Is Your Company Retirement Plan Up to Snuff?

One of the occupational hazards of being a Morningstar analyst is that friends and family members are constantly seeking my opinion on various investments. Whether it's an elderly relative asking what I think about a certain high-yielding investment (Answer: Quit chasing yield and focus on total return.) or a friend of a friend wondering whether she should hang on to  Oakmark Fund (OAKMX) despite its recent malaise (Answer: Yes.), people don't seem to hesitate to come to me with questions.

One of the most frequent questions, by far, is: Can you help me allocate my 401(k)? Along the way, I've seen scores of company plans, ranging from thoughtfully constructed lineups chock-full of superb choices to plans that made me wonder, "What on earth were they (the plan administrators) thinking?"

The broad disparity in quality among retirement plans argues for carefully scrutinizing your company plan before allocating valuable resources to it. True, it's hard to beat the tax-deferred compounding that a 401(k) plan affords. But if you have a fixed pool of investment dollars, it's probably wise to consider investing in an IRA (particularly a Roth IRA), over which you exert more control, before maxing out on a lousy company plan.

Here are some key considerations to bear in mind as you go about evaluating your own company plan.

1. Am I earning a match?
Many companies match their employees' contributions up to a certain percentage of their salaries. Firms' reasons for doing may not be entirely altruistic; for a plan to fall within government guidelines, contributions from the company's rank-and-file employees can't be substantially lower than contributions from the firm's top brass, so a company often has a strong incentive to get everyone to participate. But whatever the motive, employer matching contributions are an important perk that you should plan to take full advantage of. Even if further analysis indicates that your retirement plan is subpar, contribute at least the percentage your employer is matching you on. After all, a 100% match is like a 100% return on day one.

2. What are the costs?
In an ideal world, defined-contribution retirement plans would include only the lowest-cost investments around. After all, most companies, particularly larger ones, pool the assets of a number of employees, who together should be eligible for the low-cost, high-minimum "institutional" share class of a given mutual fund.

In the real world, however, many plans are chock-full of high-expense options. That's because some companies outsource the plan's administration to the investment firm managing the assets; that firm, in turn, extracts fees for the plan from the funds' expense ratio. In essence, the employees are paying for the administration of the plan out of their investment returns.

So how do you know if your plan is overly costly? Check out the expense ratio for each of your investment options. If the investment options in your 401(k) plan are mutual funds, check out their expense ratios on Morningstar.com; be sure to match the share class you own with the one on the site. If you can't find the information about your 401(k) plan investments on Morningstar.com, ask your company for a prospectus for each of them.

In general, it's a mistake to pay more than 1.00% for a bond fund and 1.25% for a stock fund. You might consider a stock fund with an expense ratio above 1.25%--particularly if it's a small or specialized offering, such as an international small-cap fund--but  you shouldn't go much higher.

3. How good are the core funds?
Because the assets in your company plan are apt to consume a big share of your retirement nest egg, it's essential that your plan feature worthwhile core stock and bond funds--anchor holdings to which you can devote 90% or more of your portfolio.

Start by assessing the quality of your plan's large-cap stock funds--those that land in Morningstar's large-value, -blend, or -growth categories. Your plan needn't feature top-flight funds from each of these three groups, but it should boast one or two sensible, well-diversified options. Index mutual funds, which mirror the holdings and returns of a given market benchmark, are showing up in more and more retirement plans, and can make superb anchor holdings provided their costs are reasonable. (Look for index funds with expenses of less--preferably much less--than 0.30% or so.) If your plan's core stock funds have active stock-pickers at the helm, check to see whether they have seasoned management teams and are well diversified across holdings and sectors. And for a bird's-eye view of how a stock fund is apt to behave in given market environments, review its calendar-year returns and rankings relative to its peers over the past five or so years.

You'll also want to assess the quality of the core bond funds in your plan, as such offerings are apt to take up a greater share of your portfolio as you grow closer to retirement. I'm encouraged to see more and more company retirement plans featuring funds run by "marquee-name" bond managers such as PIMCO, Western Asset, and BlackRock. Fidelity, Vanguard, and T. Rowe Price, all of whom have a big presence in the 401(k) market, also run topnotch bond funds.

4. How broad is the lineup?
Once you've checked out your 401(k) lineup's entrees, turn your attention to the side dishes. Does your plan offer worthy options for diversifying? And if it does offer a varied menu, how good are the funds? Uneven quality is a particularly big consideration if all of the funds in your 401(k) plan hail from a single fund company. After all, few shops are good at everything.

In this vein, it's particularly important to check up on whether your plan offers viable foreign-stock fund options. As I noted in a previous column, the typical investor's portfolio tends to be underweighted in foreign stocks, and for no good reason. (The U.S. market accounts for just 50% of the value of the global market, yet most U.S. investors devote far more than half their assets to U.S. stocks.)

Secondarily, check up on whether your plan feature specialized stock funds, such as small-company offerings, as well as bond offerings to help add spice to your fixed-income portfolio, such as high-yield or inflation-protected funds. A lack of these niche offerings shouldn't keep you from investing in your company retirement plan, of course, but it will help you know what fund types you might emphasize in your other accounts.

5. Are there any simple options?
As I've noted before, I'm a big fan of one-stop funds that are designed to provide you with complete stock and bond exposure in one fell swoop. Such funds, which are increasingly appearing on 401(k) menus, can be a terrific choice for investors who don't have the time or the inclination to allocate their own assets. Some of these funds maintain fixed stock/bond allocations, while others actively "mature," or grow more conservative, as the investor reaches retirement. Here again, it's not a deal-breaker if your plan doesn't offer such an option, but the lack of a one-stop choice will mean that you'll have to pay more attention to allocating your assets across the various funds in the plan.

6. What are my alternatives?
So you've evaluated your 401(k) and found it lacking on some or all of the preceding criteria. What should your next steps be? First, determine whether your plan is seriously subpar or merely lacks a full array of attractive choices. If you discover that your 401(k) plan carries ultrahigh costs and subpar management, for example, you have strong motivation to investigate your other tax-sheltered options before shifting assets into the plan. (You should at least contribute enough to earn any matching contributions, however.) But if your plan features one or two solid picks, you should plan to invest in them and look to other tax-sheltered accounts--an IRA or your spouse's 401(k) plan, for example--to fill in areas where your company plan falls short. Click here for some tips on getting the most out of your 401(k) plan. 

A Note on Planning Questions
While I'm always happy to hear from readers and read every e-mail I receive, I cannot provide you with specific financial-planning advice or help you decide which funds to pick for your 401(k).