Hi All!

So you are all set up with your retirement accounts! What's next?

As you know, companies were very excited about the 401K in the 1980's and most companies switched from pension plans to a 401K plan right away.

The reason why companies loved it was simple. Companies were no longer required to be responsible for their employee's retirement. The onus of retirement planning was on the employee! The employee had to decide to sign up for the 401K. They had to decide how much to put in it every year and how to invest the money. Whew!

Now we are back to you! How do you invest your money in your retirement account?

Retirement accounts like the 401k typically offer you a choice of mutual funds.   I'm going to divide them into Index Funds and Actively Managed Mutual Funds.

Index Funds follow an "index". An index can be a "total market" fund (all the stocks offered in the US, a Small Cap Index (the Russell 2000), an International Index or the popular S&P 500 Index.

Let's talk about how this works using the S&P 500. The S&P 500 has the top, based on size,  500 companies in the US.  Sometimes a company starts doing really well and supplants one of the companies on the S&P 500. The manager of the index fund then buys the stock of the new company and sells the stock of the company that is no longer in the top 500. This happens around 20-25 times a year. As a result, the fees to run the Index fund are very low at around .03-.05%.

Actively Managed Funds will have a specific goal that they are trying to achieve. It may be based on a planned retirement year or the type of stocks (value vs growth, small cap, mid cap, international...) they want to invest in for that mutual fund. Your manager will analyze the stocks and buy/sell the stocks based on what they think will happen in the future. This is expensive. You get to pay a salary for your manager and for all the buying/selling of the stocks. Typically this costs you about 1.5-2% a year.

Now let's talk about the performance of an Index Fund vs an Actively Managed Fund. How much do they make every year on average?

On average, a total market fund will earn around 8% per year. This is a fairly conservative number so it's the one we will use. As a comparison, the S&P 500 has, since 1957,  earned on average over 11% a year. In the past 50 years the S&P 500 has earned money 40 of those 50 years. Not too shabby!

How do the Actively Managed Mutual Funds do? 85% of them perform worse than the S&P 500. 

Let's see what those fees look like if you do pick an Actively managed Mutual Fund:

Let's say you put $10,000 a year into your 401K. Let's use the total market earnings of 8% to estimate the growth of your account.

Years                  Returns                                                 Savings

20 years                 8%                                                     $540,000

20 years                 6% (-2% for active management)     $422,000

You "lost" $120,000 in fees for the Actively Managed Mutual Fund.   

40 Years                 8%                                                     $3 million

40 Years                 6% (-2% for active management)      $1.7 million

You "lost" $1.3 million in fees for the Actively Managed Mutual Fund.

Obviously, fees have an huge impact on how your money grows! Next time we will talk about the Prospectus of mutual funds. How can you tell what it is investing in and what it charges!

See you then!