How to Make the Best of a Bad 401(k)

Investing in a 401(k) plan at work can be a lot like eating at a cheap buffet. There are a lot of options, but they’re all bad. For those trying hard to keep investing costs down and to invest with a solid asset allocation plan, having bad options in a 401(k) or 403(b) is like finding a long strand of hair in your soup.

A listener of the Dough Roller Money Podcast recently emailed me about some obstacles they were encountering with their workplace retirement plan:

My name is Rasiel, I have been following your “31-Day Money Challenge” podcast series and it has been like drinking from the firehose. Thank you for such a good job.
I just changed jobs and I’m not sure my new 401k is good enough. I was hopping it had a few stock and bond low-cost index funds I can use to easily and cost effectively setup my portfolio but I’m having a hard time finding a good balance.

My current company has its 401k with Fidelity NetBenefits. (I have attached the options in the plan, as well as the portfolio I have been working on).
My first thought -in order to make it simple- was to pick a Target-Date fund (I expect to work another 30 years, so FFFIX seemed like a good alternative)
The only problem with FFFIX is that its expense ratio is 0.78% and this 401k also has a 0.50% Administrative Fee associated with it, so I have spent a good time researching and trying to come up with a portfolio with a smaller Weighted Avg. Expense Ratio.
I’m 35, I’m a Software Engineer and I love what I do. I expect to retire around 65-70 so I’m ok being aggressive and I understand the risk associated with it.

My questions:

  1. I have came up with a 80/20 portfolio with the options I have in my plan. I reduced the expense ratio from 0.78 to aprox 0.55. I’m not sure though about the bond part of the portfolio. 15% is in short-term bond (which bogle heads favor) and 5% World Bonds. I would feel better with some mid-term bonds, but there is none in the plan. Should I be worried? If so, should I revert back to the Target-Date?
  2. I can go 85/15 by moving 5% from the bonds to REITs (my plan has this option Fidelity Advisor Real Estate I Report (FHEIX) | Asset Allocation Summary) _however_ there is no international REITs in my plan, just US. Would this be a problem?
  3. I’m rolling my old 401k over to Vanguard. In the case neither the Target-Date or the one I have came up with are good enough, should I consider using only the funds that are cost-effective in my plan, and balance with the IRA in Vanguard?

Thank you for all the valuable information you have put together.

Rasiel’s email raises an interesting question about 401(k) plans.  If the plan you have at work doesn’t offer any good investment options, or only offers one or two decent choices, what should you do? In this article we’ll cover 4 options you have to make the best of a bad 401(k). (In the podcast of this article, I also address the three specific asset allocation questions raised in the email.)

Evaluating Your 401(k) Investment Options

The first step is to evaluate the investment choices that are available in your 401(k).  For each mutual fund, you’ll want to determine the following:

1.  Asset Class:  You’ll first want to determine what asset class each investment covers. This can be trickier than it may seem. The three primary asset classes are U.S. stocks, international stocks, and U.S. bonds. That’s simple enough.

Yet within each of these broad asset classes are many sub-asset classes.  For example, a small cap U.S. stock fund invests in just small public companies in the U.S., not the entire universe of U.S. companies.  In contrast, a total stock market fund or even an S&P 500 index fund has far more coverage of the U.S. market.

Think of it like a set of Russian dolls.  A total stock market index fund is the largest doll. Lift it up and you’ll next find an S&P 500 index fund. Lift up that doll and you’ll find smaller dolls that cover less of the U.S. market, like mid-cap, small-cap and other niche funds.

The point is to understand what each fund covers.  The goal is to design a portfolio that covers each of the three broad asset classes mentioned above. A small cap fund by itself doesn’t accomplish this goal in terms of U.S. stocks. A total stock market fund or even an S&P 500 index fund does. In other words, look for the bigger dolls.

(For you investing ninjas, yes you can construct a portfolio with small cap, mid-cap and large-cap funds.  You can even add in value and growth funds, REITs, commodities, and the like. In other words, you can ditch the big doll and replace it with a bunch of smaller dolls that add up to a big doll.  I found, however, that a simple portfolio is better.)

2.  Expense Ratio: The cost of investments is a critical factor in selecting mutual funds.  As we’ve covered before, the cost of mutual funds can easily add up to tens of thousands of dollars or more over a lifetime of investing.  Thus, it’s critical to know how much each mutual fund costs.  The expense ratio will be available in the fund’s prospectus and the fund company’s website.  If you can’t find it, call the company that manages your 401(k) plan.

As a general rule, we want to find index funds that cost 25 basis points (100 basis points = 1%) or less.  As for actively managed funds, look for options that cost 1% or less.

3.  Target Date Options: Finally, take note of any target date retirement options you have and how much they cost.  Most 401(k) plans today offer these fund of funds, although they are not all created equal.  As Rasiel’s email noted, the Fidelity target date funds cost about 78 basis points.  While this is below average, Vanguard offers target date funds for much less.  Of course, Vanguard funds may not be an option for you.

With this data in hand, we can now turn to the four 401(k) investment strategies.

Four 401(k) Strategies

1. Sniper Approach: Find just one or two good investment options. This won’t allow you to cover all three major asset classes (U.S. stocks, international stocks, and U.S. bonds). In some cases you’ll only find investments for one of these asset classes. However, you then use investments in an IRA or taxable account to fill the holes.

For example, perhaps your 401(k) offers an excellent S&P 500 index fund that can cover U.S. stocks for your portfolio. You invest your 401(k) money in that index fund.  Then, in an IRA or taxable account you invest in funds that cover international stocks and U.S. bonds.

The advantage to this approach is clear. You invest only in good options within your 401(k). You ignore the bad options and let your other investments pick up the slack.

The sniper approach has a few downsides. First, you must have other investment accounts to round out your portfolio. If your 401(k) is your only investment, or you don’t have enough money in the other accounts, this approach won’t work.

Second, rebalancing across multiple accounts can feel like herding cats. As soon as you get one account squared away, you realize two others have peed all over the floor. This is where keeping an investment portfolio simple with as few funds as possible can make life a lot more pleasant.

2. The 3-Fund Approach: If you can find decent options for each of the three main asset classes, create a portfolio that doesn’t rely on outside investments. The key here is to find reasonable investment options, not necessarily the best investment options. For fans of index funds, this approach usually requires you to consider actively managed funds.

This is the approach I now take in my 401(k). Here’s my current portfolio:

  • 40% International Stocks–DODFX (Dodge and Cox International Stock Fund)
  • 40% U.S. Stocks–FXSIX (Fidelity Spartan 500 Index)
  • 20% Bonds–VBTLX (Vanguard Total Bond Market Index Fund)

Total Weighted Average Cost: 29 basis points

Note that DODFX is an actively managed fund that charges 64 basis points. I happen to think that it’s an excellent fund (which is temporarily closed to new investors), but it does cost more than I’d like to pay. Yet overall this is an excellent portfolio, in my opinion. In just three funds I cover the major asset classes at a low cost. Rebalancing is a snap as I don’t have to look to outside investments in my IRAs or taxable accounts.

3. Target Date Retirement Funds: Most 401(k)s offer target date retirement fund options. These fund of funds give you a well diversified portfolio in a single fund. It’s like buying a package vacation that includes airfare, hotel, and food all in one.

The key here is to examine the costs. As noted in the email above, Fidelity offers these funds for just under 80 basis points. While this cost is not ideal (Vanguard offers similar funds for less than 20 basis points), it’s a reasonable choice if the Sniper or 3-Fund approach is not workable given your investment options.

4. BrokerageLink: The final option is available in many 401(k) accounts managed by Fidelity. Through BrokerageLink, you can invest in many options that aren’t otherwise available in your 401(k). There are additional transaction fees associated with BrokerageLink. If your 401(k) does not offer other reasonable options, however, BrokerageLink may be your best choice.

Topics: InvestingPodcastRetirement Planning

6 Responses to “How to Make the Best of a Bad 401(k)”

  1. Rob, you may have seen it, but the WSJ had a great article this past weekend (Sat, Feb 21) I believe that discussed employees approaching their employer to inquire about better 401k choices. There was even a mention of a Boglehead form letter that employees could complete to request better choices. Hope this helps someone.

    Travis

  2. Rob — Really enjoy the podcast. Thanks. However, in this podcast and in several others you state that you think there is more scope for active managers to outperform passive index when it comes to international funds. Is your view just your conjecture or can you point to any empirical support (e.g., academic research). I know of no research documenting that finding. Simply put, the academic evidence is OVERWHELMING that active managers (on average) under perform no matter how you slice and dice the data.

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