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How index funds can transform your 401(k) plan

06/30/2010:

How many index funds are in your 401(k) plan? 0, 1, 2? If your plan has even three index funds, your plan is a rarity indeed. When it comes to retirement plans, we think 100% of your stock and bond funds ought to be in index funds.

The typical 401(k) plan tends to offer actively managed mutual funds with just a few if any lower-expense index mutual funds. Actively managed funds typically incur greater costs due to:

  • All the research and the costs of trading stocks and bonds within the fund
  • Added costs to manage an actively-managed fund (more people, support, etc…)
  • Distribution (the person who sold your company the plan) and marketing that are charged via 12b-1 fees, front or back-end loads, etc…

Here’s the catch. For each extra dollar of expense incurred, the fund must overcome these expenses to outperform its benchmark index (usually the success measure of the fund).

These higher expenses would be fine if evidence supported that actively-managed funds were consistently outperforming the indexes. While no one can predict the future, history has sided with index funds. Across major asset categories, the benchmark indexes have historically beaten 60% to 75% of actively managed mutual funds over a five-year period of time, according to the Standard & Poor’s Indices versus Active Funds Scorecard.

When you understand this, it’s down right surprising how rare the index-based 401(k) plan truly is. Some of us are working to change all that and give Americans what we believe is a better 401(k) plan.

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