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By Jason Stipp and Christine Benz | 05-09-2013 03:00 PM

401(k) Pros and Cons


Jason Stipp: I'm Jason Stipp for Morningstar. As company defined-benefit pension plans become a rare species, the 401(k) has become many investors' primary investment vehicle. But they are not all cut from the same cloth. Here to talk about the pros and cons of 401(k)s is Christine Benz, our director of personal finance. Thanks for being here, Christine.

Christine Benz: Jason, great to be here.

Stipp: So 401(k)s can be a great vehicle for investors. In fact, it’s maybe the only choice through your employer for a lot of investors. There are some pros and cons you should keep in mind about investing in 401(k)s. Let's start with the pros of 401(k)s. You say one of the biggest is just the discipline that a 401(k) brings to the retirement-investing process.

Benz: Right. It's enforced discipline. Your contributions go in without you having to lift a finger except to initially get the thing going. So it does keep you investing in good markets and in bad, and that I think tends to serve as a safeguard against investors' own worst behavioral tendencies.

The other thing is that they really make it easy for people who are a little bit lazy about their investments. So you can add on nice features that can get your plan back into whack. So you can put in place auto-escalation in a lot of plans, so your contributions bump up if you get a raise in salary. You can also auto-rebalance if you want to have your portfolio periodically scaled back to your target allocation. So those are additional features that a lot of plans have these days, and they really make it quite easy to stay disciplined and stay on track with your plan.

Stipp: Another very important feature of many 401(k) plans is some form of employer match, which can really make your money work a lot harder.

Benz: Absolutely. So regardless of the quality of your plan, once you've done a little bit of homework on what the investment options are like, you do want to contribute at least enough to earn that match if your company is indeed offering one. That's something that you will not get, obviously, if you invest outside of the confines of a plan.

Stipp: One thing that a plan can bring to investors is because it may be a bigger company you might have access to funds you wouldn't necessarily have access to otherwise, or you might get a better deal on some of those funds perhaps?

Benz: Absolutely. So there are institutional share classes of mutual funds. They often feature very, very low costs alongside the share classes that are available to retail investors buying the funds on their own. So that is a nice perk for 401(k) investors. If they are in a larger plan where the management company has swung a nice deal on behalf of participants, your total cost load for owning that plan can be very, very low.

An additional thing, Jason, is that there are investment types that only appear within 401(k) plans. You won't find outside of them. So stable-value funds, for example, would be one option. The key feature there is that you do typically get a higher interest rate than you would earn on your cash, but you get all of the safety or nearly all of the safety of cash, or you get cashlike attributes, I should say. People who invest in the Thrift Savings Plan that is available to federal government employees have a nice option that is somewhat similar called the G Fund, where you have higher interest rates, but again a lot of safety built in. You will not get these particular funds outside of the 401(k)/403(b) plan confines.

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