Best Funds for 401(k) Plans
These Are the Best Types of Mutual Funds for 401(k) Plans
Whether you are an employer that is looking for the best funds to offer in your 401(k) plan or you are an employee participating in a 401(k) plan, there are only a handful of basic fund types that are ideal within this type of retirement savings vehicle.
Best Mutual Funds For 401(k) Plans From the Employer's Perspective
At the very minimum, employers are required to offer at least three basic types of options to 401(k) participants: A stock investment option, a bond option, and a cash or stable value option.
But there are very few employers that offer just the basics. Most 401(k) plans offer several different investment options, most commonly mutual funds.
When an employer begins the selection process for investment choices in a 401(k) plan, they need to put on their fiduciary hat. A fiduciary, put simply, is a person that has a legal responsibility to act in a way that puts the interest of others ahead of their own. Therefore it is wise to provide several mutual funds from diverse categories.
Here is an example of funds types to include in a 401(k) plan, along with a brief explanation:
- S&P 500 Index Fund: A low-cost index fund that invests in large-cap stocks is a good "core holding" with which to build a portfolio. Keep in mind that there is no need to add other large-cap stock funds, otherwise you enable the 401(k) participants to invest in multiple mutual funds with similar objectives, which is called fund overlap. Investing in similar funds is not good diversification!
- Foreign Stock Fund: There is no need for more than one good foreign stock fund. Keep in mind that "world stock funds" or "global stock funds" can invest in U.S. stocks. But true foreign stock funds will invest at least 80% of the fund's assets in stocks of companies outside the U.S. World stock and global stock can have more than a third of assets in the U.S. Again, this can lead to overlap. Stick with foreign stock!
- Small-Cap Stock Fund: If you want to offer (or invest in) an aggressive stock fund option, a good choice that can compliment an S&P 500 index fund is a small-cap stock fund. Small-cap stocks have historically produced higher long-term returns than large-cap stocks. But part of their attraction in 401(k) plans is that they don't have a high correlation to the S&P 500 index, which means they can add diversification to a portfolio.
- Total Bond Market Index Fund: You only need one good bond fund and a total bond market index fund will provide diversified exposure to the entire bond market.
- Money Market Funds: Cash can be a part of a diversified portfolio. And some 401(k) participants want to take advantage of the employer match but are terrified to invest in stocks or bonds. Therefore a money market fund or a stable value fund is a must in a 401(k) plan.
- Target Date Retirement Funds: In recent years, target date retirement funds have become staples of 401(k) plans. As the name implies, these funds enable investors to choose a target date (calendar year) that is nearest their desired retirement date and allocate 100% of their 401(k) dollars to it. For example, if a 401(k) participant expected to retire around the year 2035, they could allocate 100% of their 401(k) contributions to a target date retirement 2035 fund and not worry about any further portfolio management. These funds can also make for good "default" funds for 401(k) participants that do not want to select their own investment options. To provide a range of target dates, and depending upon the age demographics of the employees, most 401(k) plans should offer a range of target retirement dates from 2020 through 2050 and the decades in between.
Worst Funds for 401(k) Plans
Sometimes the best choices are avoiding the worst choices. As a fiduciary, employers are wise to avoid placing funds in a 401(k) plan that can have big declines in price during a short period of time.
And if you are the employee and your 401(k) plan includes some of these options, proceed with caution!
- Emerging Markets: These are the riskiest of foreign stocks. They can have big short-term gains but they can also have big short-term losses. Stick with the foreign stock fund! But if you invest in an emerging markets fund, be sure you compliment it with a regular foreign stock fund and keep your total foreign exposure to 20% or less.
- Sector Funds: Although sector funds can be used wisely in a diversified portfolio, they are not always good choices for 401(k) plans. From the employer/fiduciary perspective, adding a sector fund to a 401(k) plan can be a poor fiduciary decision. What if your 401(k) plan offered a technology sector fund that just had a huge year with a return of 50%, blowing away all other investment types. A 401(k) participant then decides to invest 100% of their life savings in the tech sector fund. The next year, the year before they were expecting to retire, the tech sector falls by 50%, and so does the participant's account value. Need we say more?
- High Yield (Junk) Bond Funds: This category of mutual funds is similar to other high risk fund types. High-yield funds, also known as junk bond funds, can perform well when economic conditions are good. But these funds can also have periods of extreme declines, much like an aggressive stock fund. From an employer/fiduciary perspective, you don't want to offer a high-yield bond fund to 401(k) participants because most of the perceive bond funds to be relatively "safe." In a bad year, high-yield bond funds can decline in value by as much as 30%, whereas a total bond index fund might decline by 5% or 10% at worst.
To summarize, the goal for employers and employees alike is to do a good job of diversifying assets for retirement savings. Remember that the returns of a particular mutual fund are less important than its diversification qualities.
For more on smart diversification ideas, see our article on How to Build a Portfolio of Mutual Funds.
Disclaimer:The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.