The Opportunity Cost of Saving to a 401(k) Can Be Millions

January 16, 2015

The following blog was written by Robert Schmansky, CFP(r) and originally published by Forbes.

 

One of the reasons that very few retirement savers consider when choosing to invest in their employer retirement plan – yet one that impacts the vast majority of 401(k) investor – is the lack of available investment categories in their 401(k) plan.

 

There are many retirement experts who claim the number of investment options individuals are allowed to have in their plans should be fewer. Their position is that fewer choices will mean fewer chances for unsophisticated investors to make mistakes. The model plan for those who would like a low-fee retirement account with limited options is the government’s Thrift Savings Plan (TSP).

 

To the credit of these personal finance experts, even those retirement plans with many options often have funds that act little differently than the three stock and two bond funds in the TSP plan. Plans often simply provide more choices in the same five categories the TSP plan provides that do not provide true diversification benefits.

 

The issue that thoughtful investors should be concerned with however is not simplicity to choose fewer funds, but the ability to improve outcomes (see my past writing on how to improve retirement investing through advice rather than products and how there was no large cap US stock “lost decade” for diversified investors). Reduced choice has a real cost on the retirement ability of individuals who do not weigh options outside their employer plan.

 

I often speak to military members on financial basics, and I describe the TSP is much like MRE’s (meals ready-to-eat); it offers enough to survive but you prefer just about anything else. Like the TSP, most 401(k) fund menus I find are like a select few MRE kits: impersonal, lacking in basic necessities, and potentially damaging if you plan to live on it alone for several decades.

 

Perhaps the most obvious asset class missing from the vast majority is international small cap. The US small-cap premium has been shown to be ~3.5% over large-cap stocks over time, and it is likely that international markets will offer similar returns as investment options have become more available.

 

Another popular tilt to capture additional return in equities is value investing. Adding a value-tilt to our portfolio above allows investors to capture a value premium of ~4.8% over growth investing over time. Again, most 401(k) plans are largely large-cap and growth tilted, ignoring the potential returns that valuing investing may offer the long-term investor.

 

Additional asset classes that many plans ignore are emerging markets equities, foreign bonds, inflation-protected bonds, and real assets including global real estate funds.

 

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