My Husband’s 401k Options Are Changing. What Should We Do?

I got an interesting email from a friend recently who was trying to make heads or tails of her husband’s 401k options. She got a mailer saying that some of the mutual fund choices were going to change and that they needed to make a decision where to direct their new funds. If this ever happens to you, I suggest taking a look at your 401k fees and fund choices. As we will see, her husband’s 401k options might be better at making a finance company rich instead of them.

Current State of Husband’s 401k Options

This is what their current portfolio looks like. I’m including the expense ratio (ER for short), which is what I consider to be the most important aspect of each fund. An expense ratio is how the mutual fund company gets paid. A fee of 0.8% means they take 0.8% of whatever the account balance is each year for running the fund. Everyone pays expense ratios when using mutual funds. However, you probably will not realize how much you pay because you do not receive a bill. The company just deducts it and discloses that they do this in all their legalese. Here’s what they’re currently invested in:

We currently have 47% in large cap US stocks, 24% in small cap US, 17% in bonds, 6% in International, 3% in balanced, and 3% in money markets. I’m including our specific fund choices too.

27% Vanguard Growth Index – ER: 0.09%. Changing to AB Large Cap Growth Z as of 5/23/16. ER: 0.81%
20% Delaware Value Inst – ER 0.74%
18% Emerald Growth Institutional – ER: 0.99%
6%   Undiscovered Mgrs Behavioral Value – ER: 1.01%
11% Pioneer Bond – ER: 0.47%
6%   Columbia US Government Mortgage – ER: 0.49%
6%   Lazard International Strategic Eq Instl – ER: 0.84%
3%   Vanguard Balanced Index Fund – ER 0.09%. Changing to American Funds American Balanced ER 0.29%
3%   JPMorgan Prime Money Market Inst – ER: 0.21%

Other Investment Choices

Vanguard 500 Index Fund – Expense Ratio: 0.05%
Vanguard Mid-Cap Growth Index – Expense Ratio: 0.08%
Vanguard Small Cap Index Fund – Expense Ratio: 0.08%

Why These Changes are Happening and How I Would Respond If It Were Me

This is a classic case of over diversification. If you are not a professional investor, and even if you are, you should go with the lowest cost funds. There is plenty of academic evidence that finds high fees are not worth the expense. That means dumping mutual funds with high expense ratios, as many of her husband’s 401k options have.

Whoever is managing the 401k plan at this company (likely a financial firm) decided to replace two of the low cost Vanguard options with higher fee American fund options. They probably did this because the American funds earn more revenue for the parent company. They certainly did not do it because they care about the participant.

One could simplify the portfolio with three funds. You could choose only the S&P 500 index fund and put 100% of your contributions towards it and still have a diversified portfolio. That fund holds 500 of the largest stocks in America and has incredibly low expenses and a superb track record. If you wanted more exposure to small and mid cap stocks, you could do 1/3 each in the Vanguard small cap, mid cap, and large cap stocks. Each of the Vanguard mutual funds carry a $20 a year account maintenance fee for balances below $10,000. If you have $30,000 or more you could do the 1/3 in each option. If not, putting it all in the S&P is not a terrible option.

I have a lot of friends who work at a large 401k administrator. You pick a fund or two in each category and present a line up of funds to the person picking the 401k plan. I think they try to keep the expense ratios about 1% or lower just to make fees look reasonable. Let’s be clear though, 1% expense ratios are high and totally unnecessary. The highest expense ratio for a fund in my portfolio is around 0.6%, and it’s a passively managed small cap emerging markets ETF. I’ll pay for unique exposure to an asset class, but paying top dollar for active management is a thing of the past. Too many academic research papers have found in aggregate this is a waste of money for the average investor.

So if it was me, I would dump all the fancy sounding Strategic Equity and Behavioral Value funds in favor of the Vanguard funds. Do not allow your new contributions to go into the American funds. Doing so could cost you tens of thousands of dollars more in fees over the long run.  Your husband’s 401k options are actually pretty good. I’ve seen plans where the lowest cost funds start at 1.5%. Even worse are the poor teachers who get stuck with variable annuity 403b’s carrying 2%-3% annual expenses.

Simple is Better for 401k Plans

A lot of workplace retirement plans these days try to get you to sign up for a managed account service for an annual fee. This is also a waste of money. They charge you 0.25% to 1% a year to “manage” your portfolio. What they actually do is pick the one fund from a specific category in a set percentage, rebalance it occasionally, and take your money. Even worse, they direct you away from low cost index funds and into their expensive garbage with high fees.

Do not let the extensive fund list confuse you. Pick between one to four funds for your 401k plan. I’m very glad your husband’s 401k options still offer cheap index funds. Take advantage of them, pay the fund company less, and keep more of your own money. When he changes jobs, don’t forget he can roll the money to his own Individual Retirement Account at the location of his choosing.

Any 401k suggestions for this reader and her husband? Have any 401k horror stories?

*Annoying Disclosure required by the government: I’m not a financial advisor and you should not consider any of this to be specific advice. You should consult with a financial professional before making any personal decisions regarding your financial situation.