For millions of American workers, opening an employer’s 401(k) enrollment packet feels less like a step toward financial freedom and more like a crash course in a foreign language.
An employee typically reviews the included forms, brochures, and introductory letter to begin selecting investments and taking advantage of any employer match.
“But once you’ve read the letter, the rest of the materials simply don’t make a lot of sense,” personal finance personality Dave Ramsey wrote for Ramsey Solutions. “There’s information about vesting, beneficiaries, equities, risk assessments and 401(k) selections — but nothing’s clicking.”
“The only thing that seems clear is that investing in a 401(k) is important business,” Ramsey continued. “Your ability to retire someday depends on you getting it right today.”
“But how can you make such major, long-term decisions when you don’t even understand what the choices are?”
Dave Ramsey explains 401(k) investment options
Plan enrollment materials typically present employees with anywhere from a handful to over a dozen investment choices, along with several alternatives to standard packages.
Depending on the plan, these selections often include mutual funds and variable annuities. And increasingly, as I reported on yesterday, 401(k) plans may offer other alternatives such as private equity.
My reporting over the years also informs me that plan materials heavily promote target date funds, which are mutual funds structured with preset asset allocations tailored to an employee’s anticipated retirement year. An investor initially holds a solid allocation of growth stock mutual funds, which gradually shifts toward increasingly conservative holdings as retirement approaches.
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“We don’t recommend target date funds because by the time you’re ready to retire, your 401(k) will be mostly invested in bonds and money markets that won’t give you the growth you need to support you through 30-plus years of retirement,” Ramsey wrote.
Financial services company Charles Schwab acknowledges there are risks associated with target date funds, but identifies a key advantage as well.
“Target date funds typically invest in both U.S. and international stocks and bonds, helping reduce reliance on any single market or sector,” Schwab wrote. “This broad diversification can help smooth returns over time and reduce concentration risk.”
Annuities in 401(k) plans
Some employer-sponsored 401(k) plans include annuities among their investment options.
An annuity is a contract with an insurance company in which an individual contributes funds that grow over time, in exchange for guaranteed disbursements during retirement, providing a predictable income stream.
Among these, fixed annuities operate similarly to traditional savings vehicles, offering a predetermined interest rate that typically sits at or below 5%.
“Sounds easy and predictable, but that low rate of return won’t stand a chance against the rate of inflation,” Ramsey wrote.
Fidelity Investments offers a counterpoint to that logic, provided the annuity provides a large enough revenue stream.
“Fully covering essential expenses with lifetime guaranteed income sources can provide peace of mind that you’ll never outlive your money, no matter how long you live,” Fidelity wrote.
“Annuities can also be simpler to manage and help provide greater protection against elder fraud and abuse than can an investment portfolio alone,” Fidelity added.
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Mutual funds in 401(k) plans
Mutual funds represent the most standard investment vehicle within 401(k) plans. These professionally managed funds pool capital from multiple contributors to purchase shares in dozens or hundreds of enterprises simultaneously.
By dispersing capital across an expansive portfolio of companies, mutual funds provide automatic diversification, significantly mitigating the risk associated with individual stock holdings.
Ramsey recommends spreading investments evenly across four types of mutual funds: growth and income funds, growth funds, aggressive growth funds, and international funds.
First, growth and income funds (large-cap or large-value) invest in well-established, household-name U.S. companies to provide portfolio stability and predictable performance.
Second, growth funds (typically mid-cap equities) carry moderate market swings while delivering reliable, long-term capital appreciation.
Third, aggressive growth funds (small-cap or startup equities) sit on the higher-risk, higher-reward end of the spectrum, trading stability for maximum upside potential.
Fourth, international funds invest in foreign companies outside the United States, adding essential global diversification to spread geographic risk.
“If you put 25% of your 401(k) into each of these types of mutual funds, you’ll spread out your risk and ensure that you’re not putting all your eggs into one basket,” Ramsey wrote.
JPMorgan, however, suggests exercising caution with this approach when nearing the end of one’s working years.
“For those closer to retirement, it’s essential to ensure appropriate diversification across a mix of stocks and bonds, as well as across U.S. and international markets,” the financial services firm wrote.
This article is for informational purposes only and should not be construed as individualized tax or investment advice.
Related: Jean Chatzky flags bottom line on 401(k) expanding options
