401(k) plans have come a long way since they were first launched in 1978. The creation of the 401(k) plan represented a dramatic shift in the way individuals became involved with their personal retirement investments. Responsibility for choosing and monitoring investment performance also shifted from the employer to the employee. Over the years, many employers have worked to ensure that employees have access to simplified information and to experienced financial professionals who can help them take the guess work out of designing plans and choosing investment options.
This is a good start to helping you invest like a professional and cash in the largest retirement plan savings possible. (To learn about the basic concepts of 401(k) plans, see The 4-1-1 On 401(k)s.)
Read on for more tips on how to make the most of your retirement savings.
Benefits of 401(k)s
There is no shortage of information heralding the benefits of contributing to an individual retirement plan, whether it's a 401(k), IRA, SEP IRA or any other individual retirement plan. Benefits include pretax contributions, which can reduce your annual tax bill, and the fact that the investments grow tax deferred until they are withdrawn. Many employers also provide matching contributions to 401(k) plans to help your contributions grow even more. You may also have personal control over the types of investments to use inside the plan based on your risk tolerance and investment horizon. This is where there can be a disconnect between theory and application. Investors may point their portfolios toward extreme ends of the risk spectrum and be tempted to jump in and out of the markets without taking the long-term perspective into consideration. (To learn more about the benefits of retirement savings, see Plan To Retire Rich.)
Back to basics
Picking assets for your 401(k) is as easy as following the methods the pros use. Before investing or rebalancing your 401(k), step back and evaluate your risk tolerance and investment time horizon. Many employers have online tools to help you determine these parameters.
Next, establish a long-term asset allocation based on those parameters and just like the pros, write it down! You may want to draft an informal investment policy statement for that allocation, with guidelines for rebalancing. This will help you remove the temptation to jump in and out of the markets or make dramatic asset allocation shifts. You can estimate what your long-term performance may be based on historical ranges of various portfolios.
Your employer may offer tools to help you familiarize yourself with risk/reward relationships. The key again is to act like the pros, stick to your allocation and make strategic asset allocation adjustments just like the pros make at least semiannually. This means that your asset allocation does not change just because the market changes, but only if the premise for building your allocation changes. (For more insight, read Rebalance Your Portfolio To Stay On Track.)
Inside the Funds
For those who enjoy spending the weekend reading the prospectus distributed by the fund managers, it's fine to spend some time going over this. However, it's important to keep in mind that your plan administrator has already done the lion's share of the due diligence. In other words, the funds offered to you have been thoroughly reviewed and evaluated for fees, expenses, performance and investment. This doesn't mean you can close your eyes and toss a dart when choosing your investments, but if you have a choice between two large-cap funds, chances are they will be similar in many respects. Even though you will have no choice but to pay the internal fees, it's important to know what they are. There will undoubtedly be outliers with higher fees; you may want to stay away from funds with higher fees if you feel the fees are greater than the fund is worth. You may also pay higher fees for international investments as those funds tend to charge higher fees. It is likely that a professional firm has determined that the fees for the funds are within reasonable ranges, but you should check them anyway to be sure. (For more on fees, read Stop Paying High Mutual Fund Fees.)
What the Pros Look At
The first term you need to be familiar with is yield. Every mutual fund will post its current yield and too often, investors make assumptions about that number. Here is the secret: It means almost nothing to you in the long term.
What does yield really mean? It represents the aggregate yield on the total portfolio at a given time: because the numbers are at least one-month old, they mean even less. For bond funds, the yield may give you an indication of the maturity length, but it does not indicate the actual return. (For tips on picking assets like a pro, see Pick Stocks Like Peter Lynch, Warren Buffett: How He Does It and Think Like A Stock-Market High Roller.)
What's in a Name?
When examining various funds available to you may be confused about names. Just what is the "Strategic Balanced Asset Allocation International Fund" anyway? Forget the name - it may provide little indication of what is inside the fund. Take a deeper look to see for yourself. Your employer will most likely have a risk profile quadrant set up so you can see where each fund ranks in terms of long-term risks, so focus on the long-term performance of the fund. (For more on analyzing a company, read Understanding The Style Box.)
Whether to buy employer's stock for your 401(k) is a person choice, but there are two schools of thought on the subject. One theory is to load up on the stock in your 401(k) as it may be discounted in price and have fewer transaction fees. It may also align your goals with the company's goals. You work hard, the company does well and the stock goes up. On the flip side, by investing in your own company inside your 401(k) plan, you may be increasing the risk in your portfolio. Some good examples of this level of risk are those who lost significant assets while invested in Enron stock while working there. (For more on this, see What Enron Taught Us About Retirement Plans . If you already have employer stocks, you may find Get The Most Out Of Employee Stock Options interesting.)
You can invest and pick assets like a pro. This is easier to do in a 401(k) because a professional has likely already put significant thought into presenting your choices for investments before you started contributing. Most plans take most of the guess-work out of choosing the basic groups of funds and have provided what they feel are good categories. Your job is to act like a pro with your asset allocation and stick to it. Ignore the fancy names, look behind the scenes and don't focus on the current yield. Most importantly, stick to a written long-term strategic asset allocation plan and adjust your account based on that plan to avoid the temptation to jump in and out of the markets. This will help you earn the best returns over the long run.