Dave Ramsey issues a firm caution about 401(k) investment choices

For many U.S. workers, the packet that arrives with an employer-sponsored 401(k) can feel less like a guide to retirement savings and more like reading a language they do not speak.

Usually, employees are expected to go through the forms, brochures, and introductory letter so they can choose investments and decide whether to take full advantage of an employer match.

“But once you’ve read the letter, the rest of the materials simply don’t make a lot of sense,” personal finance personality Dave Ramsey wrote for Ramsey Solutions. “There’s information about vesting, beneficiaries, equities, risk assessments and 401(k) selections — but nothing’s clicking.”

“The only thing that seems clear is that investing in a 401(k) is important business,” Ramsey continued. “Your ability to retire someday depends on you getting it right today.”

“But how can you make such major, long-term decisions when you don’t even understand what the choices are?”

Ramsey’s view on 401(k) investment choices

Enrollment packets commonly give workers a selection ranging from a few funds to more than a dozen, along with options that go beyond standard offerings.

Depending on the plan, those choices can include mutual funds and variable annuities. Some plans may also offer alternatives such as private equity.

Plan documents also tend to push target date funds, which are mutual funds built around a preset mix of assets based on a worker’s expected retirement year. At first, the money is weighted more heavily toward stock funds, then shifts gradually to more conservative holdings as retirement gets closer.

“We don’t recommend target date funds because by the time you’re ready to retire, your 401(k) will be mostly invested in bonds and money markets that won’t give you the growth you need to support you through 30-plus years of retirement,” Ramsey wrote.

Charles Schwab acknowledges that target date funds carry risks, but says they also offer an important benefit.

“Target date funds typically invest in both U.S. and international stocks and bonds, helping reduce reliance on any single market or sector,” Schwab wrote. “This broad diversification can help smooth returns over time and reduce concentration risk.”

Annuities inside 401(k) plans

Some employer-sponsored 401(k) plans include annuities as an investment option.

An annuity is a contract with an insurance company in which a person contributes money that grows over time in exchange for guaranteed payments in retirement, creating a steady income stream.

Fixed annuities work much like traditional savings products and generally offer a set interest rate that is often at or below 5%.

“Sounds easy and predictable, but that low rate of return won’t stand a chance against the rate of inflation,” Ramsey wrote.

Fidelity Investments offers a different view, as long as the annuity can generate enough income.

“Fully covering essential expenses with lifetime guaranteed income sources can provide peace of mind that you’ll never outlive your money, no matter how long you live,” Fidelity wrote.

“Annuities can also be simpler to manage and help provide greater protection against elder fraud and abuse than can an investment portfolio alone,” Fidelity added.

Mutual funds in 401(k) plans

Mutual funds are the most common investment option in 401(k) plans. These professionally managed funds pool money from many investors to buy shares in dozens or even hundreds of companies at once.

By spreading money across a wide range of holdings, mutual funds automatically diversify a portfolio and reduce the risk tied to owning individual stocks.

Ramsey suggests dividing investments equally among four kinds of mutual funds: growth and income funds, growth funds, aggressive growth funds, and international funds.

Growth and income funds, often large-cap or large-value funds, invest in well-established U.S. companies and are meant to provide stability and steady performance.

Growth funds, usually mid-cap stocks, come with moderate volatility but can offer dependable long-term appreciation.

Aggressive growth funds, often small-cap or startup stocks, sit on the riskier end of the scale and offer greater upside potential in exchange for less stability.

International funds invest in companies outside the United States and add geographic diversification.

“If you put 25% of your 401(k) into each of these types of mutual funds, you’ll spread out your risk and ensure that you’re not putting all your eggs into one basket,” Ramsey wrote.

JPMorgan, however, says investors should be more careful with that approach as retirement gets closer.

“For those closer to retirement, it’s essential to ensure appropriate diversification across a mix of stocks and bonds, as well as across U.S. and international markets,” the financial services firm wrote.

This article is for informational purposes only and should not be construed as individualized tax or investment advice.