The castaways of your 401(k): index funds

  @Money September 6, 2013: 4:04 PM ET
index funds

Index funds are hard to find in some 401(k)s, but you needn't let high fees sink your retirement.

(Money Magazine)

After more than 30 years, the 401(k) has become our de facto national retirement savings plan. So how is it that most participants can't build a portfolio out of the best, cheapest investments around -- index funds?

In 2013 this should not be an issue. Decades of studies have shown that funds that simply track market benchmarks outperform actively managed funds over the long run because of the huge difference in fees -- a typical 401(k) stock index fund may charge 0.06% of assets, vs. 0.63% for the average fund run by a manager who picks equities.

Assuming a 7% annualized return before expenses over 25 years, that fee difference can mean a 9% bigger nest egg.

The unhappy status quo exists in part because regulators are loath to demand that specific investments be included in 401(k) plans. And in designing plans, employers rely on consultants and fund groups, which have an incentive to favor higher-cost offerings.

Today most 401(k)s offer a single index option that usually invests in large stocks like those in the S&P 500. Only 42% of plans with indexing include an intermediate bond fund, and just 31% have a foreign-stock fund, according to consultants Aon Hewitt.

Even at index king Vanguard, "only about four out of 10 plans we manage offer enough index funds to build a core portfolio," says Steve Utkus, head of Vanguard's center for retirement research.

Related: Pros and cons of using index funds

What can you do if your plan lacks index funds? Start by lobbying your employer -- new rules require 401(k)s to disclose fees, which may nudge your boss in the right direction. Meanwhile, here are three coping strategies:

Check out your plan's target date fund. Even if you lack enough standalone index options, your target-date fund, a mix of portfolios designed to grow conservative as you near retirement, may have them.

How 401(k) fees eat away at your savings

Vanguard's index target series has been pulling in the most cash, $20 billion in 2012, according to Morningstar. Now Fidelity, Wells Fargo, and BlackRock have all-index offerings that provide enough diversification for you to be able to use them as your core holding.

Opt for low-cost active funds. Otherwise, make the best of your options. Look for the cheapest fund in each market segment you want to invest in.

Related: Balance out a lopsided index fund

"Owning more actively managed funds within an asset class means you're more likely to lag your benchmark," says Portfolio Solutions adviser Rick Ferri, who has studied the benefits of indexing over active portfolios.

Index outside your 401(k). If you're stuck with high-cost stock funds charging near 2%, or bond funds charging half that, invest enough to get your employer's match. Then fund a Roth IRA or taxable account, buying stock index funds that generate little in capital gains. You'll end up with a larger nest egg, a goal your employer should want to share. To top of page

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