Best Fund Selections for 401(k) Plans

These Are the Best Types of Mutual Funds for 401(k) Plans

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There are only a handful of basic fund types that are suitable and make the best selection of funds to hold in a 401(k). As an employer, you have a fiduciary responsibility to your employees to select the best funds to offer with your retirement plan. As an employee, you must also make the best decision to fund your future retirement needs.

401(k) plans are tax-advantaged contribution accounts offered by employers. Money is taxed before it is deposited into the account so that, in retirement, any withdrawals are tax-free. In most cases, the employer will match a portion of employee-made contributions.

Employer Selection of 401(k) Funds

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 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.

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. An S&P 500 Index is just such a core fund. This index fund is a market-capitalized and weighted basket of the 500 largest U.S. companies that trade publically. The index floats and will readjust periodically to match the underlying stock's market capitalization.

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

Foreign stock funds are also known as international funds. These funds invest in companies based on the particular focus of the fund's investment goals. They can be global or region-focused in the portfolio holdings. While these funds will usually offer higher returns, it comes at the cost of exposure to higher risks—including the risk from currency exchange rates.

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, so, carefully review the funds prospectus and portfolio of holdings before selecting.

Small-Cap Stock Fund

Small-cap funds hold publically traded companies that have a market capitalization of between $300 million and $2 billion. Small-cap funds offer aggressive growth but come with more volatility. If you want to offer (or invest in) an aggressive stock fund option, a good choice that can complement 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

Total bond funds are mutual funds or exchange-traded funds (ETFs) that hold bonds—or debt—across a wide range of maturities. The debt securities that these funds hold are usually corporate-level bonds but you will also see holdings of municipal bonds, high-grade mortgage-backed securities (MBS) as well as Treasury bonds.

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. There will be times when the 401(k) held funds will return cash to the plan. A money market fund provides a perfect holding place for this cash. Money market funds include very liquid holdings.

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

Target-date retirement funds have become staples of 401(k) plans. As the name implies, these funds allow investors to choose a target—calendar year—date that is nearest their desired retirement date. The employee then allocates 100% of their 401(k) dollars to the target-date fund.

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 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. Also, if you are the employee and your 401(k) plan includes some of these options, proceed with caution and make sure you fully review the option before choosing it as part of your investment plan.

Emerging Market Risks

Emerging markets funds are the riskiest foreign stocks and invest in companies based in countries that are emerging economies. These are nations that are moving into global markets and economies. While these funds are more stable than frontier market funds, they are less stable than developed market funds.

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 complement it with a regular foreign stock fund and keep your total foreign exposure to 20% or less.

Idiosyncratic Risks

Sector funds will pool all investments into one sector of the overall market. Since these investments have a narrow focus, they are more prone to sector-unique risks—called idiosyncratic risks. 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.

Default and Credit Risks

High yield junk bond funds hold lower investment-grade bonds or debt from corporations and other entities. This category of mutual funds is similar to other high-risk fund types. The underlying debt of companies held by the fund can expose the investor to default and credit risks. The low creditworthiness of the companies may expose them to bankruptcy and defaulting on their debt.

High-yield 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.

Bottom Line

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.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.