I have a low regard for the 401(k) system. It’s supposed to provide a tax-deferred way for plan participants to save for retirement. Instead, it is a trough from which advisers, brokerage firms, and mutual fund families feed, depleting returns by billions of dollars of obscene fees every year.

And they’re the ones who are supposed to be helping you maximize your 401(k) returns.

The basic problem is the interest of these vendors is in direct conflict with the interest of plan participants. The vendors want to maximize profits. They achieve this goal by populating the plan with expensive, actively managed mutual funds (where the fund manager attempts to beat a designated benchmark), preferably its own proprietary funds.

As a plan participant, you want to maximize your returns. It’s in your best interest for the plan investment options to include only low-cost stock and bond index funds, preferably in pre-allocated portfolios at different risk levels. Low costs correlate with superior returns. But they also mean lower profits for advisers, brokers, and mutual fund families.

Plan participants, many of whom are not sophisticated investors, are left with the daunting task of putting together risk-adjusted portfolios suitable for them from a wide array of poor choices. This is not easy or fair.

Here are some guidelines that will help you make better selections from your 401(k) options.

Look for index funds. Check the fund options and see if there are any index funds available. Typically, these funds have “index” as part of the fund name. The goal is to find an index fund that uses the following benchmarks:

The ideal plan would have index funds that use each of these benchmarks as an index. If you are among the few fortunate employees to have such a plan, take these steps:

  1. Determine your asset allocation. You can do this by taking a free risk-capacity survey. There are many on the Internet. I have a good one on my website.
  2. Put 70 percent of the amount allocated to stocks in the index fund that benchmarks the Barclays Capital U.S. Aggregate Float Adjusted Index or the Wilshire 5000 Index.
  3. Put 30 percent of the amount allocated to stocks in the index fund that benchmarks the Total International Stock Index or the FTSE All-World Ex US Index.
  4. Put 100 percent of the amount allocated to bonds in the fund that benchmarks the Barclays Capital U.S. Aggregate Float Adjusted Index or Barclays Capital U.S. Aggregate Bond Index.

Look for target-date funds. Most plans now include target-date funds. These funds permit you to buy just one fund, which automatically becomes more conservative over time. All you do is pick the fund with the year in its name closest to your projected retirement date. These funds can be great choices for investors, but they’re not right for everyone.

Check to see if the underlying funds are index funds. Vanguard’s retirement funds consist solely of its low-cost index funds, making them a particularly good choice.

Even if the underlying funds are not index funds, picking them might still be a better choice than trying to put together a portfolio from the many funds available to you. Be sure to check the asset allocation of the target-date fund and see what percent of the fund is allocated to stocks versus bonds. Make sure the asset allocation is right for you.

Focus on cost. If you are stuck with a selection of mostly actively managed funds, focus on the cost of the funds. The cost of a fund is listed as its “expense ratio.” If a number of funds indicate they are attempting to beat the same benchmark, pick the fund with the lowest expense ratio. Try to find funds that indicate they use the benchmarks noted above.

Use a conversion chart. In The Smartest 401(k) Book You’ll Ever Read, I provide a list of common domestic stock, international stock, and bond funds and list the expense ratios of these funds. You may find this list helpful in making the best of a bad situation.

Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, and The Smartest Retirement Book You’ll Ever Read. His latest book is Timeless Investment Advice.

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