03/05/08 - 401(k) T n' T (Tips and Terminology) Part II
By: Investor Solutions, Inc.
When was the last time you changed the oil, tested your battery, or aligned the tires on your 401k plan? Most of us contribute a certain percentage, pick a handful of investments, and check in years later right after moving onto our next company’s retirement plan. In part one of this series we “checked under the hood” of your 401k to offer suggestions on catch up contributions, employer matching amounts, and retirement plan rollovers. In this segment, we will “tune-up” your 401k to create an asset allocation that makes sense and find investment options that will create a sound investment portfolio.
401(k) Asset Allocation & Investment Options
Included in most employer sponsored 401k plans is a broad range of investment options that offer exposure to equities, bonds, and money markets mutual funds, guaranteed investments, and sometimes, even company stock. How your money is invested will have a huge impact on your overall return, so it is essential to educate yourself and understand your options in order to make sound decisions. A nice thing about 401k plans is that you are able to divide your money into different investments, spread out your risk and provide balance in your portfolio. A good way to accomplish these goals is to invest in a combination of equity and bond mutual funds. Mutual funds are a great way to diversify your money since they are made up of hundreds, sometimes thousands of individual stocks, bonds and/or money market instruments. Essentially, by investing in one mutual fund your money may be spread out over 500 different companies so if one of the companies performs poorly there are 499 other companies to make up for it. This gives even the small investor the ability to participate and reap the rewards in the equity markets.
Tip: Before choosing your 401k investments create an asset allocation and find out how much risk you are willing to take. This will determine your balance between stock and bond funds. Historically, investing in equities has yielded higher returns than bond investments and outpaced inflation; however, this comes at a cost of more risk and higher volatility. Normally, if you are more than 20 years away from retiring and depending on your investment comfort level, a portfolio of 70%-100% invested in equities and 0%- 30% invested in bonds is appropriate. If you have less than 20 years until retirement, 50%-70% in equities and 30%-50% in bonds may be appropriate. Vanguard has a pretty good online questionnaire that can help measure your risk level and determine an appropriate allocation: https://personal.vanguard.com/us/FundsInvQuestionnaire
After the right balance of stocks and bonds is in site, the next step is to choose from the variety of investment options offered within your plan. When we look at our client’s company sponsored 401k plans we look for the least expensive mutual funds that provide exposure to a variety of asset classes. Generally, index mutual funds have the lowest costs and can give you exposure to domestic, international, emerging markets, real estate, and fixed income asset classes. The alternative to index funds is cherry picking from the slew of active mutual fund managers with high expenses that fall below their competing index 80% of the time. Unfortunately, sometimes we find our client’s 401k investment options are so bad we have to choose the least worst when making recommendations.
Tip: If index funds are offered as an investment option within your plan, use them. Most 401ks will offer at least an S&P 500 index fund, maybe an international index fund and possibly a bond index fund. If this is the case, utilize the index funds as your core positions and acquire asset class exposure with the alternatives. Utilizing index funds will keep your 401k costs to a minimum and provide you with a long-term plan for success.
Conclusion
Not all 401k plans are created equal. With a little education and some understanding of your long term retirement goal, constructing a portfolio with the right investments and a sound asset allocation is simple. It is always better to have ten good mutual funds to choose from than 100 bad ones. If you are fortunate enough to be employed by a company that offers a 401k plan with low costs and good investment options, utilize it. Unfortunately, nothing in this world is free and ultimately the 401k plan is part of your overall compensation package. In my next article and final part of the 401k T n’ T series, we will explore the hidden costs of some 401k plans and determine if the Roth 401k option is right for you.