How to select investments for your 401(k)

The average Social Security benefit for the retired individual collecting social security is $1,907/month (just over $45,000 per year before tax). And that’s not accounting for any of the potential adjustments that may need to be made to the Social Security system to ensure that the program can still pay out benefits to future Americans.

Needless today, saving outside of just the Social Security system is paramount.

According to the Bureau of Labor Statistics, approximately 73% of Americans have access to a work retirement plan while only 56% of employees actually enroll in the plans that their eligible for.

Taking advantage of a work retirement plan can be the difference in having a successful retirement or not.

Now, for most individuals reading this, it’s likely that you’re enrolled in your companies retirement plan and are contributing enough to the plan to receive any employer match that your employer offers (and if you’re not, stop reading this and go make the necessary changes to your plan to do so. Don’t leave free money on the table).

For simplicities sake, let’s say you’re enrolled in your work retirement plan and are making contributions into the plan.

How do you go about selecting the investments that your contributions are invested in?

• Do you choose a little bit of everything?

• Do you ask your friends/family/co-workers?

• Do you just go with whatever the default is?

In today’s post, we’re going to tackle this question.

401(k) Investment Options

Work retirement plans are different than Individual Retirement Plans in terms of the investment options you can choose from. In an IRA account, you can choose from virtually any investment that's eligible to be held inside a qualified retirement plan. A work retirement account generally has a list of investment options (in the ballpark of 15-30 choices) that you can use inside your account.

Usually, you’re not able to choose investments outside the list unless you rollover your funds into another employer 401(k) or IRA. 

That’s not necessarily a bad thing. 

In my mind, it actually makes the management process slightly easier for individuals who are managing their retirement plans by themselves.

You’re retirement investment selection is going to look something like this:

As you can see, there are all sorts of different investments to choose from. Equity funds, bond funds, target allocation funds, etc.

Some companies will also offer the option to invest in company stock within the plan, but this only really applies if you’re working at a company that’s publicly traded.

When determining your asset allocation, you need to first determine what your risk tolerance and goals are. If you’re someone approaching retirement, you may want to have a higher allocation to bonds vs. equities and vice versa if you’re younger. The equity and bond funds that your employers make available typically all have different investment objectives, although there may be some overlap.

Generally, if you were to build out an investment allocation on your own, you’re going to want to diversify your exposure to the varying asset classes available in the plan. For example, if you’re young and willing to take some calculated risk, your allocation may look something like this:

• U.S. Large-Cap Equities – 55%

• U.S. Mid-Cap Equities – 10%

• U.S. Small-Cap Equities – 10%

• International Equities 20%

• Emerging Market Equities – 5%

If you’re approaching retirement and know you may start withdrawing funds from the account soon, you’re likely going to want to incorporate some fixed income with varying duration to your portfolio while dialing down your equity exposure.

Every retirement plan I’ve ever seen also make target date funds (sometimes called lifecycle funds) available for you to choose from. 

These funds are great for the "set it and forget it" crowd. You choose the fund that closest aligns with the date you want to retire and allocate your funds to that portfolio. 

For example, let’s say you want to retire in 2040 and have the Vanguard 2040 Target Date Fund available in your plan options.

The Vanguard 2040 fund has approximately:

• 47% allocated to the Vanguard Total Stock Market

• 30% to the Vanguard Total International Stock Index

• 15% to the Vanguard Total Bond Market Index

• 7% allocated to the Vanguard Total International Bond Index

As you can see, this fund is already pre-diversified so you don’t need to add additional funds to your plan if you don’t want to. In fact, sometimes adding funds in additional to a target date fund can complicate the process and make your portfolio more aggressive/conservative than you would otherwise want.

That being said, target date funds are a great place to begin.

Factors to consider if you’re updating your allocation

When selecting funds for your portfolio you want to make sure you’re paying attention to a few things.

1) If you’re buying a specific fund, what’s the purpose?

Is it to provide growth, stability, income, etc.? Understanding why you hold certain positions can go a long way in helping you in the long-run especially when, inevitably, markets go down.

2) Look for funds that have low expenses.

Not all funds are created equal. They each have an investment fee associated with investing in them. Generally, you want to look at funds with low expense ratios. This is something that you can easily Google or ask your retirement plan administrator for. 

If you’re going to hold more actively managed investment funds (which typically have higher fees associated with them), understand why you’re buying the position and if they’ve had a track record of outperforming the general investment market they’re tracking. Past performance isn’t indicative of future results, but it can give you a flavor of what to expect.

3) Mechanics of updating investments.

In most cases, you should be able to update your investments online when you want to, although some employers only let you adjust your allocation periodically (e.g. quarterly). 

Generally, the process of updating your investments will be a 2-step process. 

1. First, you’ll want to update your current balance to reflect the new allocation you choose. 

2. Second, you’ll want to update your ongoing payroll contributions to reflect the new allocation as well.

This part is super important to make sure your allocation is aligned with your goals. I often times see individuals only update one or the other and it throws of the allocation of the overall portfolio.

Wrap-Up

Work retirement plans can be overwhelming, especially if this kind of stuff isn't your ‘cup of tea’. Keeping things simple is typically the best approach. If you’re wanting to build your own allocation outside the pre-diversified Target Date Funds, make sure that you’re buying positions that align with your goals and risk tolerance.

If you’re worried about “messing things up”, that’s typically when it’s time to look for professional help. Regardless of whether you get professional help or take the DIY approach, it’s important to understand the funds you’re invested in. It can go a long way in helping you control your emotions when markets go haywire. 

About The Author

Caleb Pepperday, CFP®, ChFC® provides Fee-Only Financial Planning and Investment Management Services for medical professionals. Advanced Practice Planning, LLC is based in Missoula, MT, but works with clients in a virtual capacity nationwide.

As a CERTIFIED FINANCIAL PLANNER™ and fiduciary, Caleb Pepperday works to create financial plans for medical professionals with their best interest in mind. As a Fee-Only financial planner, Caleb Pepperday is only compensated through the investment management or financial planning fees that you pay him directly and never earns a commission.

Caleb Pepperday primarily focuses on helping mid-career and pre-retiree Physician Assistants/Physician Associates retire with confidence.

Disclosures:

The information provided in this article is for educational purposes only and is not intended as financial, legal, or tax advice. No content within should be construed as such. The material presented is based on general financial principles and concepts, and individual financial and tax situations may vary. Readers are strongly encouraged to consult with a qualified financial advisor, tax professional, or legal expert for personalized advice regarding their specific financial, tax, or legal circumstances. Any actions taken based on the information in this article are at the reader’s own discretion and risk. The author and publisher make no representations or warranties regarding the accuracy, applicability, or completeness of the information provided. This article does not endorse or promote any specific financial products, services, or companies. Readers are responsible for conducting their own research and due diligence before making any financial, legal, or tax-related decisions.