401k Index Funds: A Guide to Maximizing Returns and Minimizing Fees

Index funds are a popular choice for 401k investors, and for good reason. They offer diversification, low costs, and consistent returns.

By investing in a 401k index fund, you can spread your risk across a wide range of assets, reducing the impact of any one investment on your overall portfolio. This can help you sleep better at night.

According to the article, the average annual return of the S&P 500 index fund over the past 50 years is around 10%. This is significantly higher than the average return of actively managed funds.

Investing in a 401k index fund can be a straightforward process, with many plans offering a range of low-cost index funds to choose from.

Having an investment policy for your 401(k) plan is a fiduciary best practice. It helps ensure that your investments align with your goals and are managed efficiently.

A simple investment policy with three basic objectives will suffice for 401(k) plans trying to earn market returns at a low cost with passively-managed index funds. These objectives are diversification, market returns, and efficiency.

To achieve diversification, your investment policy should include a mix of different, internally diversified alternatives with materially different risk and return characteristics. This means offering participants a range of options with varying levels of risk and potential return.

Here are the three objectives of a simple investment policy:

Having an investment policy is a crucial step in creating a solid investment strategy. It's a fiduciary best practice to have one for your 401(k) plan.

A formal written Investment Policy Statement (IPS) is recommended for 401(k) plans with actively-managed funds. This documentation can help defend the selection of funds that underperform their respective market benchmark, net of fees, over time.

But for 401(k) plans trying to earn market returns at a low cost with passively-managed index funds, a formal IPS may be overkill. A simple investment policy with just 3 basic objectives will suffice.

Here are the 3 basic objectives of a simple investment policy:

These objectives will guide your investment decisions and help you create a well-rounded investment portfolio.

Index funds often offer superior returns too! According to Bloomberg, passive funds saw inflows of $88.9 billion while active funds saw outflows of $124.1 billion from January to August 2019.

Index funds have grown in popularity by 401(k) plan sponsors since 2006. The use of index funds by plans in the BrightScope Defined Contribution Plan Database increased from 79% of plans and 16.7% of assets in 2006 to 91.3% of plans and 33.2% of assets in 2016.

More than 95% of 401(k) plans with more than $10 million in plan assets offered index funds in their plan lineups in 2016. Index mutual funds typically had lower expense ratios than other fund types, with an asset-weighted average expense ratio of 0.09% of assets in 2016.

Index funds don't incur the costs of bigger teams to analyze, trade, and predict where the markets could be going. This results in expense advantages over actively managed funds.

Index funds also tend to not have 12b-1 or other marketing or revenue sharing that can increase the cost of the fund.

Index funds have become increasingly popular among 401(k) plan sponsors, with their use growing from 79% of plans and 16.7% of assets in 2006 to 91.3% of plans and 33.2% of assets in 2016.

Index funds tend to offer superior returns compared to actively-managed funds, with passive funds seeing inflows of $88.9 billion while active funds saw outflows of $124.1 billion from January to August 2019.

Index funds also tend to have lower expense ratios, with the asset-weighted average expense ratio for index mutual funds in 401(k) plans being 0.09% of assets in 2016, compared to 0.46% of assets for domestic equity mutual funds including both index and actively managed funds.

Index funds offer a win-win for 401(k) plan sponsors and participants, making it easy to avoid fiduciary liability while also earning enviable long-term investment returns.

Diversification is key when it comes to investing in index funds. To meet this objective, you can select index funds that meet the “Broad range of investment alternatives” requirement of ERISA section 404(c).

This requirement can be met by offering as few as three fund options that cover equity (stocks), fixed income (bonds), and capital preservation asset classes. Index funds that track a broad market are internally diversified.

To ensure your index funds are diversified, look for options that cover different asset classes. This can include stocks, bonds, and capital preservation assets.

Index funds that track a broad market are a great option for diversification. They can be a low-cost way to gain exposure to various asset classes.

By selecting index funds that meet the ERISA section 404(c) requirement, you can meet the diversification objective with just three fund options.

Index funds often offer superior returns too! According to Bloomberg, passive funds saw inflows of $88.9 billion while active funds saw outflows of $124.1 billion from January to August 2019.

Index funds that track the broad stock market indices are more likely to offer superior returns over time, net of fees charged. Need proof? Check out the latest SPIVA Scorecard from S&P Dow Jones Indices.

It's not impossible to find actively-managed funds that outperform their market benchmark, but the odds just are not in your favor. If you want to try, I strongly recommend you hire a fiduciary-grade financial advisor for unbiased professional advice.

Leading index funds can be a win-win for you and your 401(k) participants, making it easy for you to avoid fiduciary liability and for plan participants to earn enviable long-term investment returns.

Paying just 1% more in fund and investment expenses can cost each employee hundreds of thousands in savings over a 40-year career.

You can save significantly by paying attention to fees, as seen in the example where Jill paid 1% less in fees and saved an extra $376,321 compared to Dan over 40 years.

The effects of higher costs can compound and become profound over time, highlighting the importance of keeping fees low in your 401(k) investments.

Paying 1% more in fund and investment expenses can cost each employee hundreds of thousands in savings over a 40-year career.

Every dollar paid in investment expenses is one less dollar invested in the markets, and high costs can compound over time. In this case, paying just 1% more in fees can make a huge difference, as Jill and Dan's hypothetical example shows.

Jill paid 1% less in fees than Dan, and over 40 years, she saved an extra $376,321, which is 27% more than Dan.

Paying 1% less on investments can make a huge difference in your retirement savings. This is evident in the example where a 1% difference in expenses can impact your 401(k) over a 40-year career.

A 1% difference in expenses can add up to a significant amount over time, especially when compounded with a fixed annual 7% return on investments. The example assumes a 7% return before expenses with no distribution or tax considerations.

Assuming a salary of $75,000 in year one and a 3% merit raise each year, the impact of a 1% difference in expenses is even more pronounced. This is because the employee's contributions and company matching contributions also increase each year.

The example assumes the employee contributes 5% of her salary each year and receives a 3% company matching contribution, which adds to the overall impact of a 1% difference in expenses.

Having a clear investment policy is essential when selecting funds for your 401(k) plan. A simple investment policy with three basic objectives will suffice: diversification, market returns, and efficiency.

Diversification is key to minimizing risk. Plan investments must provide participants with different, internally diversified alternatives with materially different risk and return characteristics.

To meet this objective, you should select funds that offer a range of asset classes, such as domestic and international stocks, bonds, and real estate. This will help spread risk and increase potential returns.

Market returns are also crucial. Plan investments must offer returns that closely correlate to a target benchmark over time. This means choosing funds that track a specific market index, such as the S&P 500.

Low expenses are essential for efficiency. Plan investments must possess low expenses to reduce drag on participant returns. This means selecting funds with low fees, such as index funds.

Here are the key characteristics of a well-chosen investment: