While we can discuss risk and the risk of too little risk, the real risk might be where you put your money in your 401(k). In fact, what your plan offers may be so limited that your choices boil down to good and not-so-good. Most common, garden variety 401(k) plans offer index funds, lifecycle funds and if you are fortunate, actively managed funds.

Life cycle funds represent a group of offerings focused on a particular target year that you would like to retire. These are essentially actively managed funds that shift, at least in theory, from aggressive to conservative over the course of your career. Actively managed funds tend to pick a sector, such as large-cap stocks, and focus their investment prowess to the best possible return. Index funds are designed to track an index of stocks (or bonds), ranging from the top 500 companies to indexes that track the smallest.

Before I tell you about how index funds can differ (which is odd, considering an index fund essentially attempts to mimic the published index) I want to talk about a person who wrote me last week. Although her email sounded panicked, she knew that there was little she could do about what her 401(k) plan was doing to her portfolio.

She told me she had chosen four funds in her 410(k) to invest in, the bulk of which was directed towards a small cap index and a mid-cap index run by Merrill Lynch. She believed, and rightly so, that this would be where the recovery would take place. These funds had always done well she told me, and when the markets turned sour and her funds were brutally beaten down, she kept her investment dollars streaming in.

Because markets do recover and her investments remained consistent, her portfolio value is now within a couple of thousand dollars of her year end balance in 2007.

Her concern was a change her plan sponsor was making in those funds, switching to another group of funds offered by Northern Trust. The reason according to a notice she received from her plan sponsor was the cost of fees.

Focused on Fees
In general, index fees should be as low as possible.
The idea is simple:
1.There is no trading to be done between the time the index is set and the next time it is adjusted;
2.There are no research fees;
3.And inside your 401(k), there should be no 12b-1 fees (the cost of advertising for new investors paid for by the current investors);
4. And lastly, because the company, in her case it was Kroger, the fiduciary responsibility (what a plan sponsor does is based on the assumption that it is best for the employee’s future) demands the best deal.

That would be in a perfect world. Not to pick on her company’s plan, but it doesn’t fair very well when they are searched for using BrightScope, a retirement plan quantifier (information about their invaluable service can be found here) and this had her worried. Just because she has a plan, doesn’t make it the best of all worlds, simply the one she has to live with.

Her plan was shifting her small cap index fund (with an expense ratio of 0.15%) to one that offered to track the same index but at 0.06%. At first glimpse, this seems like a good move. Lower fees are always good. Second glances however show how poorly the new fund offering has done compared to what she had before. Her new fund has a year-to-date performance of 12.52%; her old fund had chalked up a 29.83% return. Year-to-date, the Russell 2000 index of small cap stocks has racked up an impressive 22.43%.

Why would they do this, she asked? Other than being able to suggest that they are trying to do all they should for you, substituting one index for another based simply on fees, there seemed to be no clear answer. It is troublesome to be sure but not uncommon. It is also evidence that not all indexes are created equal or cost the same.

Index funds are subject to all sorts of influences. Fees run the gamut from absurdly low to ridiculously high. There is also the pesky probability of tracking error, a problem some fund managers get into as they try to outperform the benchmark. This tends to increase the expense ratio by forcing more trades and increased research. But it might also allow the index to outperform.

Keep in mind, your index fund does not buy every stock being benchmarked. An S&P 500 index generally has only about 75% of the stocks on the list in the portfolio. How much of each is often the reason for the disparity in returns. A Russell 2000 index fund has only about a third of the companies listed.

Most people think of Vanguard Group when they think of index funds. But their much-touted S&P 500 index fund carries an expense ratio of 0.15%. My friend’s small-cap index fund, the one that did so well, charged her the same as this less risky S&P 500 index fund cost.

Add to that, there is relatively poor information available to her even through her plan. A great many of the funds offered inside your plan are not offered to individual investors making information gathering difficult. Plan information is improving but comparisons are still hard to make. She was more upset that no one asked her if she would like to switch.

Not All Plans are Created Equal
Looking inside your 401(k) is never easy. For Boomers (and anyone focused on retirement), it can be especially difficult. You are torn in many cases between necessary risk and the fear of that risk. Your portfolio may not have recovered as quickly as my friend’s did but consider the option of too little risk as one not worth taking.

There are basically only two ways of achieving the goals you may have set. You could increase your risk and/or increase your contribution. If you do the later, you can use the additional funds to purchase something more conservative while leaving your original contributions, the funds directed towards more risk, intact.

You should remember that if your plan offers only index funds and lifecycle funds (target-date funds), chose the index offerings. If your plan offers choices beyond index funds, choose the actively managed funds across a range of disciplines (large-cap, mid-cap, small-cap and international). In some cases, the fees might even be as competitive as the index fund that tracks them.

In the end, my friend did nothing. She had one of those not-so-good plans. Her only option was to increase her contribution to make up for the unrealized returns.

Paul Petillo is the Managing Editor of BlueCollarDollar.com