401(k) plans can be the best possible way to save for retirement. You won't beat the free money that many employers provide through matching contributions, and being able to see your savings grow on a tax-deferred basis can save you thousands at tax time over the years.
Yet many 401(k)s have lousy options when it comes to investing your money. This article won't name names as far as the absolute worst investment options for 401(k)s, but it will give you the information you need to assess your 401(k) plan and figure out which of its available investment choices aren't worth investing in. In particular, the following three groups of funds should be the last you turn to with your hard-earned retirement savings.
1. High-fee funds
There's nothing worse for a 401(k) saver than a fund that charges excessive fees. It might not seem like that big a deal, but for someone who puts aside $3,000 of their own money each year in a 401(k) and has that $3,000 matched by an employer, the difference between a 0.1% annual expense ratio on a fund and a 1.1% fee works out to more than $210,000 in extra savings from the cheaper option, assuming the same average annual 8% return before imposing fees.
It's tempting to think that the higher-fee fund will generate better returns over time. But consider this: In the preceding example, the more costly fund would have to generate 9% gross returns just to break even compared to what the cheaper fund made in an 8% return environment. Some funds can overcome that handicap, but most won't -- and they'll reap the rewards of the money you lose.
2. Money market funds
The primary purpose of saving for retirement is to let your money grow to the greatest extent possible. Yet many people end up with extensive amounts of money in money market funds, earning next to no return.
In some cases, this is because employers default to funneling contributions to a money market fund unless you select otherwise. Yet some investors are just nervous about the ups and downs of the stock market and don't want to see their retirement accounts go down in value.
A mix of stocks, bonds, and other investments is prudent, and as you approach retirement, you'll want to be more conservative with your 401(k) portfolio. But using the cash option as anything other than a temporary placeholder is usually a poor use of your retirement funds. Even conservative investors can typically find options that provide more income with similar stability, such as stable value funds.
3. "Funds" in an annuity wrapper
Finally, some 401(k) plans offer extensive investment choices through insurance company annuity contracts. These investment options typically come with a host of additional fees, thereby often making them even more expensive than the funds at the upper end of the mutual fund cost spectrum.
Annuities can come with attractive add-ons that can provide useful benefits, such as guaranteed death benefits, minimum income payouts, or a guaranteed total amount of withdrawals. Each add-on typically comes with an extra fee, however, that allows the insurance company selling the annuity to apply the appropriate hedging transaction and retain something extra for its profit.
In limited cases, annuities in a 401(k) can be valuable. For the typical 401(k) investor with decades of future earnings to consider, paying extra for these guarantees often ends up being wasted money that means less in savings for retirement.
Be smart with your savings
Using a 401(k) plan account to save for retirement is smart, but picking the wrong fund options isn't. By being aware of these poor choices for 401(k) saving, you can turn your attention to your plan's better alternatives.