Investment Options in Retirement Savings Plans
All investment decisions are a trade-off between risk and reward. In this post, I’ll focus on how risk and reward affect your decision among the investment options in your employer-sponsored retirement plans.
If you look at returns over very long periods of time, well diversified, riskier investments tend to produce higher returns with lower risk. For most of these investments, “a very long period of time” is somewhere between 10 and 30 years. That doesn’t mean that the riskiest investments will always outperform the less risky investments in every 10 or 20 year period, but, if you look at enough of them, they generally will on average.
When I Take More Risk
Very briefly, three characteristics I use to help decide whether I want to lean towards a more or less risky investment are:
- With only a small amount to invest, I will tend to be purchase less risky investments than if I have a larger amount because I have less of a cushion and I want to protect it.
- When I know I will need the money very soon, I invest in less risky investments (or possibly keep it in a savings or checking account). With longer time periods, riskier investments have more time to recover if they have a large decline. If I need the money soon, I might not have enough money for my purchase if the values declined.
- If I have almost as much money as I need for a purchase that isn’t going to be made for a while (for example when I had enough money saved for my children’s college education), I will purchase less risky investments as I don’t need a high rate of return to meet my objectives and also want to protect my savings.
If you aren’t comfortable with the concept of risk, I suggest looking at my post on that topic.
Commonly available investment options in employer-sponsored retirement plans are listed below. I have put them in an order that roughly corresponds to increasing risk.
- Money market funds – Money market funds invest in what are considered short-term, liquid (easily sold) securities. They are similar to, but slightly riskier than, interest-bearing savings accounts.
- Stable value funds – A stable value fund usually buys and sells highly-rated corporate or government bonds with short to intermediate times to maturity. The return on a stable value fund is the sum of the changes in the market value plus the coupon payments on the bonds held by the fund. Because stable value funds tend to buy bonds with shorter times to maturity than typical bond mutual funds, they often have lower returns and be less risky.
- Bond Mutual Funds – Bond mutual funds buy and sell bonds. The return on a bond mutual fund is the sum of the changes in the market value plus the coupon payments. Although they don’t track exactly, the market values of bonds tend to go down when interest rates go up and vice versa.
- Large Cap Equity Mutual Funds – These funds buy and sell stocks in large companies, often defined as those with more than $10 billion of market capitalization (the total market value of all the stock it has issued).
- Small Cap Equity Mutual Funds – These funds buy and sell stocks in smaller companies.
- Foreign Equity Mutual Funds – These funds buy and sell stocks in foreign companies. Every foreign equity fund is allowed to define the countries in which it invests. You’ll want to look to see in what countries your fund options invest to evaluate their level of risk.
- Emerging Market Equity Mutual Funds – These funds buy and sell stocks in companies in countries that are considering emerging markets. Morocco, the Philippines, Brazil and South Africa are examples of currently emerging markets.
- Retirement Date Funds – These fund managers buys bond mutual funds and equity mutual funds. Each fund has a range of retirement dates associated with it. The fund manager selects the allocation between bond funds and stock funds based on its evaluation of the amount of mix you should take given the length of time to retirement. The key advantage of a retirement date fund is that you don’t have to make any decisions – the fund manager does it all. The disadvantages of retirement date funds include the fact that they ignore your personal risk tolerance, they don’t consider other assets you may own outside the retirement date fund and some of them have fairly high fees, since the retirement date fund manager receives a fee on top of the fees charged by the mutual funds selected by the fund manager.
Some employers offer index funds which are variations on equity mutual funds. An index fund’s performance tracks as closely as possible to a major stock market index. The Dow Jones Industrial Average, the Standard & Poors (S&P) 500 or the Russell 2000 are examples of indices. The first two indices have risk and return characteristics somewhat similar to large cap equity mutual funds. The Russell 200 is more closely aligned with a medium or small cap equity mutual fund.
Increasingly, employers are offering Target Retirement Date Funds as an option. The fund manager not only selects the individual securities that will be owned by the fund, but also chooses the mix between equities and bonds. In theory, the number of years until the target retirement dates for that fund determines the mix of investments. For example, a fund with a target retirement date range of 2021 through 2025 might be invested more heavily in bonds than a fund with a target retirement date range of 2051 through 2055. People who are close to retirement are often more interested in protecting their investments (i.e., want less risk). On the other hand, people who don’t plan to retire for many years are often more willing to take on additional risk in exchange for higher returns. You can accomplish the same mix yourself using bond funds and equity funds, but some people prefer to let the fund manager make that decision.
Some employers allow or require you to invest in company stock in their defined contribution plans. Many of these employers consider an investment in the company’s stock as an indication of loyalty. I view it as a very risky investment option. I discuss the benefits of diversification in this post. If your investment portfolio is diversified, it means that a decline in value of any one security will not adversely impact the total value of your portfolio too severely. If you purchase your employer’s stock, you are investing in a single company rather than investing in the larger number of companies owned by a mutual fund. In a really severe situation, you could lose your job and the stock value could drop significantly, leaving you with much smaller savings and no salary. As such, you take on much less risk if you select a mutual fund than company stock.
How I Decided
As I made my 401(k) investment selections, I thought about what other investments I had, if any, and used the 401(k) choices to fill in the gaps. That is, I used my 401(k) investment selections to increase my diversification. When I was young, I selected two or three funds that had US exposure to each of small and large cap equities. As I had more money both in and out of my 401(k), I still selected two or three funds, but invested in at least one fund with foreign or emerging market exposure to further diversify my holdings.
As a reminder, I am not qualified to give investment advice for your individual situation. Nonetheless, I can provide insights about the types of investment options I’ve seen in employer-sponsored retirement plans. I’ll describe the characteristics of most of these investment vehicles in more detail in later posts, but want to touch on them now as many of you will be making employee benefit elections before then.