Mutual Funds in 403(b) Plans

July 9, 2024

By Barbara O'Neill, CFP®, AFC®

2024 is an important anniversary year for mutual funds. It is the 100^th anniversary of the founding of the first mutual fund in 1924 and the 50^th anniversary of the year (1974) that mutual funds became an option for 403(b) plans. From their start in 1958 through 1974, 403(b) plans could only invest in annuities.

A mutual fund is an investment company that collects deposits from many people, invests the money in a portfolio of securities (e.g., stocks and bonds), and manages the money on an ongoing basis.  Investors own shares, which represent part of the holdings of a fund portfolio. Examples of investment companies include Vanguard, Fidelity, and T. Rowe Price. 

In 2022, there were 7,393 mutual funds in the United States according to Statista. However, 403(b) plan participants are limited to the mutual funds on their plan vendor’s product list. Much wider fund access is available through taxable (brokerage) accounts and Roth and/or traditional IRAs.

This post provides a primer on mutual funds as a 403(b) plan investment including advantages and disadvantages, types of mutual funds, mutual fund fees and expenses, resource materials, fund selection criteria, and mutual funds available through three top 403bwise Green vendors. It also describes mutual fund prospectuses and concludes with a summary of research about fund performance, three “need to know” facts, and six take-away action steps.

How Mutual Funds Work

Mutual funds are the first investment product that many people make, often in a tax-deferred retirement plan such as a 403(b). 

There are three major mutual fund objectives:

• Income- Funds (e.g., bond funds) that focus on dividends and interest that provide regular income.
• Growth- Funds (e.g., growth funds) that focus on increasing the value of invested principal over time.
• Stability- Funds (e.g., money market funds) that focus on protecting investment dollars from losses.

Growth funds are typically riskier than income-oriented funds but generally provide higher return potential over time. Stability-oriented funds are the least risky fund type but often provide the lowest earnings.

Three ways that investors make money on mutual funds are: a pro-rated share of dividends and interest earned on securities that a fund owns, a pro-rated share of capital gains when a fund sells securities at a profit, and an increase in the value of shares when a mutual fund holds securities that increase in value.

Net asset value (NAV) is the price that mutual fund shares are bought and sold at. It is shown in newspaper lists of mutual fund share prices and online. NAV is calculated by adding up the value of securities in a mutual fund portfolio at the end of each trading day. Any liabilities for that day are subtracted to arrive at a fund’s net assets. The value of net assets is divided by the number of fund shares to arrive at a fund’s NAV.

Mutual Fund Advantages

• Full-time, professional management
• Reduced risk of loss due to diversification
• Provides access to low-expense investment options (e.g., index funds)
• Transparent pricing information makes monitoring fund performance easy
• Highly regulated by the federal government with specific information disclosure rules

Mutual Fund Disadvantages

• Unwanted taxable distributions in taxable accounts
• No guaranteed rate of return and potential to lose money
• Generally follow market performance trends (up and down)
• Subject to market risk (growth funds) and interest rate risk (bond funds)
• All mutual funds charge fees for management and operating costs, which lowers returns

Types of Mutual Funds

Below is a brief explanation, in alphabetical order, of popular mutual fund categories. Available vendors and products will determine their availability to 403(b) plan participants.

Aggressive Growth Funds- The riskiest stock mutual funds that often provide the largest gains and heaviest losses. They typically include small companies and new companies with an unproven track record.

Asset Allocation (a.k.a., Target-Risk) Funds- Include stock, bonds, and cash investments in varying proportions in different portfolios (e.g., aggressive growth, growth, moderate growth, and income). The manager decides the percentage of assets in each portfolio, typically in response to market conditions.

Balanced Funds- Seek both current income and growth of principal by holding bonds and/or preferred stock in varying proportions to common stock (e.g., 60% stock and 40% fixed-income).

Bond Funds- Funds with an objective to provide current income that invest in U.S. Treasury securities, corporate bonds, and tax-free municipal bonds.

Concentrated (Focused) Funds- Funds that invest in a small number (e.g., 20 to 30) securities instead of a larger portfolio. Reduced diversification can result in both outsize gains and losses.

Emerging Market Funds- Funds that invest in securities from developing countries (e.g., in South America and Asia) and are often more volatile than securities in developed markets.

Equity-Income Funds- Funds, considered a conservative equity investment, that invest primarily in stocks, preferred stocks, and convertible bonds of companies with a track record of paying dividends.

ESG (Environmental, Social, Governance) Funds- Previously known as socially responsible funds, they screen their portfolio against management-determined criteria and only include companies that make the cut.

Funds of Funds- Funds that invest in other mutual funds (typically within the same investment company) instead of individual securities.

Global Funds- Funds that invest in securities that are issued worldwide, including the United States.

Gold (Precious Metals) Funds- Funds invested in mining companies or securities linked to precious metals.

Growth Funds- Funds that seek long-term capital appreciation as a primary investment objective and often invest in stock from well-established companies.

Income Funds- Funds that seek a high level of current income by investing in bonds and dividend-paying (e.g., utility company) stock.

Index Funds- Passively-invested funds that attempt to match the performance of a specific stock or bond index and are known for broad diversification and low expenses vs. actively-managed mutual funds.

International Funds- Funds that invest only in securities that are traded outside of the United States.

Junk (High-Yield) Bond Funds- Funds that invest in the bonds of issuers that are rated BB or lower.

Life-Cycle (Target-Date) Funds-Funds consisting of stocks, bonds, and/or cash assets that gradually and automatically become more conservative (less stock) as investors age and approach the date in the fund name.

Money Market Funds- Funds that invest in short term debt securities such as Treasury bills and certificates of deposit. They have no growth potential and often lose purchasing power after inflation.

Regional Funds- Funds that invest in a group of countries (e.g., in Europe or Asia) instead of worldwide.

Sector Funds- Funds that limit investments to companies in a specific industry sector (e.g., health care or technology) and are riskier than growth funds due to reduced diversification.

Small Cap Funds- Funds that invest in companies with a relatively small market capitalization (i.e., number of shares x price per share) of $2 billion or less that tend to be more volatile than mid- and large cap funds.

Value Funds- Funds that take a contrarian approach and invest in out-of-favor stocks that are expected to turn around and make a profit.

Mutual Fund Fees and Expenses

Costs matter in determining the return on a mutual fund, especially when compound interest over many decades is applied. To learn more about fees associated with a particular mutual fund, read its prospectus which describes fees charged to investors individually (e.g., front-end loads) and those charged against mutual fund assets (e.g., management and operating expenses.). 

The later category, in addition to 12b-1 fees for marketing and distribution expenses (if applicable), comprise a mutual fund’s expense ratio (expenses as a percentage of fund assets). Look for the lowest expense ratio possible. All things equal (e.g., fund performance), low-cost funds net higher returns than high-cost funds.  

The lower the expense ratio (e.g., 0.20% versus 1.2%), the better because fewer fund expenses are passed on to shareholders, which is a drag on investment performance. Over time, this can add up to a difference of tens, even hundreds, of thousands of dollars in earnings between funds with high and low expense ratios. 

Mutual Fund Resource Materials

Monitoring mutual fund performance is easy. Share prices (NAV) are available on mutual fund websites and in the financial section of large newspapers like The Wall Street Journal. Other information sources include prospectuses and annual reports issued for individual mutual funds, performance reviews in personal finance publications such as the AAII Journal, and rating services such as Value Line and Morningstar.

Mutual Fund Prospectuses

A prospectus is a legal document that describes characteristics of specific mutual funds. A statutory prospectus is the traditional long form that often runs 40-50 pages. A summary prospectus is typically 8-12 pages and contains key information about a fund in an abbreviated format. The U.S. Securities and Exchange Commission specifies information that must be included in prospectuses and requires funds to present key data (e.g., fees and past performance) in a standardized format so investors can easily compare different funds. 

Prospectuses can be downloaded from mutual fund websites. Print copies may also be available upon request. The best way to read a prospectus is cover to cover using a highlighter to identify key information.

Fund Selection Criteria

Four key factors should be considered in the selection of a mutual fund. The best funds for a 403(b) plan should: 1. match an investor’s objectives, 2. have below-average expenses for their fund category (e.g., growth funds), 3. have sustained above-average performance compared to peer funds and/or relevant market indices, and 4. have investment policies that align with personal investment risk tolerance. Use the worksheet below to list key data about three similar funds (e.g., stock index funds) for a side-by-side comparison.

Green Vendor Mutual Fund Options

Below is a brief summary of mutual funds available through three highly rated 403(b)wise vendors.

• Vanguard, a 403bwise Green + vendor, offers over 40 mutual funds, including 12 All-In-One Target Date Funds, on its product list for 403(b) plans. Six funds, including four index funds, are labeled as “Core Funds” and 35 funds in a variety of categories described above are listed as “Supplemental Funds.”
• Fidelity, another Green+ vendor, has a wide selection of Fidelity Freedom target-date funds on its non-profit organization product list and dozens of other selections including growth, equity-income, bond, emerging market, index, global, and other fund categories.
• T. Rowe Price, a Green vendor, also has a 403(b) plan product list with over 90 mutual funds that are grouped into categories including stock funds, bond funds, target-date funds, asset allocation funds with all-in-one portfolios, and money market funds.

Research Results

According to the Dow Jones Indices SPIVA Scorecard, nearly 88% of large-cap funds trailed the S&P 500 index during the past 15 years with basically the same story for mid-cap and small-cap funds. Nearly 60% of actively-managed bond funds also lagged their benchmark index. Morningstar found that, from 2014 to 2023, just one in every four actively-managed funds beat its average indexed peer. Index funds simply aim to match market performance and do not have the added expense of identifying and vetting “hot” securities.

Another study investigated 403(b) plan fees and found that a majority of public school employees are unaware of fees they are paying on 403(b) accounts and the effect these fees have on account balances over time. In addition, most participants save less per year than the maximum allowed in a traditional IRA. The researcher recommended investing in an index fund within a traditional IRA to avoid high-expense plan options.

Three (More) Things

• A mutual fund’s turnover ratio (%) measures trading activity within one year. The higher the ratio (up to 100%), the more a fund’s portfolio changes, which can result in higher trading costs and lower returns.
• Vanguard Total Stock Market Index Fund admiral class (VTSAX) has an expense ratio of 0.04% and is the most widely held mutual fund containing over 3,700 stocks.
• Historical performance is a key screening factor. Prospectuses are required to disclose a mutual fund’s total return for the past 1, 5, and 10 years or since its inception.

Six Smart Strategies

No. 1: Read Prospectuses — Do not invest in any mutual fund without reading its prospectus and thoroughly examining the fund’s objective, performance history, and fee structure.

No. 2: Compare Options — Use the worksheet above to compare three mutual funds of the same type (e.g., growth funds) that are available on your 403(b) plan vendor’s product list.

No. 3: Be a “Couch Potato” — Consider the passive index investing strategy developed by personal finance writer Scott Burns that includes just two funds: a stock index fund like VTSAX  and a broadly diversified bond index fund.

No. 4: Consider “Core and Explore” — Select index funds for the bulk (e.g., 75% to 90%) of your retirement savings and actively-managed funds for the remainder if you want the thrill of potentially outperforming the market. 

No. 5: Read Mutual Fund Documents — Sign up for text alerts when documents such as annual reports and updated prospectuses are available and read them to stay current on your investments.

No. 6: Get Help When Needed — Reach out to a green vendor (if you have one) with questions about their mutual fund products and utilize the resources listed above including Morningstar reports and personal finance publications.

In Summary

Mutual funds are an attractive alternative to high-cost annuities in 403(b) plans. They are well-diversified portfolios of securities and index funds, especially, have low expense ratios. 403bwise Green vendors offer dozens of mutual funds to 403(b) plan participants. As with all investments, research available options first.

This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.

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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.

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