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 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 will be tax-free. Often, the employer will match a portion of employee-made contributions.
- Employers are required to offer at least three types of options to 401(k) participants: a stock investment, a bond option, and a cash or stable value.
- Most 401(k) plans offer several different investment options, most commonly mutual funds.
- The goal for employers and employees is to diversify assets.
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 a cash or stable value option. However, very few employers offer just the basics. Most 401(k) plans offer several 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 who has a legal responsibility to act in a way that puts the interests 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. It is a market-capitalized and weighted basket of the 500 largest U.S. companies that trade publicly. 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 regional in the portfolio holdings. While these funds will usually offer higher returns, they come 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. True foreign stock funds will invest at least 80% of their assets in stocks of companies outside the U.S. market. World stock and global stock funds can have more than one-third of their assets in the U.S. This investment mix can lead to overlap, so carefully review the fund's prospectus and portfolio of holdings before selecting.
Small-Cap Stock Fund
Small-cap funds hold publicly traded companies that have a market capitalization between $300 million and $2 billion. These funds offer aggressive growth but come with more volatility. If you want to offer—or invest in—an aggressive stock fund option, one 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 in recent years, 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), and 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 funds in a 401(k) would return cash to the plan. A money market fund provides a perfect holding place for this cash.
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—timing 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 who do not want to select their investment options.
To provide a range of target dates—and depending upon the employees' age demographics—most 401(k) plans should offer a range of target retirement dates through 2050 and the decades between.
Worst Funds for 401(k) Plans
Sometimes the best choice is to avoid 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.
These funds 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.
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 may then decide 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 could fall by 50%, and so would 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 they may default on their debt.
High-yield funds can perform well when economic conditions are good. However, these funds can also have periods of extreme declines, much like aggressive stock funds.
From an employer/fiduciary perspective, you don't want to offer a high-yield bond fund to 401(k) participants because most of them perceive bond funds to be relatively "safe." In a bad year, high-yield bond funds might decline in value by as much as 30%, whereas a total bond index fund would potentially decline by 5% or 10% at worst.
The Bottom Line
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 or 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.