My mom has been asking me to look over her 401k plan, as she has been worried about its performance and suitability recently. In fact, she changed all the future contributions to 100% bonds a while back. As her 401(k) had somewhat limited choices (although they could definitely be worse), I had to make do with what was available. Usual disclaimer applies: I am not a financial professional.
1. Decide on an asset allocation.
This can be a complex topic, but I put most of my research in this series of posts on asset allocation. Given my mom’s age, years until retirement, other existing investments, and and risk preferences, I recommended an overall asset allocation of 60% stocks and 40% bonds. Currently, she is at 68%/32%. I would definitely like to have at least a broad US stock fund, a broad international stock fund, and a broad US bond fund. It might be nice to have Large-cap Value, Small-cap Value, Emerging Markets, Real Estate, or Inflation-protected Bond funds. The final ratios will be similar to the asset allocation breakdown here.
2. Make a list of fund options and characteristics
First up, you’ll want to gather a list of all your available investment options. Usually this includes about 5-30 mutual funds. If the fund details are not well organized, just ask for the ticker symbol and pull up their Morningstar.com snapshot. Put them in a spreadsheet, and include the each fund’s asset class, any front- or back-end loads, and annual expense ratio. Here are the 15 options in my mom’s 401(k) plan:
Now, I am completely ignoring Morningstar “star” ratings. They are based primarily on past recent performance, which have been shown to be a poor indicator of future long-term performance. You could buy a 5-star fund and have it end up a 1-star fund a few years later. Fund managers change all the time as well. I want to create a low maintenance portfolio that doesn’t involve chasing hot managers or performance.
3. Narrow down the options by cost and asset class.
If I don’t need the asset class, then I cross it out. If there are two similar funds, then pick the cheaper one with lower loads. In my “nice to have list”, if it is too expensive, then it becomes less useful as a diversifier and I cross it out as well. An example is the AIM Real Estate fund, with the 5.5% front load. The 6 bolded funds above are the ones that I am left with.
4. Decide if you are going to do a full asset allocation or cherry pick
It is often recommended that you implement your asset allocation across all your investment accounts (401ks, IRAs, brokerage) as one pie. For example, you might hold all your bond funds in tax-sheltered accounts for optimal tax efficiency. Or your 401k might only have one really good fund, and you can buy the other asset classes elsewhere. If this is the case, then you might want to cherry pick the funds you want for your 401k.
For other reasons, you might just want to implement your entire asset allocation as best you can within the 401k. I’m going to go ahead with this latter route for now.
5. Consider Target-date Funds or Pre-Set Model Portfolios
Many 401(k)s include an even simpler option, either all-in-one Target-dated funds or pre-set portfolio mixes. But all target-date funds are not made the same. Look at the prospectus and see what funds are included within them, and if they charge you an extra layer of management fees on top of the fees of the underlying funds. Many are crap, and you could do much better with your own custom mix. My mom’s 401k has no such option.
She does however, have a few options for pre-set model portfolios. These are basically a set ratio of selected funds (the pink and blue highlighted items above), which are are automatically rebalanced once a year. Shown above is the breakdown the “balanced model” option. However, I don’t like them because they include several expensive funds and exclude some of what I think are the best funds. Not including the large front-end loads of two of the funds, the average weighted expense ratio of the model portfolio was 0.59%.
6. Construct Your Custom Portfolio
In the end, I chose the 5 funds below. I decided to leave out Windsor II (Large Value fund) for the sake of simplicity. I calculated the averaged weighted expense ratio to be 0.48%.
7. Explain and Implement
Now, I have to explain to my mom why I picked these funds, and how they may perform in the future. If she wants, I may shift it to 50% stocks/50% bonds. I’ll check in on it again after a year to show her how to rebalance. This is not the perfect portfolio, but it will be better than her previous hodgepodge, and also be easier to manage.