The 401(k) is one of the most important, most popular ways the average person can build up a retirement nest egg. Sponsored by your employer -- or yourself if you're self-employed -- the 401(k) offers a number of benefits to help you grow your money. This includes reduced income taxes each year you contribute (though our elected officials are considering cutting that benefit substantially), tax-free growth of your investments, and generally matching contributions from your employer.
As much as all those benefits play a role in making the 401(k) a great retirement savings tool, picking the right funds is every bit as important. Here are five of the best funds you can choose for your 401(k). And if these exact funds aren't available to you, there's a good chance a similar one will be.
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1. Start here
Whether you're less than a year on your first job or quickly approaching retirement, a low-cost index fund like the Vanguard S&P 500 Index Fund (VFINX -0.03%) is an ideal starting point. When you invest in an S&P 500 index fund, you literally own a stake in the 500 largest publicly traded American companies, a solid proxy for the U.S. stock market, as a whole.
Historically, this index has averaged around 10% per year in returns across both the good and the bad years. That's good for doubling your money about every eight years, on average. The Vanguard fund's expense ratio is 0.14%, or $1.40 a year for every $1,000 in the fund. Other S&P 500 index funds should charge similar fees.
2. Investing in the economies of tomorrow
Gaining some exposure to the fastest growing segments of the global economy -- emerging markets -- can help boost your returns over the long term. The Vanguard Emerging Markets Stock Index Fund (VEIEX -0.18%) is an excellent choice.
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You'll generally pay a little more -- this fund has a 0.32% expense ratio -- and also experience higher volatility due to the unpredictable nature of still-developing economies like China, Africa, and South America. But you'll also gain exposure to markets that are growing at twice, or even three times, the rate of the U.S. economy. In the short term, this means more risk, but over the long term, adding this exposure can help boost your returns.
Make sure to avoid actively managed funds, which generally charge higher fees, but rarely generate higher returns. Stick with a low-cost index fund such as the one listed here.
3. Low-cost bond funds as you approach retirement
Stocks, as represented in the two funds above, should be the biggest part of most savers' 401(k) allocation, but the closer you get to retirement, bonds become more important. Bonds may generate lower returns than stocks most of the time, which is why stocks are the better long-term growth tool, but they're more predictable and far less likely to lose value.
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That doesn't matter as much for younger workers who have time to ride the market back up after a downturn. But the closer you get to retirement, the less you can count on time, and the more you have to protect your risk of losses.
The Vanguard Total Bond Market Index Fund (VBMFX) is comprised of 30% high-quality investment-grade U.S. corporate bonds and 70% U.S. government bonds. It's 0.15% expense ratio, about $1.50 per year for every $1,000 invested in the fund, is also cheap.
Don't see a similar bond fund in your 401(k)? You may be able to create similar exposure by investing in a corporate bond index fund and a U.S. government bond fund in your 401(k), following the same 30/70 mix that balances the higher yields of corporate bonds with the lower risk of government bonds. Pro tip: Make sure to invest in index funds if you can versus actively managed bond funds that charge higher fees, but usually deliver worse returns.
4. What about cash?
If you leave your money in cash, you're losing money, since low interest rates won't even cover inflation. But that doesn't mean cash funds -- generally money market funds -- have no place. They just shouldn't have much of a role before you retire.
Once you're retired, a fund such as the Vanguard Federal Money Market Fund (VMFXX) can be useful. Generally speaking, cash funds like this will pay an interest yield that's tied to short-term rates, which means very low returns. For instance, the Vanguard fund generated about 0.3% in interest yield in 2016, while higher rates have produced 0.63% in yield since the beginning of 2017.
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You won't make money, but you won't experience a 10% or more loss of value, either. This is ideal for very short-term purposes, such as holding money you'll spend over the next year, but have yet to withdraw from your 401(k).
There's also an argument for even younger retirement savers keeping a small amount -- maybe 5% or less of your account balance -- in a cash fund for rare opportunities, like a market decline during a recession. On average, the market falls by 20% once every five years or so, and if you can have some "dry powder" set aside to buy near the bottom, you can boost your returns.
The challenge is having the discipline to buy when the market is falling, and not sell. The reality is, too few people are able to buy when everyone else is selling. Ask yourself the hard question: What makes you different?
5. Want to make it as simple as possible? Target-date funds may be for you
If your goal is to get solid returns in as hands-off a manner as possible, a target-date fund may be ideal for you. A target-date fund will automatically start shifting your asset mix from stocks to bonds as you get closer to retirement. For example, let's compare the Vanguard Target Retirement Income Fund (VTINX 0.07%), Vanguard Target Retirement 2020 Fund (VTWNX 0.07%), and Vanguard Target Retirement 2055 Fund (VFFVX 0.05%).
| Fund | Stock/Bond mix | Expense ratio |
|---|---|---|
| Target Retirement Income | 30/70 | 0.13% |
| Target Retirement 2020 | 55/45 | 0.14% |
| Target Retirement 2055 | 90/10 | 0.16% |
Source: Vanguard.
As you can see, these three funds have very different asset allocations, since they represent people in different situations: in retirement, nearing retirement, and decades away from retirement.
What makes target-date funds appealing is that the fund managers will automatically start shifting the asset mix away from stocks and more into bonds as retirement gets closer, eventually moving from the 90/10 stock/bond mix for young savers to the 30/70 mix for retirees.
