index Fund. Investing in stock markets outside the US provides important diversification benefits. Here are examples of how to recreate the Total US Stock Index and Total International Stock Index using multiple funds.
[4] For example, put 100% of your bond holdings in a Total US Bond Index Fund.