If you have a white-collar job, there's a good chance your employer offers you a 401(k) retirement plan. Participating is usually a good idea — especially if your employer offers to match your contributions.
But there's also a good chance you're getting ripped off. The most expensive mutual funds charge more than 20 times as much as the most affordable ones. And the evidence suggests that they're not worth the money. In fact, choosing an expensive plan can cost you tens of thousands of dollars in lost earnings over the course of your career.
So here's what you should do to avoid getting ripped off by mutual fund companies:
- Put money into a 401(k), especially if there's an employer match
- For most investors, choosing a "target retirement" fund from Vanguard or State Street is a good idea. If those are not available, Fidelity's Spartan funds are another good choice.
- If your employer doesn't offer any low-cost mutual funds and doesn't match your contributions, consider an individual retirement account (IRA) as an alternative.
Read on for details about how to get the most out of your retirement savings.
Trying to beat the market is a bad strategy
A lot of people on Wall Street make a lot of money by convincing ordinary investors that they can provide better-than-average returns. But the reality is that beating the market is really difficult. Most people who promise to do it don't deliver.
Some mutual funds spend a lot of money doing market research to decide which stocks to invest in. In the 1960s, academic researchers started studying whether these funds produced higher returns for their investors. Surprisingly, the answer was no: the average returns for these "actively managed" funds wasn't much better than you'd get by choosing stocks with a dart board.
This research led to the rise of a new type of mutual fund known as an index fund. Rather than trying to beat the market, these passively-managed funds simply buy every stock in an index such as the S&P 500. Index funds allow investors earn the average market return. And because they don't have to hire a bunch of people to do research, they're very cheap to run. As a result, their returns after expenses tend to be higher than those of actively managed funds. A half-century later, studies are still finding that passively managed funds consistently overperform actively managed ones, once expenses are taken into account.
So when choosing mutual funds, don't worry about which funds have earned the best returns in the past. Those funds probably just got lucky, and past performance is no guarantee of future results. Every mutual fund publishes an "expense ratio," which is the percentage of your investment that will get eaten up by management expenses each year. Whenever you have a choice between two similar funds, you should pick the one with lower expenses.
The best option is a low-cost target retirement fund
Which fund should you buy? The best option for a novice investor is a "target retirement" fund — but only if it has reasonable expenses.
A good example is Vanguard's Target Retirement funds. You pick the year you want to retire (for example, if you're in your late 20s you'd pick the Target Retirement 2050 plan), and Vanguard automatically allocates your savings to a mix of stocks and bonds that's appropriate for your expected retirement date. It has a modest 0.18 percent expense ratio, meaning that consumers pay just $18 for every $10,000 invested. (Disclosure: I have most of my retirement savings in Vanguard mutual funds, and because Vanguard is structured as a cooperative, that technically makes me a Vanguard shareholder.)
Last year, State Street Bank began offering low-cost target retirement plans too. With an expense ratio of 0.17 percent — slightly cheaper than Vanguard's — these are another great option.
But other mutual fund companies' target retirement funds are a lot more expensive. For example, Fidelity's Freedom 2050 fund and T. Rowe Price's Retirement 2050 funds have expense ratios of 0.78 percent and 0.76 percent, respectively. If you invest $10,000 in these funds, you'll lose $70 every year (and more as your money grows). That's a terrible deal.
How to build your own portfolio
Most investment advisors recommend investing your retirement savings into three types of assets: domestic stocks, international stocks, and bonds. Target retirement accounts do this for you automatically based on your desired retirement date. But if your employer's 401(k) plan doesn't offer you an affordable Target Retirement plan — one that charges 0.20 percent or less — then you might need to do it yourself. This chart can help.
For each of these three categories, you'll want to choose the broadest fund with the lowest expense ratio. For example, Fidelity's Spartan Total Market fund, with an expense ratio as low as 0.05 percent, is a good choice for domestic stocks. It invests in more than 3,000 US stocks. Fidelity also has a Spartan International fund (0.12 percent expense ratio) for international stocks and a Spartan U.S. Bond fund (0.10 percent expense ratio) for bonds.
Unfortunately, many mutual fund companies don't offer low-cost index funds. And mutual fund companies seem to make this process as confusing as possible. In the chart above, I've listed the most affordable funds I could find from each company (the last column is the average cost assuming you invest 60 percent in stocks and 20 percent in the other categories). However, many mutual funds are offered in several different "classes" with wildly different fees.
Take JP Morgan, for example. I've listed the company's Equity Index Fund as having a respectable 0.20 percent expense ratio based on the fund's "select" share class. However, JP Morgan also offers another version of the exact same fund, called "Class B," with an insane 1.2 percent expense ratio, 24 times the cost of Vanguard and Fidelity's funds. So if your employer is offering JP Morgan mutual funds, it's important to read the fine print. The "select" version of the fund is a pretty good deal. Other versions are not.
What to do if your employer doesn't offer any good options
It's possible your employer's 401(k) plan won't offer any low-cost funds. In that case, you have a few options:
Skip your employer's 401 and invest in an individual retirement account instead. IRAs offer most of the same tax benefits as a 401(k), but are not tied to an employer. That means you, not your employer, choose which mutual funds company to use. You can sign up for a Vanguard IRA here or a State Street IRA here.
There are two big downsides to this strategy: first, you miss out on any matching contributions your employer might offer, and these will usually be worth more than the extra fees you have to pay.
Second, the contribution limits are lower for IRAs: currently $5,500 for an IRA versus $18,000 for a 401(k). So if you earn an above-average income, you will probably want to save more than the IRA limit. Still, you can max out your IRA first and then invest any remaining amount in your 401(k).
You can roll your 401(k) contributions into an IRA when you leave your job. High fees add up over the course of a career, but they're not necessarily a big deal if you're only paying them for a year or two. Once you leave your job, you'll be able to transfer the money to an IRA managed by a lower-cost fund.
Lobby your HR department to switch to lower-cost options. Your HR department may not realize how many thousands of dollars of employee savings are being wasted by mutual funds that charge too much. While switching retirement plans isn't trivial, it can be done, and your coworkers might thank you for it. Right now, Vanguard offers the broadest range of low-cost funds, but Fidelity and State Street also offer good options.