There's no denying that putting money in a 401(k) is one of the most effective ways to save and invest for retirement. However, you may not realize how much more efficiently you can use your 401(k) by being slightly more hands-on.
One drawback of a 401(k) plan is that you have limited investment options. Unlike an IRA, whereby you can invest in any individual company or exchange-traded fund (ETF) you want, a 401(k) provides you with limited investment options. For most plans, this includes company stock, index funds based on different market caps, and target-date funds.
Target-date funds are funds put together based on someone's projected retirement year. For example, "Fund ABC 2045" would consist of an investment mix that the fund manager deems appropriate for someone planning to retire around 2045.
The idea behind target-date funds is that they automatically rebalance to become more conservative (holding fewer stocks and more bonds and cash) as you near retirement. This allows investors to be hands-off and gives them a virtual one-stop shop for retirement investing -- at a cost.
Being too hands-off can be costly
Since target-date funds must be rebalanced with time, there's an element of active management involved with them. This can add a hefty price tag to most target-date funds that can really eat away at an investor's returns over time.
At the end of 2021, the average expense ratio of a target-date fund -- which is charged as a percentage of the total investment -- was 0.34%, according to Morningstar. For perspective, the Vanguard S&P 500 ETF (VOO -0.23%) has a 0.03% expense ratio.
To get an idea of how seemingly slight differences in fees can add up, imagine two people, each of whom invests $500 monthly in a fund that averages 8% annual returns over 25 years. Here's approximately how returns would stack up with a 0.34% expense ratio versus a 0.17% expense ratio:
| Expense Ratio | Ending Value | Amount Paid in Fees |
|---|---|---|
| 0.17% | $427,800 | $10,700 |
| 0.34% | $417,400 | $21,100 |
Data source: Author calculations (rounded to the nearest hundred).
Even that slight 0.17% difference in fees accounts for around $10,400 in fees over 25 years. If you invested everything in that S&P 500 index fund, your fees would be even lower, and you'd save even more.
Forgo the middleman and do it yourself
One way to get around the high fees of target-date funds is to invest in the funds they typically hold. Generally, target-date funds contain U.S. and international stocks, bonds, and cash. You can achieve a well-rounded stock portfolio with four broad types of index funds: large caps, mid caps, small caps, and international funds.
Large-cap companies are usually more stable than smaller companies, so you want to increase your stake in them and away from smaller-cap stocks as you near retirement. That way, you're not as susceptible to huge swings. Look no further than an S&P 500 ETF like the Vanguard S&P 500 ETF for this option.
Small-cap stocks may be riskier than large-cap stocks, but they have more upside. When you're younger, you have a lot more time to recover from down periods, so it's often worth it to take on a bit more risk to hopefully benefit from the upside. Mid-cap stocks represent a sweet spot between more stability and higher growth potential.
Regarding international stocks, having around 20% of your stock portfolio in them is a good rule of thumb, regardless of age. Investing in international stocks gives you access to growth opportunities and industries that may not be as prevalent in the U.S. It also ensures you're not just relying on the U.S. economy for your portfolio's success.
Here's a rough idea of how you could allocate your stock portfolio based on age range:
| Age Range | Large-Cap Percentage | Mid-Cap Percentage | Small-Cap Percentage | International Percentage |
|---|---|---|---|---|
| 30s and younger | 50% | 15% | 15% | 20% |
| 40s | 60% | 10% | 10% | 20% |
| 50s | 65% | 10% | 5% | 20% |
| 60s and older | 70% | 5% | 5% | 20% |
Data source: Author calculations.
Always do what you're comfortable with
How you allocate your portfolio depends on your financial situation and risk tolerance; there isn't a one-allocation-fits-all answer.
Use these percentages as a baseline and adjust them according to what you're comfortable with. If you're in your 50s and don't mind added risk, for example, feel free to have more small-cap stocks. If you're 35 and risks aren't your thing, you may decide to focus only on large-cap and international stocks.
Whatever the case, by taking a few minutes every few years or so, you can save yourself lots of money by reallocating your own portfolio instead of relying on target-date funds. In a 401(k), it's usually as simple as logging into your account online and changing your allocation percentages.
The money you'll save makes this well worth it, in my opinion.
