No. of Recommendations: 1
I wholeheartedly agree with Tom's central assertion that it's a bad idea to have conflicted plan providers offering advice to employees on 401(k) allocation decisions. Nevertheless, I think his article gives the impression that 401(k) plans are generally better served by being invested in index rather than actively managed funds. I do not generally agree.

Although Tom's contention that most actively managed funds do not usually beat the market index is correct, it is correct primarily for returns after transaction costs, which include both management fees AND -- often more crucially -- TAXES. In fact, many actively managed funds have long histories of beating the market indeces, even after management fees are subtracted, on a PRE-TAX BASIS.* But the central distinguishing principle for 401(k)s and IRAs is that you pay no taxes today on dividends or capital gains.

Thus, at least for taxpayers in higher tax brackets, 401(k)s and IRAs are the absolute worst place to hold index funds, because you lose a principal advantage of those funds, namely, that the lower turnover implicit in tracking an index gives a lower tax liability. (This assumes that these taxpayers hold index funds in their taxable accounts, probably a safe assumption for higher bracket taxpayers.)
Instead, 401(k)'s and IRAs are ideal for high yield bond funds, REIT funds, high-dividend stocks and certain actively managed equity funds. Indeed, you might argue that actively managed funds rationally exist primarily for the tax deferred accounts of higher bracket taxpayers, or for the taxable accounts of those taxpayers with low tax liability, much as tax exempt bonds exist primarily for the taxable accounts of higher bracket taxpayers.

I just think that it's important we not overbash actively managed funds in the context of tax deferred retirement accounts. Yes, it's very difficult for managers to beat the market on an after-tax basis; but lots of proven fund managers have beaten the market on a pre-tax basis, which makes actively managed funds a very attractive component of tax deferred accounts for investors without the time, inclination, or sophistication to choose individual securities.

*For example, Vanguard's Windsor Fund returned 14.4% over the 10 years through Dec. 2001, on a pre-tax basis, which beats the S&P's return of 12.94% over the same period; still, after all taxes (assuming the top marginal rates), its return was 10.77%, which loses to the S&P.
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