The nineteenth century was a time when philosophers were wondering what exactly was free will. To these thinkers, it was a concept that needed help to achieve what they believed was control over your soul. Identifying the seven deadly sins were a product of this effort, blocking their passage into your life allowed your free will to soar where they thought it ought to go.
But often, in this day and age, the exercise is also pressured by more than those temptations of sloth and greed, wrath, pride, lust, envy and gluttony. It is a social one that makes us look to our peers for guidance in what is right and what is wrong. This is certainly true of investors. And because our free will is actually more bound than footloose, this becomes a conundrum of sorts for those inside their company's 401(k) plan.
Call them schools of social thought, call them religion, but once an idea makes sense it becomes the must-have. This is certainly true of exchange traded funds, which have very smart people in this investment's corner. And with good reason that we'll discuss in a future post. For now, it is the mutual fund, that stalwart investment inside those 401(k) plans that is the focus. Why has it lost its luster? In my opinion, the downturn of several years past had a great deal to do with it but something else changed in those fateful months in 2008. But what?
Mutual funds are what we have to work with at the moment. Although you will begin seeing the addition of ETFs to the mix of options available, and there might even be an all-ETF plan coming to your workplace in the future, the mutual fund will reign supreme inside this bounded world of free will investing. You have the right to choose which investments you want. You have the right to contribute as much as the IRS allows. You have the right to make your retirement possible.
And yet, few of you do what is necessary to achieve the goal, a point in life that might be aptly referred to as "from the free choices of your working life" to the "free choices in retirement." Both are bounded by the amount of money you have. You also have the right to choose how tight those bounds will be.
You will soon find out how much everything costs within this plan. It will be a dry read without a doubt but if it does what it is supposed to do, it will shed some light on how much every dollar you invest in your plan is divvied up amongst the providers of the plan. It might be 1% of $100 or a dollar for every contribution of that amount. You can use this as a benchmark on whether your plan is expensive or not.
But what if it's higher than one percent? Fleeing is not an option (in the free will scenario). What that one percent actually does is begins to limit your investment options in two ways. All of the funds in your 401(k) will charge a fee of their own. So the higher the plan's cost, the more higher priced mutual funds as a result becomes unattractive - if inly from the fee perspective. And for some investors, this removes some of the risk they might have found worth taking. What you are left with, and this is in no way a criticism of this kind of investment, is the index fund.
Index funds are incredibly inexpensive. The fund manager is almost non-existent and the stock (or bonds) in the fund are tracking a predetermined basket of stocks (or bonds). The risk is still there but it is greatly underplayed by the those who are fans of this type of fund. The risk however is, as they say, much less than any actively managed mutual fund available. This is a truism with caveats.
When an index fund is created, the real decision is built on how much of which stock will be bought to mimic the index. An S&P 500 index fund may hold 500 stocks. The question is the proportion or as they refer to it, weighting. The risk is also in the lockstep with that decision. If the market goes up, so does your index fund. If the market goes down, you will also shadow the drop in your index fund. If you index didn't keep pace withe index it is mimicking, then weighting is to blame or credit. Not all indexes are created the same.
In some instances, diversification across a basket of index funds helps offset this sort of risk but if the drop is comprehensive, involving all sorts of regions and investments, this will be of little comfort. So you will pay less for an index but not fully eliminate the risk of owning it.
If your plan costs less than 1%, you have some wiggle room, the opportunity to take on a little more risk than you might have otherwise considered. The smaller more drilled down index funds can provide some of this risk at a lower cost. But some funds who may be benchmarked to the indexes of smaller sized companies and off-shore regions, even some alternative type investments, might seem appealing in small portions.
The best 401(k) is one that mimics your life, the boundaries you have set or have been set for you. You can follow some simple rules here than should reflect the basis of that life.
First: take care of your business. In real life this is paying the bills (on time) and making the money you earn part of a budget. In your 401(k), this means making the matching contribution or 5% if your employer doesn't match. Both numbers have little or no impact on that fragile take home pay and huge difference in your future.
Second: taking care of your retirement. The brutality of numbers suggests that even if you maximize your contribution, putting as much as the law allows, you will only end up with 75% of your current income in retirement. This simply means that if you can live on 75% of what you make now (ideally socking the rest away for retirement), the transition will be a breeze. You will have lived within that 19th century thinking: your free will will have a budget.
Third: the fun part of the plan. Boring leads to angst and takes away our human-ness. This ignores who we are and the habits we have. If we like to "cut loose" on occasion, our investments should reflect a little of that habit as well. Your "bad habits" or the fun things you do take up less than 10% of your time in real life. Your retirement plan should have 10% devoted to something less conservative, something a little more risky.
I see it as a way to keep you engaged (you will check your plan more often) and to learn balance. Keep that "risky" portion at 10% and the other ninety percent nicely indexed across five or six categories, and you will begin to watch what you are doing in this "retirement life" more closely.
One final word on the lost luster of mutual funds. They have gotten cheaper since the Great Recession and probably will continue to do so. Some will shine, some will falter and others will follow the markets. We provide the luster and if we fail to use the tools we have, we won't be able to see our reflection in the shine.
Next up: The Glow of Exchange Traded Funds