As of 2011, The Investment Company Institute reports that the 401(k) plan retirement system holds over $3,000 billion in assets, over 50% of which are found in stock-based mutual funds. Despite their popular use, many investors are uncomfortable with them and unfamiliar with the "rules of the road" when it comes to the proper care and feeding of your retirement nest egg. Since popular media is replete with articles and webcasts on the wise management of a 401(k) plan, there are few that address mistakes that can spell the difference between retiring on a princely (or princessly) sum and retiring as a pauper (i.e. not retiring). Here are just five common mistakes you should avoid.
Tutorial: Introduction To Retirement Plans
1. Not Participating in Your Company's Retirement Plan
As the saying goes, "You've got to be in it, to win it." Gone are the days of the pension plan and the gold watch at retirement. The responsibility is on the employee to take the initiative and complete the paperwork. Be it a 401(k), 403(b), 457 or other similarly numbered option, you must take the time to actually enroll. Fortunately, it's not hard and much of the enrollment process can be handled online. In fact, many employers will automatically enroll you in their plans which is great for you and typically great for the employer. Of course, now that you have signed up, you need to contribute. It goes without saying that if there is a company match, you should contribute at least enough to qualify for the match. By doing so, you are basically giving yourself a raise.
If your employer matches up to 6%, that means that for every dollar you contribute to the plan up to 6% of your earnings, the employer will contribute to the plan as well. How do the numbers look for an employee earning $50,000 per year with a plan that pays a match of 50% of the employee's compensation up to 6%? Six percent of the employee's earning equals $3,000; the employer's match of 50% of contribution on this $3,000 equals $1,500. That is a total of $4,500 that goes into the plan versus just $3,000 if there was no match. Compounded over time, this benefit grows to a significant sum of money. (Most of us will rely on a pension plan in the future, so it's best to know the details of the various plans before signing up. Check out A Primer On Defined-Benefit Pension Plans.)
2. Trying to Time the Market and Not Diversifying
For most Americans, their principal exposure to the nation's stock and bond markets is by way of their employer's retirement plan. Many take this as an opportunity to play hedge fund manager with their retirement portfolios. Don't do it! Well-recognized investors like Warren Buffett and David Swensen, manager of YaleUniversity's $15-billion endowment, advocate index investing. For the investor focused on their retirement, 2008-2009 was a great buying opportunity. Sure, during the debacle it didn't feel great, but having a long-term focus kept many 401(k) and 403(b) investors from cashing out at the bottom. In fact, many continued to contribute, thereby lowering the average cost of their holdings.
Take the time to choose an asset allocation policy that best suits your risk return profile - sometimes the help of a financial planner or free asset management tools can help in this decision. Select your asset allocation or investment model and LEAVE IT ALONE. These options are one-stop choices for diversification. Unrest in the Middle East, higher than normal inflation, tsunamis or any of the other short-term shocks to the global economy, while unsettling, should not change your individual retirement plan and therefore should not significantly change your asset allocation. Focus your efforts on the things you can control.
3. Borrowing From Your Plan
Some things are legal but just not wise. This is one of those things. The common perception is that you borrow from yourself and the interest gets paid back to you. What is the harm? In fact, while you are borrowing against your balance, you will incur a loan charge typically around $150 regardless of the size of the loan. The rate that is charged on the loan can vary. Some are as low as the prime rate but some plan loans have significantly higher rates. While it is true that the loan and the interest eventually gets paid back to your account, it does negatively impact your total return on those funds and therefore the long-term results from the investment. Loan repayments have two components: the principal replacement and an "interest" payment.
Looking at the retirement portfolio in isolation from your other assets, interest on the loan can be viewed as a return on borrowing. However, the total return is reduced by the foregone investment growth. In other words, if the prime rate today is 3% and the investor took out a loan today, that is the rate they would receive. Assuming the equity markets perform similar to their historical norms then one might expect a pre-tax return of around 7% for a global equity portfolio. That is a 4% opportunity cost. Also, you must consider that the dollars used to pay the "interest charge" are after-tax dollars and you will pay taxes on those dollars again when you finally take the money out at retirement. Lastly, if you lose your job or leave your job for any reason, you will owe the entire amount back otherwise it will count as a distribution. If you are less than 59.5, the 10% penalty applies.
In my experience, taking loans from a 401(k) exacerbate the cycle of poverty because the people who typically take advantage of this option are the ones whose positions are most at risk and the things the money typically gets spent on have virtually no value. (Left with no alternative but to take money out from your retirement savings? Here are some guidelines. See Borrowing From Your Retirement Plan.)
4. Cashing Out Your Plan
I am always amazed by the number of people who cash out their plan when they leave their previous employer. I hear excuses like, "It was easier than rolling it over," or "I needed the money for moving expenses," or, the best, "I used the money to fund my vacation before I started the new job." If you are 59.5 years of age or younger, you will pay a 10% penalty on what is called a premature distribution. Let's put 10% into its proper context. Taking out $1,000 would result in a $150 charge plus an additional $100 penalty, resulting in an immediate 25% loss. Secondly, you will pay the income taxes that are due at your current rate. Finally, the amount of borrowed funds has to be returned to the account eventually, possibly in an environment with a gloomy market forecast.
5. Too Much Company Stock
In my humble opinion, company stock doesn't belong in a 401(k). Having company stock in a 401(k) plan is good for the company in a few ways, but it is a bad idea for the non-owner employees in many ways. The principal reason is that you lose the multiple benefits of diversification. Remember, a key tenet of successful investing is to reduce risk as much as possible. When you both work for the company and your investment capital is invested in the same company, you have significantly increased the probability that bad fortunes at the company may translate to bad fortunes for you and your family. Remember, the number of years you can productively work is limited; 40 or so years is the norm these days. During that time, you must save enough to support yourself for perhaps another 30 years!
Sometimes, companies make their stock available to employees at a discount through employee stock options or other direct purchase programs. It may seem like a great idea. The requirement to diversify is so great that you are probably best served by taking advantage of the discount and realizing the gain on the "discount" as soon as practicable. Of course, you're thinking, what about the Google employees who are now millionaires because of their stock? Don't confuse luck with skill. On the streets of this nation, there are many former employees of Enron, Pan Am, Worldcom and others who also believed in their company's stock. Even if your retirement plan does hold your employer's stocks, try to minimize the holding to ensure minimal correlation between retirement plan returns and human capital. (Half of Americans lose their nest eggs when they switch careers. Learn why you should avoid this trap. Refer to Transfer Retirement Savings When You Change Jobs.)
The Bottom Line
As with many things in life, it is often the mistakes you avoid that spell all the difference between success and failure. If you are reading this article, you are already well on your way to gaining the self-education you are going to need to build a solid retirement nest egg.