How to maximize your 401(k) investments
by Paul Merriman
For most working Americans, the 401(k) plan (and its close cousins which go by similar names such as 403(b), 457 for state and municipal government workers and the federal government’s Thrift Savings Plan) is the backbone of retirement savings.
A 401(k) plan makes it easy for workers to use payroll deductions to automatically follow the tried-and-true advice to “pay yourself first.” Tax deferral keeps the money working for the investor, not Uncle Sam. Many plans provide matching funds from employers, giving workers a powerful incentive to save instead of spend. That’s the “carrot.” The “stick” is a set of federal laws that penalize most withdrawals before an investor reaches age 59 1/2.
Still, 401(k) plans are under-used by many workers and misused by many others. Most participants’ money is not working as hard for them as they worked to earn that money in the first place. As a result, many thousands of potential retirement dollars – sometimes millions of dollars in a single account – are never saved or never earned – and thus never available when they are needed.
These problems aren’t entirely the fault of workers.
Legally, employers cannot tell participants how to invest their retirement money, lest the employers be sued if returns fail to meet expectations. This leaves employees to fend for themselves or to rely on third-party advice. In most employer plans, it takes some work to determine the best options.
If you just want my recommendations on specific plans, follow the links to Microsoft, TIAA-CREF and others. However, my bottom-line advice will be much more useful to you if you understand why I make the recommendation I do.
Four decades of helping people with their money have taught me that unless an investor understands what’s behind a recommended strategy, that strategy may be in danger of being abandoned for some other strategy that’s no more clearly understood, just more compellingly – or more freshly – presented.
I believe you will be much more likely to be satisfied and successful if you review the following material.
Start by thinking of a 401(k) plan not as an end in itself but as a tool designed to help you do a job. And I recommend you think carefully about what that job is.
TWO JOBS TO DO
On the surface, it appears that the job of a 401(k) is to efficiently set aside money and make sure it’s there for your retirement. Federal tax laws encourage workers to put money aside as they earn it and encourage employers to sweeten the pot further with matching money. Those laws also penalize early withdrawals, thus making it more likely that the money will be there for workers in their 60s and later.
If that were the only job of a 401(k), we’d be in fine shape. But there’s another very important job, and it’s one that most 401(k) accounts fail to accomplish very well. This second job is to make your money work hard for you in the years and decades between the time you earn it and the time you’re ready to spend it.
This second job requires that the money be invested properly. Study after study has shown that the majority of money in 401(k) accounts is invested in types of assets not well suited to long-term investors.
Some of the blame for this belongs to 401(k) plan trustees who don’t give workers adequate choices and adequate education. Sometimes those trustees seem to put employers’ interests ahead of employees’ interests.
But a big part of the blame also belongs to plan participants. Most don’t take the time to understand investing or go to the trouble of trying to understand the options in their plans. Many don’t participate at all, or save at inadequate levels.
Many 401(k) investors are over-cautious, leaving most or all of their savings in cash-like guaranteed investment contract (GIC) funds or similar options that aren’t likely to make their money gain any purchasing power.
Many other participants take too much risk for the returns they are getting – which is another way of saying they are not adequately compensated for the risks they take. Most of them don't realize this is happening until they are forced to learn it the hard way in a bear market like the one that wiped out trillions of dollars in retirement savings in 2000 through 2002.
If you’ve read my book, you know that investing in the proper asset classes can make a huge difference in the size of your ultimate retirement nest egg. But it’s not always easy to put that knowledge to use in a 401(k) plan with limited options.
While I cannot review every company’s plan, I can give you some guidelines to help you figure out the best way to use the plan for which you are eligible.
EIGHT KEYS TO SUCCESS
Properly investing your 401(k) doesn’t require rocket science or an advanced degree. There’s no great mystery about it. But it doesn’t happen automatically. You have to make it happen. If you get eight essential things right, you’ll be in excellent shape. Here they are in snapshot form:
- Contribute. Contribute regularly. Contribute automatically. Contribute as much as you can. This is pretty basic, I know. But you might be surprised how many people don’t contribute, or contribute only a little bit. If you don’t do this, none of the rest matters.
- Invest in stock funds instead of money-market funds and similar “no-risk” options. Over the past 200 years, the U.S. stock market has had a strong upward bias, and I see no reason to think that the growth of our economy is about to run out of steam.
- Invest part of your money in funds that own small companies – which of course have the potential to grow rapidly. In the late 1980s, Microsoft was a relatively small company, growing very rapidly and making fortunes for its early shareholders. In the early 1990s, the same was true of Starbucks and Dell Computer. These are now big companies. Don’t put all your money in small-cap stock funds, because these stocks are risky. But if half your stock investments are in small company funds, you’ll be on the right track.
- Invest some of your money in value stocks, ones that for various reasons are out of favor with the big institutional investors that dominate the stock market. The most popular, well-known and “safest” companies don’t make the best long-term investments. From 1926 through 2004, U.S. large-cap growth stocks generated annualized returns of 9.6 percent. U.S. small-cap value stocks, to choose one example of something less popular, grew at an annualized rate of 14.7 percent. Millionaires pay lots of attention to facts like that; poor people sometimes act as if they don’t want to be bothered. I recommend you invest like a millionaire.
- Invest in funds that hold the stocks of foreign companies. Many people may tell you that everything you need is right here in the U.S.A. They can make an appealing case. But the facts are that over the long run, an equity portfolio split 50/50 between U.S. and international stocks has generated higher returns at lower levels of risk. If your 401(k) has good international fund options, I recommend using them for 30 to 50 percent of your stock investments.
- Manage your risk. Understand your ability to tolerate risks (“Fine Tuning Your Asset Allocation” at FundAdvice.com will help you with this) and adjust the equity and fixed-income part of your portfolio accordingly.
- Keep your expenses low. You know all about this from Chapter 11 in my book. When you have multiple choices of funds in a particular asset class, find low-cost options. You’ll have to pay more for some asset classes such as international small-cap funds. But among comparable funds, choose those with the lowest expenses.
- Invest in index funds. This will give you maximum diversification and spare you the grief of worrying about whether the manager of your fund will be among the relatively few who beat the market.
These eight guidelines and the recommendations that follow are based not on the marketing hype of Wall Street but on decades of academic research into what really matters in producing long-term investment returns.
THE PERFECT 401(k) PLAN
The perfect 401(k) plan would match employees’ contributions at least 50 cents on the dollar. It would have an automatic “default” provision that enrolled new employees in the plan and would contribute at least 10 percent of their pay unless they actively chose some other option. It would provide unbiased educational guidance on smart ways to use the plan’s investment options.
Ideally, employees would have no more than about 20 well-chosen investment options. I’m all in favor of choices. But very few people can intelligently cope with dozens or hundreds of places to invest their money, and employers shouldn’t saddle their workers with this burden.
Those choices should include, on the fixed-income side, a guaranteed income contracts fund or a broadly diversified bond fund. On the equity side, there should be at least one low-cost index fund in each of these asset classes: U.S. large-cap stocks, U.S. large-cap value stocks, U.S. small-cap stocks, U.S. small-cap value stocks, U.S. real estate stocks, international large-cap stocks, international large-cap value stocks, international small-cap stocks, international small-cap value stocks and emerging markets stocks.
(Our ideal weightings would be 10 percent each in U.S. large-cap, large-cap value, small-cap, small-cap value and real estate as well as 10 percent each in international large-cap, international large-cap value, international small-cap, international small-cap value and emerging markets.)
In addition, workers should not be able to channel more than 10 percent of their 401(k) contributions into their employers’ stock. As well, if company stock ever grew to be worth more than 25 percent of the account value, mandatory annual rebalancing should be required to bring the percentage back down to 25 percent. This should be scheduled for the month of each employee’s birthday in order to spread sales throughout the calendar year. (I realize this is an unusual proposal that won’t be popular. Many employers like the steady demand for their stock from workers’ retirement accounts.)
YOU AND YOUR OWN PLAN
Most plans fall far short of this ideal. Too often they contain actively managed funds with high expenses, sometimes with sales loads that in effect make workers pay the administrative costs of running a 401(k) plan in the first place. Few plans offer all the essential asset classes, concentrating instead on large-cap U.S. growth funds and mid-cap funds. International funds are mostly limited to large-cap growth stocks.
Americans love to go shopping. But they can’t shop for 401(k) plans. Once you have an employer, you’re stuck with that employer’s plan. Plan trustees sometimes can be persuaded to improve the options, but that requires a lot of work for an uncertain outcome.
The result is that participants are responsible for making the most of what they have. There’s a process for doing that. In my specific recommendations for Microsoft’s plan, I walk you through that process.
Whatever plan you have available to you, there’s something else you can do. Once you understand what investment options should be in a 401(k) plan (and which ones are actually in yours) you can try to persuade the trustees of your plan to offer better options. My book and various articles available online at FundAdvice.com, plus this article itself, may help you get the attention of those trustees.
Almost every plan can be improved. And a better plan is in everybody’s interest, including every company’s most highly paid employees (usually executives). To the extent you can successfully lobby for positive change, you will do yourself and your fellow employees a valuable service.
