Does your IRA or 401(k) contain mostly actively managed funds or index funds? Do you know the difference between those two funds? Do you even know what's in your IRA or 401(k) at all? If any of those three questions give you pause, it's probably time to review your retirement account and think about whether you are investing properly to meet your needs.
Consider the difference between actively managed funds and index funds, starting with their objectives. Index funds attempt to match the return of a given index (such as the S&P 500 or the Russell 2000). These funds are easy to manage, because all that's required is buying the stocks in that index and maintaining them in relative proportion to their importance in that index. Actively managed funds employ fund managers who are constantly attempting to beat the market and provide a greater return than the index average.
The tradeoff is in fees. Actively managed funds have significantly higher fees than index funds on average (0.84% for active funds versus 0.11% for index funds, according to The Motley Fool). Not only must an active fund manager provide a better return than the market, the difference must be large enough to cover the higher fees.
While a 0.73% difference in fees doesn't seem like much, remember that as your retirement funds grow, overall fees grow since they are assessed as a percentage of assets in your account. Higher fees can make a difference of hundreds of thousands of dollars over a lifetime of retirement investments.
An analysis by NerdWallet found that a millennial with a $25,000 starting investment and annual $10,000 additions would save $533,000 over the course of a 40-year retirement investment if fees were cut from 1.02% to 0.09% (assuming a 7% average annual return). A 0.93% difference is not hard to find when switching from an active fund to an index fund.
You may find an active fund manager that crushes the market and provides stunning returns – but the odds are against you. Research from Standard and Poor's in May 2017 suggests that you have a nearly 5% chance that picking an actively managed domestic equity mutual fund will provide a better overall return than a passively managed index fund.
If your chosen retirement vehicle is an IRA, you have the freedom to choose any type of account that you want. You can simply do research on the index funds that have the lowest fees and perform up to the index benchmark (which should always be the case), and make your choice from those options. An employer-based 401(k) plan may have limited options, but generally at least one index fund will be available to you.
Of course, if you contribute very little to your retirement accounts – or have no retirement accounts at all – you have some work to do before considering what type of investments to select.
Make sure that you take full advantage of any employer-based 401(k) account, especially up to any matching fund levels. Put away as much money as you can afford into your IRA or 401(k) up to the annual limits. For 2018, 401(k) limits have risen to $18,500 per year with an extra $6,000 if you are at least 50 years old, and IRA limits stay at $5,500 with an extra $1,000 if you are at least 50 years old.
Unless you can pick a great active fund manager, or are talented enough and have enough time to manage your own funds, we suggest going with low-cost index funds. If you do decide to go with an active fund with higher fees, just make sure that you are getting your money's worth for the extra expense.
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