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As more and more companies move away from offering traditional defined-benefit pensions to their workers, employee-directed plans like the 401(k) have become increasingly common. Since employees are responsible for deciding how their money is invested in these plans, they bear all the risks of good or bad investment decisions.
Unfortunately, many plans offer only high-cost fund options that can put investors even further behind in the game. But now there is another choice in retirement plans hitting the market that seeks to lower costs and allow workers to keep more of their own money.
Tracking the market
Charles Schwab (NYSE: SCHW ) recently launched a new 401(k) product named Schwab Index Advantage, which consists entirely of lower-cost index mutual funds. According to Schwab, there will be no actively managed funds, target-date funds, or money-market funds in the new product, just low-priced index funds -- a different look than most investors are used to.
This plan will also come with the option of getting investment advice from investment advisory firm GuidedChoice, which would run employees roughly 0.65% to 0.70% in expenses a year. Plan participants can also opt out of the "get advice" option, in which case expenses will run them 0.20% to 0.25%.
In general, I think the concept Schwab is putting forth is a sound one. Although I'm a big proponent of actively managed funds, the fact remains that it's extremely difficult for retirement-plan sponsors to identify those few, rare funds that can beat the market consistently over time. And given that the average investor in a mid-sized retirement plan featuring actively managed funds is faced with average expenses of roughly 0.86%, lowering that bar by relying on index funds should help investors reach their retirement goals that much sooner.
The bigger picture
Of course, even if your employer doesn't offer index funds in its retirement plan, you can still make these investment vehicles a primary part of your investment plan, by opening either a separate IRA or taxable account. When it comes to passive investments like index funds and exchange-traded funds, you should keep two things in mind -- cost and diversification.
Since you're not paying for a manager's expertise in trying to beat the market, you want to aim for the cheapest fund that will get the job done. You should also stick to well-diversified funds that invest in broad sections of the market, rather than ones that track tiny segments, such as semiconductors or Japanese consumer stocks.
For example, one of my favorite index funds is the Vanguard Total Stock Market Index (VTSMX), which invests in a wide array of large-, mid-, and small-cap domestic stocks. If you're an ETF-lover, you may want to opt for the ETF version of this fund, Vanguard Total Stock Market ETF (NYSE: VTI ) . Likewise, for foreign coverage, investors may want to consider the Vanguard Total International Stock Index (VGTSX) or Vanguard Total International Stock ETF (NYSE: VXUS ) , both of which offer exposure to a full range of foreign countries, both developed and emerging.
Fixed-income investors should find a lot to like with an index fund like Vanguard Total Bond Market Index (VBMFX) or exchange-traded fund Vanguard Total Bond Market ETF (NYSE: BND ) , which track a broad bond benchmark including government, corporate, and mortgage bonds. Prices on these funds range from 0.07% to 0.26%, so more of your money goes where you want it -- back into your account -- and not the fund company's coffers.
Putting it all together
Of course, when investing with index funds, getting your asset allocation right is more important than ever. Since manager skill is not at play here, you need to ensure that you've got exposure to all the necessary asset classes to fuel your portfolio's long-term growth. Here's a very basic idea of how you might want to structure an index-fund portfolio if you've got a decade or more until you bid adieu to the working world:
More conservative types or investors closer to retirement will obviously want to cut back on their equity exposure and bump up their allocation to bonds, but they should still have at least some exposure to all of these asset classes.
Ultimately, I think we're going to see more of a push to include index funds and exchange-traded funds in employer-sponsored retirement plans in the future. That's probably a good thing, in that it will lower costs across the board for investors. However, as with any mutual-fund investments, you'll need to continue to focus on the long run and not chase performance by shifting into asset classes that have shown the best short-term returns. Building on a foundation of a solid long-term asset allocation, any investor can make index funds a successful part of their retirement portfolio.
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