Four Steps to 401(k) Success
June 1, 2011
Tired of relying on market timing, outstanding security selection and luck to grow your 401(k)? These four steps will help you stay on pace to meet your retirement goals.
Contributing enough to obtain your employer’s full match must be automatic. People who save 15 percent of their gross income are usually comfortably on pace to retirement. For instance, a 30-year-old earning an average of $60,000 throughout his career would need to contribute 10 percent of his salary and receive a five percent employer match each year to build a $2 million nest egg by age 65, assuming a nine percent return. Consistency is the key.
Develop a portfolio with the appropriate mix of stocks, bonds and cash to provide sufficient return to reach your goals while not increasing risk. A 30-year-old shouldn’t hold only cash and miss years of market growth. Similarly, a retiree shouldn’t be invested exclusively in stocks the next time the market has another year like 2008. Apply this general formula to estimate an appropriate allocation:
110 – (your age) = % of stock in portfolio
It’s important to not have all your financial eggs in one basket. For instance, large cap stocks should be considered one basket within your diversified portfolio, as should mid cap, small cap and international stocks. U.S. government, corporate and international bonds should also be represented. Having assets diversified among these seven baskets ensures that if one basket breaks, you’ll still have other baskets supporting your financial future. When the stock market lost 37 percent in 2008, U.S. government bonds gained 23 percent. Clearly, diversified portfolios decline less during periods of market deterioration.
However, diversification can be challenging within 401(k)s. Many employer retirement plans consist of only five to 20 investment options, making it difficult to fill multiple baskets. Further, many 401(k)s have just one small or mid cap stock option and that fund may have a history of underperformance. In this case, the investor must either invest in a poor fund or not diversify. Finally, utilizing cost-effective mutual funds is critical but this can be another difficult goal with so few investment options.
Determining whether your 401(k) has a self-directed option can alleviate these problems. A self-directed option enables employees to move their 401(k) funds to a brokerage firm with access to 2,000 to 3,000 mutual funds. Accordingly, it’s easier to construct a diverse portfolio consisting of top-tier investments while keeping costs low. Many of Utah’s largest employers offer self-directed options, including Intermountain Healthcare and government employers utilizing Utah Retirement Systems.
Alternatively, your employer’s HR department can tell you whether the company allow “in-service distributions,” which enable employees to roll their 401(k) into an IRA while still employed. An IRA allows access to more than 23,000 mutual funds. Some employers allow in-service distributions to employees at least 55 years of age, and nearly all allow them once the employee turns 65.
Retirement accounts should be rebalanced annually. Stocks experienced tremendous growth between 1995 and 1999. A portfolio that began the period with a 50 percent stock, 50 percent bond mix likely ended the period 70 percent stock and 30 percent bond. Consequently, an investor who didn’t rebalance lost significantly more than they could afford when the market declined from 2000 to 2002. The prudent investor sold some stocks when they were highly valued and purchased some bonds when they were cheap to maintain their target asset allocation. This was sound investing (buying low and selling high), and prevented the investor from taking excessive risk.
Separately, in most cases, employees should roll their 401(k) into an IRA after leaving an employer. The tools to adequately diversify, utilize high quality investment options, and keep costs low are generally more obtainable in an IRA. Additionally, multiple 401(k)s can be rolled into one IRA, eliminating the hassle of tracking more investment accounts than necessary. However, those wishing to withdraw money from their retirement account before age 59.5 may have easier penalty-free access to funds within a 401(k). These are general rules, so speak to a financial advisor before moving forward.
These four steps will help your 401(k) achieve a satisfactory return while limiting risk. Brightscope.com is a free service that ranks your employer’s 401(k) plan, ranging from costs to the quality of investments. If you participate in only an average plan, getting your money where you have more control via a self-directed option or in-service distribution may be worthwhile. These options require more due diligence on your part, but a financial planner can help, and isn’t your retirement worth the effort?
Lon Jefferies is an investment advisor with Net Worth Advisory Group. He can be reached at firstname.lastname@example.org