July 2006
Cultivating your 401(k)
If you let it go to seed, it might not grow as much as you need
It was probably while you were doing something else--say, living your life--when your 401(k) turned into something that looks like that weedy patch in your backyard. Some investments flourished; others withered to nearly nothing. New mutual funds popped up--replacements for ones that you didn't even know had gone. The balance between stocks and bonds you so carefully laid out as long as a decade ago is now out of kilter.
Even if you haven't thought about your 401(k) since before the cell phone, you should do so now. In the past several years, the industry has churned out a bunch of new products and features, including automatic rebalancing and funds targeted toward specific retirement dates. Congress, too, has introduced new investment options, such as the Roth 401(k). Then too, there are some not-so-wonderful changes--new and higher fees, for example.
How do you know what might ail your 401(k)? Here, we've identified the typical problems and possible solutions.
I started with one mutual fund but never got around to adding any more.
Few gardeners would plant only cucumbers, but according to Fidelity Investments, the Boston mutual-fund Goliath, more than half of the 8.6 million 401(k) participants it serves held four or fewer investment options in 2004, and about a quarter held just one. Many folks apparently still have not learned that diversification is key to reducing investment risk.
What to do: Investment experts we talked to generally concur that five to eight funds are sufficient to cover the waterfront of risk and return. A good, basic mix includes one large-cap fund (or an index fund based on the Standard & Poor's 500) and one each of a mid-cap, small-cap, international, and bond fund. To further diversify, you could split the large-, mid-, and small-cap investments between growth and value funds. James Lange, a CPA, attorney, and author of "Retire Secure!" (Wiley, 2006), recommends putting no more than 30 percent of your funds in any one asset class.
More important than the number of funds is the amount of overlap among investments within the funds. For example, a combination of Microsoft, Lowe's, and Target running through every fund you own would not be a good way to diversify. To analyze your holdings and reduce any overlap, you should take a trip on the Web to Morningstar, a Chicago financial research company, at www.morningstar.com. Click on Funds, and then Instant X-ray, which provides an analysis. You have to have a premium membership ($135 a year; $14.95 a month) to use the service, but there's a two-week free trial. The X-ray can help you evaluate all your investments, including those outside your 401(k), and alerts you, for example, to a single-stock overload or high fund fees and expenses.
I got a notice in the mail about new funds, but I never read it.
New fund species and varieties may have joined the portfolio since you last looked. Lifestyle funds, for instance, have been growing in popularity, particularly over the past three years. Those funds, themselves baskets of stock and bond funds, are designed to reflect investors' differing attitudes toward risk: conservative, moderate growth, and aggressive growth. A variation, the target-retirement fund, rebalances automatically, shifting as retirement nears to hold more in fixed-income investments and less in stocks.
Sponsoring companies tout the simplicity of such funds for investors who are willing to rely on professionals to decide how to rejigger their portfolio as time goes on. In "Target: Retirement," however, in the June 2006 issue of CRMA, we looked at 27 such funds and found they're far from simple. They offer a wide and confusing range of investment strategies, and their fees often take a big bite out of returns.
Some 401(k) offerings may have disappeared since you last looked. Vigilant plan trustees periodically eliminate funds that aren't performing well, usually replacing them with funds that have similar aims but better performance histories. Providers of 401(k)s are obliged to tell employees, and there's a grace period in which you may choose new funds for deploying your money. But once the grace period ends, providers will just stash your money in a replacement fund. If you haven't paid attention to your incoming mail, you could find all your money arrayed in funds you've never heard of.
What to do: Lifestyle and target-retirement funds may be useful for beginners or for folks who want to put their retirement savings on autopilot. If that's you, read the fund's prospectus carefully. Some of the funds are surprisingly expensive and somewhat risky.
If some of your money has migrated to a replacement fund, make sure the fund has an investment style close to that of the old one. Check out the fund on Morningstar's Web site, which offers free style assessments for thousands of funds. Also get a prospectus for the fund from your plan administrator, especially if the fund is designed just for your plan and is not listed in newspapers.
I have a ton of my employer's stock. It keeps piling up.
The 401(k) employer match--typically 50 percent of your contribution up to a limit of 6 percent of pretax income-is the easiest way to earn a pay raise with no extra work. But you're taking a risk when that match is all company stock--the case in 36 percent of 401(k) plans, according to Hewitt Associates, an Illinois employee benefits consultant. Enron employees discovered just how risky when they lost their jobs and company stock in their 401(k)s when Enron went under. They couldn't move their matching funds until they reached age 50. A growing number of companies, however, are allowing employees to move match money out of company stock sooner.
What to do: If your employer lets you sell company stock, take advantage of the option. Company stock should represent no more than 20 percent of your 401(k).
The stock market's going wild, but my 401(k) funds are blah.
Be grateful. The tech bust of 2001 proved that putting a load of money in specialty or sector funds, or one stock, could leave you with a sadly depleted retirement fund. Since then, many 401(k) plan administrators have avoided (and pared down) high-flyers lest they crash. Fund trustees, who have a fiduciary duty to make sure that employees retire with their savings intact, don't want adventurous investors to put all their money in such funds and lose their shirts. "We rarely recommend using these funds in plans," says Steve Yeager, senior vice president at SYM Financial Advisors in Warsaw, Ind., which consults with 401(k) plans.
What to do: You need your retirement money for your retirement, and if you're getting close, you should minimize risks. If you still have sector funds in your 401(k), move that money to a more diversified, less risky fund-say a mid- or small-cap growth fund. Your investment will then be better protected should an individual sector, say computer or oil stocks, crumble. If you want to invest in what look like hot single stocks or sectors, do so with your play money, drawn from outside of your 401(k).
I'd rather have my hip replaced than worry about asset allocations.
Fiddling around with a 401(k) is not always fun, but you have to keep on top of the stock-bond mix. Otherwise, you could end up with an all-stock portfolio just when the market goes phutt.
What to do: When you're in your 20s and 30s, you have time to recover from market downturns or your own investment mistakes. You can afford to be aggressive, with a split of 80 percent in stocks and 20 percent in bonds and cash. As you get older, you should gradually shift some money to fixed-income investments.
In recent years, many 401(k) plans have introduced auto-rebalance, which returns your funds to parameters you establish--say, 70 percent stock, 30 percent bonds. If you've got it, use it. But opt to rebalance just two or three times a year. Rebalancing creates transaction costs, notes King Lip, a certified financial planner and portfolio manager at Bingham, Osborn & Scarborough, a wealth-management firm in San Francisco. "If you do it too often, it reduces performance."
I wonder if I'm contributing enough.
Don't worry. You probably aren't. Fidelity says the average contribution by its plan participants has stayed at 7 percent of gross income since the late 1990s. If your income grows, your 401(k) contribution should too. Currently employees younger than 50 may contribute $15,000 a year to their plans; those 50 and older may pay in $20,000. But employees often sign up at a certain contribution level and forget about it. Or they stop or reduce the contribution during hard times and never re-up when their situation improves.
What to do: Hewitt Associates reports a small but growing number of companies offer automatic contribution escalation, which ups your 401(k) contribution yearly at a prescribed rate. A third of the employers it recently polled said they were very or somewhat likely to add the feature soon to their 401(k) choices. If your company offers automatic contribution escalation, take it. If not, raise the ante at the first opportunity, and stick a reminder on your calendar to do it again next year. A good rule of thumb, says Yeager, is to increase your contribution by 1 percent of income each year until you've maxed out.
I am still clueless. Help!
In a turnabout from just a few years ago, many 401(k) administrators now offer free investment help and, occasionally, advice for a price. Free help is often Web-based software that determines the proper mix of available funds in your 401(k).
A new twist on 401(k) advice is fee-based account management--a financial adviser just for 401(k) funds. One such service, provided by Diversified Investment Advisors in Purchase, N.Y., which offers a Web advisory service, costs individuals a small percentage of their plan assets each year. The service decides where the money should go and can move it for you.
What to do: Consumer Reports evaluated two Web-based advisory modules, Financial Engines and Fidelity's Retirement Income Planner, in February 2006. It concluded that they're very good tools if you have some financial savvy and the patience to plug in all the numbers.
If data entry leaves you cold and most of your financial assets are in your 401(k), you may find it worthwhile to pay for a managed 401(k) account. However, if you've got significant savings outside your 401(k), you may want to consult a certified financial planner, who can advise you on the big picture including insurance, estate planning, and other financial concerns. Two fee-only advisers are Garrett Planning Network (www.garrettplanningnetwork.com) and Cambridge Advisors (www.cambridgeadvisors.com).
So I left my 401(k) with my former employer. What's wrong with that?
New federal rules adopted last year allow 401(k) plans to charge former employees higher administrative fees than they charge current employees. Those fees can range from $50 to $200 a year.
What to do: If you still have money in your ex's 401(k), roll it over directly into an IRA. Aside from skirting those fees, you'll most likely be opening up your investment options far beyond what your 401(k) offers. Financial institutions, angling for lucrative rollovers, often offer some nice incentives to attract your money. T .Rowe Price, for example, offers to provide free retirement planning to rollover customers.
