A common question is whether or not to choose index funds or target-date funds from the investment options offered in 401(k) plans.

Let's look at the pros and cons of each. 

Index Funds

I am a fan of index funds and can understand why they are a popular choice for both individual investors and financial professionals. At their best, index funds are style-specific and low cost. Index funds from providers like Vanguard, Fidelity Investments, Charles Schwab Corp. and a few others are very low cost. Here are the expense ratios for some popular index funds tracking the S&P 500 Index. (See also: The Lowdown on Index Funds.)

  • Vanguard 500 Index (VFINX): 0.17%
  • Fidelity Spartan 500 Index (FUSEX): 0.09%
  • Schwab S&P 500 Index (SWPPX): 0.09%
  • SSgA S&P 500 Index (SVSPX): 0.15%

Not all index funds are low cost. Case in point is the Rydex S&P 500 Index (RYSOX) with an expense ratio of 1.59%. This is astounding when you realize this is exactly the same product as the low-cost S&P 500 index funds mentioned above. (See also: Target-Date vs. Index Funds: Is One Better?)

Index funds span the gamut of stock and bond investment styles both domestically and internationally. Many track mainstream indexes like the S&P 500, the Russell 2000, the EAFE and others. Others may track some obscure indexes that in some cases were created with back-tested data. I’ve rarely seen these in 401(k) plans, thankfully.

If a plan offers several low-cost index fund choices, perhaps an S&P 500 or total stock market index fund, an international stock index fund and a bond index fund, there is enough variety to serve as the core of a diversified portfolio. Add index funds that cover small-cap stocks, mid-cap stocks, emerging market stocks and perhaps real estate investment trusts (REITs) and participants can easily build a well-diversified all-index fund portfolio. (See also: Ways to Cut 401(k) Expenses.)

The Target-Date Fund Decision

If a 401(k) plan participant is looking for a managed solution, target-date funds are an alternative to consider if offered by their company’s plan. In my opinion, this should be an either/or decision. Either invest all of a 401(k) account in the appropriate target-date fund or invest in a selection of the investments from the plan’s open lineup. (See also: Target-date Funds: More Popular, Cheaper Than Ever.)

Generally, there will not be a choice in terms of the target-date fund family offered by a plan. Target-date funds can be found in many 401(k) plans. Most are funds of mutual funds and the three largest providers are Fidelity Investments, T. Rowe Price Group and The Vanguard Group (combined, their market share is about 80%). All three use their own funds as the underlying investments. Other firms may offer strategies, such as funds of exchange-traded funds (ETF), but using fund of mutual funds remains the most common structure. (See also: Target-Date vs. Index Funds)

Target-date funds, like any investment, require thorough analysis to determine if they are the right choice. Retirement plan sponsors also need to perform their due diligence on target-date funds before offering them as an option in their company’s plan. There are wide variations in the equity percentages at the various target-dates and in the various glide path philosophies. The glide path is the reduction of equities into and during retirement until it flattens out at some age. This assumes that you will hold the target-date fund virtually until death. (See also: Few Target-Date Managers Invest in Their Own Funds.)

A common misconception I hear from plan participants is that target-date funds lower investing risk. This is not necessarily true. Target-date funds came under a lot of fire in 2008 when many shorter-dated funds suffered larger-than-expected losses. For example, the T. Rowe Price 2010 fund lost 26.71%, and the Fidelity Freedom 2010 fund lost 25.32%. These losses seem excessive for funds designed for investors within two years of retirement at that point in time. Don’t assume that target-date funds provide any extra level of protection from downside risk than their asset allocation would imply.

Index Funds as Part of the Mix

Actively managed mutual funds have gotten a bad rap, and in many cases this is well deserved. However, not all actively managed funds are a bad investment choice. Many offer consistent returns, are well managed and have reasonable expenses. The choice in my mind isn’t index fund or target-date fund, rather its target-date fund (or other managed account option) or a menu of the other funds offered in the plan. (See also: Mutual Funds Commonly Found in Retirement Plans.)

It is best to have an asset allocation in mind for those going this route. If the 401(k) plan is the only investment, then this account is the only one to worry about. For those that have other investment accounts such as an individual retirement account (IRA), a spouse’s workplace retirement plan and taxable investments, a 401(k) plan allocation should be looked at as part of an overall portfolio. (See also: 401(k) Risks Advisors Should Know About.)

The Bottom Line

Choosing between index funds and target-date funds in a 401(k) is a common dilemma. Index funds are generally a good, low-cost choice that is very investment-style specific. Target-date funds offer professional management. The choice should first be between either a target-date fund (or other managed account option) and the open funds on the menu, both active and index.

It is important for plan participants to understand the particulars of the target-date funds offered and most certainly that they don’t necessarily dampen investment risk, at least to the extent that some may think. Index funds can be a great choice but not all index funds are as low cost as others. (See also: The Impact of 401(k) Outflows on Advisors.)