Sunday, December 20, 2009

The Ideal 401(k) Plan

This is just a quick post to share what I personally would look for in a 401(k) plan.  Since it's unlilkely you'll be able to influence your 401(k) plan once you're hired, the main point of this post is to help you evaluate potential employers' 401(k) plans as part of your job selection process.

Obviously, the most important thing is that the employer offers a 401(k) (or 403b, if it's a non-profit organization).  Assuming that, here's what to look for:
  • Some sort of employer match; i.e., your employer kicks in some money to match some percentage of your contributions.  The more the better.  Some employers offer a match, some don't.  If they do, it's basically additional salary, assuming you can afford to contribute to the 401(k).  You should definitely factor this into whatever salary you are offerred.
  • The broadest possible selection of low cost index mutual funds.
  • Being able to participate as soon as possible.  All other things being equal, give preference to the employer who allows you to start participating in the 401(k) plan immediately, rather than having to wait a year.
Unfortunately, many (perhaps most) 401(k) plans don't offer very good fund selections.  They are often filled with high cost, actively managed funds.  Hopefully you'll have at least one low cost, large blend index fund (e.g., a fund based on the S&P 500 index or a total stock market index).  If you're lucky, you'll also have a low cost international index fund and a low cost bond index fund (or index-like bond fund, as discussed in previous posts).  If you're super lucky, you'll have access to low cost small cap, small cap value, value and REIT index funds, and an international index fund that includes emerging markets (or a separate emerging markets index fund).

From what I've seen in the various plans offerred by employers of family and friends, it's highly unlikely that you'll have really good choices in your plan.  In this case, you'll have to make the best of what you've got.  I would look for the lowest cost funds that most closely track the index of the category they're in.  Doing that is beyond the scope of this post.  Especially if you're employer offers a matching contribution, then it's likely that you'll still come out ahead if you can find a somewhat decent fund that hasn't diverged too much from a similiar index fund over the last 5 years.

Many 401(k) plans offer some sort of lifecycle or target retirement fund, and this may be the default choice for your investments (although it may not be the best choice).  These funds invest more in stocks in the early years, and gradually shift toward more bonds in the later years.  For example, a 2040 target retirement fund might be 80% in stocks and 20% in bonds now, with a strategy of shifting a little more to bonds each year, and being 50% stocks and 50% bonds by the year 2040.  Unfortunately, the strategies and expenses of these funds vary widely, so depending on your other choices, a target retirement fund may or may not be your best option.  I personally wouldn't use one, unless the other options really sucked, because I'd rather determine my own asset allocation than depend on the target retirement fund to do it for me, and you often can achieve something similar at lower cost.  However, for someone who doesn't want to learn anything about investing, and doesn't have anyone to help them, a target retirement fund may be a reasonable choice.

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