Forget SpaceX, Does Index Investing Still Make Sense for a 401k?
You'd have to be living on Mars not to hear that your 401k index fund will be investing in SpaceX. But the more important question is whether index investing for a 401k still makes sense.
When SpaceX issued its huge IPO today, all those shares will, sooner or later, qualify for inclusion in many stock indexes. Many 401(k)s invest in stock indexes, therefore your 401(k) may soon include SpaceX! Articles about the SpaceX IPO and its affect on 401(k)s are everywhere.
But I want to back up a bit. Rather than worry about SpaceX specifically, I want to reflect on the 401(k) fund and whether index investing in a 401(k) still makes sense. And then think about how SpaceX might fit into that picture.
Employee Retirement Accounts: 401(k)s
I always like to start with history. Where did the 401(k) come from and what is it supposed to accomplish? Long before there were 401(k) plans, there were pension plans. A pension is a promise to pay a stream of income to an employee after retirement. Pensions were generally provided only by very large employers and they work completely differently than 401(k) accounts do. An employee with a pension has no individual account, nor any control over how the retirement money is invested, just a promise of a future stream of income. If the employee dies the day after they retire, they get nothing, no matter how long they worked and earned benefits, because they don’t actually have an account with a balance, just a promise of a lifetime payment. If the employee changes jobs, they may not get anything. The value of the future promised income varies depending on the credit-worthiness of the specific employer, and employers can and have changed the rules over time.
A 401(k) is an individual account that is specifically associated with the employee. Both the employee and the employer can contribute to it. The account has a balance that accumulates over time. The employee is guaranteed to be able to take out their own contributions, and they are also guaranteed access to the employer’s contributions after a vesting period. If the employee dies the day after they retire, they still get the whole account they have accumulated. Most importantly, the employee can make decisions about how to invest the fund, although the decisions may be limited to a very short list of potential investments.
Section 401(k) of the Internal Revenue Code was enacted in 1978. That law didn’t actually say anything about retirement accounts, it just clarified that employees don’t have to pay taxes on “deferred” pay until they receive it. The law was directed at things like deferred bonuses. But a couple years later Ted Brenna, the father of the 401(k), realized it could be used to allow employees to pre-fund retirement accounts. In 1981 the IRS issued regulations about how employee retirement accounts could be handled legally, and by 1983 many big companies were providing 401(k)s for their employees.
The 401(k) is a “tax-deferred” account. The employer pays a salary that the employee would ordinarily pay income taxes on. If the employee puts part of that salary into a 401(k), they don’t have to pay income taxes on that part of their salary. And they don’t pay income taxes on any of the income, dividends, and capital gains on the investments in that fund. No taxes are paid until the employee takes money out. At that point, the employee pays ordinary income taxes on everything they withdraw. Theoretically that day is far, far in the future, and by then they won’t be in a high income tax bracket. So they avoid taxes when they are working and in a higher tax bracket, and take it out when they are no longer working and in a lower tax bracket. Pretty sweet!
Even more sweet, the law clarified that employers can contribute to the account as well, in the form of a match. And the employer’s contribution is not taxable income to the employee either until they take the funds out later.
In 2001, a really significant alternative was introduced, a Roth 401(k). A Roth 401(k) works just the same as a regular 401(k) with one huge difference. With a regular 401(k) you don’t pay any income taxes on the money you put into the fund but you do pay income taxes on the money you take out. With a Roth, that’s reversed. You pay income taxes on your salary before you add your contribution to the fund, but you pay no income taxes when you take money out. You pay no income tax when you take out the money you put in, nor on any of the interest, dividends, and capital gains that accumulated over the years in the fund. That means you NEVER pay income taxes on the interest, dividends, and capital gains in a Roth 401(k) fund! In case you can’t tell, I’m a huge fan of the Roth 401(k)! The take-away is that a Roth 401(k) is just a 401(k) alternative that has different tax consequences.
With either kind of 401(k), the employer deducts whatever amount the employee elects to contribute, and sends it to the third party administrator of the fund. That third party administrator has prepared a list of possible things the employee can invest in. Most of the time that is a short list of mutual funds, including one or more index funds. The third party administrator keeps an accounting of each individual account, and pays it out when the employee requests, which they can do when they retire or leave employment or in a few other specific situations.
The 401(k) and its variants have proliferated. Public schools, hospitals, and non-profits can provide a 401(k)-style offering called a 403(b) plan. State and local governments provide 457(b) plans. Federal employees and military personnel have access to Thrift Savings Plans. Small employers can provide SIMPLE IRA plans. At this point, about 70% of all employees in the US have access to some sort of 401(k)-style retirement plan.
Index Funds in 401(k)s
Mutual funds are “stocks” that do nothing but invest in a basket of other stocks. It’s a great way to invest in a diversified basket of stocks, way easier than buying and selling a lot of individual stocks. A similar vehicle is an “exchange traded fund” or ETF. Mutual funds and ETFs are tailor-made for something like a 401(k). It makes it easy for the retirement account to be diversified with a minimum of work. I’ll continue to call them mutual funds, but ETFs fundamentally provide the same results.
Many mutual funds are “actively managed”, which means they buy and sell stocks all the time to meet whatever the goals of the fund are. Actively managed funds take fees and expenses out of their earnings. The more active the management, the higher the fees and expenses may be. Those fees reduce the earnings of the fund, and can have a huge impact when compounded over many years. Unfortunately, actively managed funds in 401(k)s tend to have especially high fees and expenses, something employees should be very aware of.
Indexes are lists of stocks that have something in common. There are a number of really well-known indexes, like the S&P 500, which is supposed to be the 500 best big publicly traded stocks. There are lots of other indexes, some well known, and some very proprietary.
In the S&P 500 index the specific stocks included are determined by a committee. The goal of that index is to have something that very generally will mimic the returns of the entire market, without the need to own everything in the entire market.
Index funds are mutual funds that buy and hold the stocks in an index. Publicly traded index funds were the brainchild of Jack Bogle, who ran the Vanguard Group. He created the first S&P 500 index fund, making stock investments easy for the general public. At that time investing was very much a rich man’s activity. You could only buy and sell individual stocks in lots of 100 shares. No fractional shares. No odd lots. To put together a diversified portfolio that matched the S&P 500 in 100 share lots at that time would have required an investment of $1.5 to $2 million dollars! And you would have paid thousands of dollars in brokerage fees to do that. It’s hard to overstate how revolutionary the index fund was in making it easier and cheaper to buy stock.
The only time index funds need to buy or sell is if the index itself changes. That happens from time to time. If the index adds a stock, the fund that tracks it must also add the stock. If the index removes a stock, the index funds will have to do the same. This very limited trading means fees and expenses are also very low.
In many ways, an index fund is the perfect match for a vehicle like the 401(k), where millions of individuals are creating small portfolios which they hope will fund them through retirement. Fees and expenses are minimized, but the accounts are well diversified, and can track, more or less, the returns of the stock market in general, or whatever other goal a specific index might have.
The SpaceX IPO its Impact on Index Funds
Periodically the S&P 500 and other index committees review their index lists. From time to time they determine that some stock needs to be added or removed from an index. If a list is supposed to contain a certain number of stocks, like the S&P 500, when a stock is added they must also remove another, and if they remove one they have to add another. In addition, if the components in the index change, the percentage represented by each stock in the fund may change, and tracking funds may need to buy or sell other stocks to match that. This whole exercise is called “rebalancing”.
Indexes are usually watching companies that have gradually grown big enough to be included. With the SpaceX IPO, all the indexes had to decide if a brand new, but huge, company should be included in the index, and how quickly that should happen. And the same question will come up in two more huge IPOs that are expected later this year, Anthropic and OpenAI.
The S&P 500 index decided not to change the rules for new IPOs. They won’t include SpaceX or other new IPOs for at least a year, and after that they’ll still expect them to meet the usual rules for profitability. That means that if an employee is invested in a S&P 500 index fund in their 401(k), they won’t own SpaceX, Anthropic, or OpenAI for at least a year, if ever.
Other indexes will include them sooner. If an employee has an index fund in their 401k that will include SpaceX sooner, they will become SpaceX owners at that point. And eventually they will become owners of Anthropic and OpenAI.
Rebalancing may also impact the price of other stocks. Stocks other than SpaceX may have to be sold by various index funds when they add SpaceX, and all those sales could create enough selling pressure to reduce the prices of the stocks they sell. So, one potential impact is that these three huge IPOs will reduce the price of at least some other stocks. That would reduce the total value of every fund that owns those stocks, which is not great. But if employees continue to make regular 401(k) contributions to funds that own those stocks, they will be making new investments at lower prices, and, assuming those stocks will eventually recover their value, that could produce nice gains by the time employees need those retirement funds.
The impact on other stock prices is a giant unknowable unknown, but something to be aware of.
Index Funds Are a Good Match for a 401(k)
So do index funds make sense in a 401(k)? The giant IPOs coming up certainly muddle the picture, but I do think that an index fund is still a brilliant fit for a 401(k), for lots of reasons:
An fund is the easiest way to own a diversified basket of stocks.
The fees and expenses in an index fund are as low as possible.
Low expenses mean you will keep more of the returns, adding to your retirement fund.
If companies in the index no longer fit the criteria, they’ll get added or dropped automatically, with no work on your part. You just need to pick a theme, like following the S&P 500.
The important thing is to build a retirement nest egg any way you can. You can accumulate very healthy amounts if you make even small but regular investments over many years, and 401(k)s make that easy to do. You have no way to know for sure who the winners and losers will be so you need to spread the risk around by diversifying, and index funds do that, while keeping expenses as low as possible. The SpaceX IPO may cause some hiccups, but index funds still make sense.
Verdict: Yes! Index funds belong in your 401(k)!
Photo by Martin Ceralde on Unsplash