Overwhelmed by 401(k) options?

By Morningstar

Because I work at Morningstar, a lot of family members and friends ask me to make recommendations for their 401(k) plans.

I'm always glad to help. After all, I want those who I care about to make good choices for themselves, financially and otherwise. I also think of it as an opportunity to step into the shoes of a more typical investor and see what they're up against.

If my friend Oscar's experience is any indication, many investors face a bewildering number of choices in their 401(k) lineups. Oscar recently asked me to help him pick investments for his first 401(k) plan, and he was overwhelmed.

I couldn't blame him. His employer had given him a long list of funds to choose from -- 36 in all -- that would have taken an awful lot of time and effort to research, even for experienced folks such as me. Not only did Oscar have a daunting number of options, he had to decide on an overall asset allocation and how much of each fund he wanted to own. Had he not known me, he would have probably made all of those decisions without much guidance.

If you're struggling with a similar situation, don't fret. To help you find your way, here are a few strategies that Oscar and I considered.

Option 1: Autopilot

Initially, this is the route I urged Oscar to take. He wants to invest, but he doesn't want to spend a lot of time doing the necessary legwork to choose and monitor his investments.

That's why I suggested he invest in one of his plan's target-retirement funds. Target-retirement funds, also known as target-date or target-maturity funds, are about as low-maintenance as they come. The only thing Oscar would have had to do is pick the fund that corresponds with his retirement date, and Fidelity, which runs his plan, would handle the rest.

Oscar expects to retire around 30 years from now, so he'd choose Fidelity Freedom 2040 (FFFFX). The fund, which is designed to offer one-stop exposure to stocks and bonds and is composed of a diverse mix of Fidelity funds, becomes increasingly conservative as an investor's retirement nears. As Oscar approached retirement, the fund would lighten up on stocks and increase exposure to bonds.

I liked this option most for its simplicity, but ultimately, Oscar decided he didn't want his portfolio on total autopilot. He wanted to control his asset allocation. With three decades until retirement, he thinks he can handle the volatility of an all-stock portfolio, and the target-date option includes a modest bond stake. It also has a fairly conventional allocation to international funds (around 25% of the portfolio), and Oscar wanted more. Target-retirement funds make sense for one-stop shoppers, but make sure your plan's options work for you.

Option 2: The middle ground

After Oscar ruled out the easiest option, we moved on to the next-least-complicated solution possible. Oscar's plan included some good, actively managed funds, such as Fidelity Dividend Growth (FDGFX), but we ruled them out because they would require more-regular monitoring than he desired. (Fidelity funds change managers rather frequently.)

Because he wanted to control his asset allocation while taking a relatively hands-off approach to his investments, index funds made the most sense. Fortunately, his plan included Fidelity Spartan Total Market Index (FSTMX) and Fidelity Spartan International Index (FSIIX), which offer broad exposure to domestic and international markets with rock-bottom costs. Oscar put 60% of his portfolio in Total Market Index and the remaining 40% in International Index. He'll have to reset that balance every so often, but that's about it, at least for now.

Of course, Oscar's all-stock portfolio is fairly bold, and it wouldn't be the right asset allocation for everyone. How you split your portfolio among stocks, bonds and cash should hinge on your age, when you want to retire, how much you're saving each year and your risk tolerance.

One tool you can use to come up with an appropriate asset allocation is Morningstar's Asset Allocator. (This tool is available free for 14 days by clicking here.) Asset Allocator simply requires you to enter your current portfolio value, your savings rate, your age and when you hope to retire. It then helps you figure out how much you should have in stocks and bonds, and it gives guidance on how much you should have invested in large caps, small caps and international stocks. If it looks like you'll fall short of your goal, Asset Allocator lets you tweak each of these variables to help determine how to make it happen.

Option 3: The fund picker's portfolio

Obviously, Oscar's simple, all-index plan wouldn't work if you didn't have any broad-based indexes from which to choose. Your 401(k) plan also might offer access to some worthy active managers, giving you a shot at beating the markets. You'd have to do some homework to identify them, though, and it'd require constant attention to make sure they were meeting your expectations or, for that matter, were still at the helm.

But before you delve too deeply, spend some time identifying which funds in your plan would make good core holdings. These would be your portfolio's steady workhorses, which should account for at least 75% to 80% of your holdings. They typically reside in the large-blend or large-value categories, though a conservative large-growth fund could do the trick, too. On the bond side, look for a high-quality intermediate-term bond offering. With the remainder of your portfolio, you could add niche offerings that focus on small caps, emerging markets or high-yield bonds, but don't go overboard.

Next, you could delve more deeply into your fund options. There's the temptation to be wooed by returns alone, but don't make that mistake. Yes, you want to choose funds that have delivered solid returns over the long haul, but don't stop there. Ask yourself whether the manager is experienced or a newbie. Also, with expenses being among the most reliable predictors of long-term performance, it makes sense to gravitate toward the lowest-cost options in your plan. Finally, see what Morningstar analysts have to say about the funds. Morningstar's Fund Analyst Reports provide in-depth analysis for roughly 2,000 funds, including most high-profile funds included in 401(k) plans. Our analysts' Fund Analyst Picks provide a sampling of what funds we like the most.

Option 4: Full control

If you don't like what's on your 401(k) menu, you might be able to go outside it entirely. An increasing number of employers are allowing participants to invest outside their plans using their provider's self-directed brokerage option, often called a "window."

Using self-directed brokerage, participants can put part or all of their assets in investment vehicles of any kind. You'd be in complete control of your 401(k), but remember that with freedom comes responsibility.

This article was reported and written by Christopher Davis for Morningstar.