401(k) retirement plans that do not offer a selection of index funds may not afford employees the same financial advantages as 401(k) plans that do. According to the Securities and Exchange Commission, index funds are mutual funds designed to track and match the performance of an index such as the Dow Jones Industrial Average. These indexes are designed and selected by financial companies such as Dow Jones to provide market performance benchmarks that can be used to monitor industry and economic performance over time. Several reasons exist as to why mutual funds that track these market benchmark monitors should be used in 401(k) defined contribution retirement plans.
• Lower cost
401(k) plans that offer index funds give employees the opportunity to invest in financial instruments at a lower cost. This is because index funds are ‘passively managed’ meaning the capital in the index fund is invested in such a way that costs are not incurred as much as with a non-indexed mutual fund. For example, also per the Securities and Exchange Commission, index funds are less likely to realize capital gains and therefore have lower tax related costs. There are also additional costs incurred when a non-indexed mutual fund actively invests mutual fund assets.
Since index funds follow indexes by investing in similar financial products, the objective of the fund is pre-defined and fixed. In effect the company that creates the index does the research and the index mutual fund uses that research to base its investment decision on. Mutual funds that do not track indexes are not necessarily pre-defined and may change investments frequently. This means the 401(k) owner must stay up to date with the mutual fund’s financial reports in order to better assess what the fund is investing in and how well it is managed. This is made evident in a Bureau of Labor Statistics report that quotes as few as 39 percent of 401(k) owners know how their 401k money is apportioned.
• Investment flexibility
Another reason why 401(k)s should offer index funds is because other financial products offered through the 401(k) may not suit the individual employees retirement planning goals. To illustrate, an employee in their 20s or 30s is more likely to be able to invest in a small-cap index fund than someone in their 60s because these are riskier companies to invest in. Moreover, higher risk funds have a greater chance of leveling out risk over time, and younger investors have more time to regain losses if the investment loses value. Better yet, if the index fund is an ‘enhanced index fund’, then it might even perform better than the index itself.
• Higher returns
When lower cost is combined with greater average performance overall, index funds offer 401(k) owners a greater opportunity to increase their retirement savings. Not only can they benefit from 401(k) employer matching which is bonus money from an employer, but that yield itself can be compounded via investment in a well chosen index fund. Moreover, according to Ron Lieber of the New York Times, the majority of other mutual funds have not performed as well as index funds over a two decade time period ending in December, 2011.
.• Hedging and diversification
Index funds can also serve the purpose of hedging investment risk and are structurally diversified by design. In other words, an index fund in a 401(k) plan may be able to balance out declines in value by investing in counter cyclical index funds. To illustrate, during an economic down cycle that is also accompanied by a high level of currency devaluation, a precious metal index fund may perform better than other types of diversified mutual funds.