One Approach to Selecting 401k Investments if There’s No Target Date Fund on Offer
Hi Friendos,
Deadly heat, poisoned air, flash floods…but here I am, with another installment of 401k summer school. I know it probably wasn’t top of mind. But…if you are not yet of retirement age, wait. Odds are you’ll get there and you’ll need money to live. Social Security will be around, but won’t be enough to pay for all you need. Ordinary poverty is a deadly threat, often more deadly that today’s flashy headlines. Retirement savings are very, very important.
Last week I talked about how you can select a target date fund as your only 401k (or 403b) investment and be extremely well diversified. This week is about selecting low cost, well-diversified investments when your employer’s plan does not offer target date funds.
There are many reasonable ways to approach this task. In short, I recommend starting with the lowest cost funds and picking 1 fund for each segment of your chosen asset allocation, such asone fund for U.S. stocks, one for international stocks, and one for bonds. After that, your work is done. You don’t need to research every fund in the menu of options.
Here’s my two-step approach in more detail:
Step One: Decide on an asset allocation.
Aim at something appropriate to your age, number of years to retirement, and ability to withstand market ups and downs. Maybe that’s 75% stocks, 25% bonds. Maybe it’s 60%/40%. Maybe it’s 40%/60%. It’s not magic. There is usually a reasonable range of what is suitable for a given person, and your financial success does not require great precision in picking your allocation, just that you pick something reasonable.
If you can’t decide or don’t want to think about it, just look up the allocation of a target date fund of your approximate retirement year and copy what it does. Example: you are 30 years old today and want to retire at age 65, in the year 2061. Fidelity offers the Freedom Index 2060 Fund and it currently has an allocation of 56% U.S. equities, 38% international equities, and 6% bonds. That’s an overall split between stocks and bonds of 94%/6%. Great, that’s your asset allocation. Don’t like Fidelity? Ok, do what Vanguard does in its Target Retirement 2060 Fund (54% U.S. equities, 37% international equities, 6% U.S. bonds, 3% international bonds; an overall stocks/bonds split of 91%/9%).
How critical is the difference between a stock allocation (aka, equity allocation) of 94% vs one of 91%? Not very. An important article on this topic by the excellent Wade Pfau explored the question of “what is the optimal asset allocation during retirement?” and found that for any given probability of a retiree totally spending down their portfolio, a “wide range of asset allocations tend to provide very similar results” in terms of how much a retiree could spend down their portfolio each year. Getting at this in a different way, here’s a chart comparing returns for the last few years of the Fidelity and Vanguard 2060 target date funds I mentioned above:
Pretty similar if you ask me.
Let’s say you decide to go with 90% stocks, 10% bonds. Within stocks, you want some U.S. and some international, so overall you decide on:
- 55% U.S. stocks,
- 35% international stocks,
- 10% bonds.
Step Two: Identify specific investments to implement that asset allocation. If you were me back in 2012, here are the 401k investments you could pick from (from a new employee mailing I got from my employer at the time):
Wow, 21 options to pick from and they’re grouped in categories like “Growth & Income” that mean nothing except to finance nerds but I’m a finance nerd and had never heard the phrase “Portfolio Fund” before I saw this mailing.
You decided on a portfolio that is 55% U.S. stocks, 35% international stocks, and 10% bonds, so maybe we can start by seeing if there’s a fund like that on the list? I can tell that the first fund listed (the “Stable Value” fund) is like a money market fund (no stocks inside that one), the next 3 are 100% bonds (the “Income” funds), all 7 of the “Growth” funds are 100% stocks, one of the “Growth & Income” funds is 100% real estate, and now I’m wondering if I have to research all 21 funds and I’ve lost the will to live. Time to pause and regroup.
Start by investigating the funds with the lowest fees. In my 401k mailing, there’s a table with fee information:
Across the whole list, we have two funds that only charge 0.08% a year, the BlackRock Equity Index Fund and the Vanguard Mid-Cap Index Fund. Looking at literature for the BlackRock fund (which should be available on your 401k website) I see: “The fund is intended for long-term investors seeking to capture the earning potential of large U.S. companies. The fund invests in the same stocks held in the Standard & Poor’s Index.” The S&P 500 has returns that are very similar to those of the entire U.S. stock market. This is a good fund for our 55% allocation to U.S. stocks.
Now we need a place to put our 35% international stock allocation and our 10% bond allocation. There are three international offerings and two of them have fees over 1% — no way. So, how about the Vanguard Developed Markets Index Fund, which costs only 0.20% a year? “This index fund provides investors low-cost, diversified exposure to large-, mid-, and small-capitalization companies in developed markets outside of the United States. …Long-term investors may wish to consider this fund as a complement to a well-balanced domestic equity portfolio.” This is the place for our 35% international stock allocation.
Scanning the list again, the second-lowest fee offering is the Vanguard Total Bond Market Index Fund, coming in at only 0.10% per year. This fund is described as: “seek[ing] to track the investment performance of the Bloomberg U.S. Aggregate Float Adjusted Index, an unmanaged benchmark representing the broad, investment-grade U.S. bond market.” A low-cost index fund that will track the U.S. bond market, perfect. This is our bond fund and our work is done.
You will log on to your 401k website and select where you want your contributions to go (the amount that comes out of each paycheck):
- 55% of it goes into the BlackRock Equity Index Fund
- 35% into the Vanguard Developed Markets Index Fund
- 10% into the Vanguard Total Bond Market Index Fund
And if your employer matches your contributions, have that money go into those same 3 funds in the same proportions.
By starting our research with the lowest fee funds, we quickly identified index funds that were an appropriate match for our chosen asset allocation: one for U.S. stocks, one for international stocks, and one for bonds. And we didn’t need to research anywhere near all 21 of the funds offered in the 401k menu of investment options.
If your 401k or 403b offers a target date fund, I really do encourage you to use that option. If you don’t have a target date fund available, you’ll need to do a little research to select funds on your own.
-Stephanie
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