Most of us have the opportunity to save for retirement using a retirement plan through work. It is most likely a 401k or a 403b depending on the type of organization. I can recall my first exposure to a 401k Retirement Plan when I began employment with IBM after graduating. I received all the plan documents and enrollment information. It included details about how the plan works and the investment options available in the plan. It was an intimidating experience. I was determined to learn what I could about the plan and the investment options, so that I could be knowledgeable about my decisions, but finding time to do all the necessary research was very difficult. Part of my desire to become an advisor and help families navigate their investments is certainly based on my personal experience.
Today, the expectation is that you make educated decisions regarding how your retirement savings are invested. It is easier said than done. Based on a study done by Brightscope and the Investment Company Institute, the average 401k plan has over 20 different investment options. How do you know the difference between all the options and what type of investments they are? Taking the time to research and make decisions on top of everything that life has in store from work to kids’ activities is daunting to say the least. Not to mention that the names of the different funds don’t really give you a lot of information.
Typical 401k Investment Options
My goal over several entries is to give you some perspective of what sorts of funds are typically offered in retirement plans and the types of investments each different fund might have based on broad asset classes. I hope to educate you so that you are more informed as you review your investment options for your retirement plan or any other investments you might be researching.
In your 401k plan, you will potentially have access to five different types of fund options. At a minimum, you will have access to three.
1) Stock Funds
2) Bond Funds
3) Money Market or Stable Value Funds
4) Risk Allocation Funds
5) Target Date Funds
Since the typical plan has over 20 different funds to choose from on average, each high level classification of fund is divided into sub classes of funds. There were 9,520 mutual funds and 1,594 Exchange Traded Funds (ETF) available in 2015 according to the 2016 Investment Company Fact Book from the Investment Company Institute. This is a staggering number, and it continues to grow. It is easy to understand why. At the end of 2015, total assets invested with fund companies exceeded $18 trillion dollars. With so many possibilities, making investment decisions can be very difficult. It is like trying to choose a blue paint. There are many different shades and each one is slightly different, so how do you choose.
Let’s start the discussion with stock funds and the range of options that may be offered because every plan offers a stock fund. Stock funds are mutual funds or ETFs that purchase shares in individual companies for your benefit. Stock funds are first classified as domestic or international.
A “Domestic Large Cap Fund” will purchase shares of companies that are household names and have their headquarters in the United States. As I write this, Apple is the most valuable company in the United States. In addition to Apple, there is a long list of companies that are possible investments for Domestic Large Cap Funds. For example, Alphabet, Facebook, GE, Verizon, Pepsi, and IBM are companies that the Domestic Large Cap Mutual Fund or ETF could have as an investment. Typically, these mutual funds are based on the S&P 500 index. This index is made up of the 500 largest companies in the US. What does that mean? Largest by number of employees…..No. The “size” of a company for investment purposes is determined by Market Capitalization (Market Cap). The calculation for Market Cap is:
Market Cap = current stock price * the number of shares outstanding
For example, Apple’s Market Cap based on its shares and closing price as of 5/31/2016 is:
5,477,425,000 (shares per form 10-Q as of April 8, 2016) * $99.86 (closing price 5/31/2016) = $546,975,660,500
As a general rule, the size of companies are divided into Large, Mid and Small. These categories are based on a % of total corporate value. Large companies make up 70% of corporate value, mid cap companies have the next 20% of value, and small companies are the last 10% of value across publicly traded companies. As a result of this division, mutual funds and ETFs are divided into the corresponding categories. The goal of the categories is to help reduce the number of funds that need to be reviewed as investment decisions are made, but can sometimes make it more confusing without an explanation. Below is a table that covers the different fund categories and examples of companies and funds for each.
As you can see, there are a number of possible categories for mutual funds. In each segment there are some companies that are very well known. There are also companies that will certainly not be household names. So what happens when you own a mutual fund? You instantly become a business owner in the United States. Business ownership has been a great way to build wealth over years. You are able to capture the productivity and value that corporations produce. Funds give you the ability to build immediately diversified portfolios because the fund owns a large portfolio of different companies.
Above there is also Foreign and World categories included. Funds that invest internationally, are typically classified into Foreign, World (includes US investments) and Emerging Markets. They are invested in larger companies whose headquarters are outside the United States. In many instances, there is hesitation to invest in international or foreign companies. The reality is that many international companies are household names. Some international companies that come to mind besides the ones listed above include Siemens, BASF, Panasonic, and Prudential. These are all companies that have a significant global presence. It would be hard to imagine not taking advantage of their future growth simply because they are identified as international.
As you review your retirement plan investments, whether you build your own portfolio with fund options, choose target date funds, or use the default investment option, I hope that this provides some insight. Don’t leave your financial future to chance. Educate yourself and be engaged in the process. As we continue our series on the different investment options, we encourage you to ask yourself, how is my 401k invested? If you find your 401k confusing, let us help.