The S&P 500 had a banner year, one of the best in the past century, racking up a 25% return after the 37% drubbing the year before. But not all investors were raising their glasses at the end of 2009. With so many skittish after the crash of 2008, many spent the year avoiding or limiting their 401(k) contributions, while others moved their investments into bond and cash funds, which (while stable) didn't provide nearly the boost of the stock market. (Learn about the benefits and drawbacks of this new investment account and see if it's right for you, in A Closer Look At The Roth 401(k).)
Very few investors had the full allocation to stocks that they wanted when the market hit its lows in early March of last year. According to a new study conducted by mutual fund industry trade group the Investment Company Institute, about 90% kept asset allocations the same between January and September of last year.
Indeed, most of us spent 2009 frozen to get back into stocks again, and in so doing missed out on the best run in a decade. But that same survey discovered that 73% of us feel confident that our 401(k) can help us reach our retirement goals.
In the spirit of the latter's (correct) conclusion, below are a few 401(k) moves to help you survive 2010, or for the optimistically-minded, a revival guide for your retirement assets. Before we begin, it's worth taking a moment to reflect on just how vital the 401(k) is to the modern worker. (Learn five steps that'll put your retirement back into your own hand, in Chipping Away At The Pension Freeze Trend.)
The 401(k) Landscape
The 401(k) program is the new pension system. For the majority of working Americans, the 401(k) is the only retirement vehicle that can realistically become a sizable chunk of one's retirement nest egg. The ability to set aside pretax money - and in many cases get a percentage match from your employer - can't be beat in terms of bang for your buck.
Because 401(k) funds are paid out of pretax dollars, investors can essentially earn a free return equal to their tax rates. So a hypothetical 401(k) pretax funding of $1,000 would only be $750, were it to show up in your paychecks, given a 25% tax rate.
The general consensus on 401(k) advice is twofold: first, you should always try to contribute as fully as possible, at the very least, up to the percentage of your income that the company will match – that is just plain free money. Secondly, you should seek out diversified investments in stocks and bonds, whether you have just a few options in your plan or hundreds. Save your riskier investment choices for taxable accounts. (Employees have a love/hate relationship with this retirement option. Find out more in Pension Plans: Pain Or Pleasure?)
5 Moves to Renovate your 401(k)
- Know Your Company's Most Up-to-Date Match Policy
After limiting company matches or cutting them altogether during the recession to help save money, many firms are reinstating their match policies in 2010. Starbucks, American Express and just recently JPMorgan Chase are included in that list. Check with your plan manager to see what the current status of your plan is, and, if you need to, press your plan sponsor or human resources director for information.
- Use Your 401(k) in Asset Allocation Calculations
Every investor should know the overall asset allocation by including all invested assets. This should include any IRAs, taxable accounts, and even side investments like gold and real estate. Your 401(k) is an essential piece of this puzzle. Because most 401(k) plans offer a number of free transfers per year, use this to your advantage and shift things around to get your total asset allocation where you want it to be.
For investors under the age of 40, aim to have at least 60% of your total asset allocation be towards stocks; you've got enough time to retirement to let the historically higher returns of stocks outweigh the potential for an off year. For investors within 10 years of retirement, it's time to transition the lion's share of your nest egg into fixed income (bond) assets, or blended mutual funds that offer exposure to corporate and municipal bonds as well as U.S. Treasuries. (The retirement income distribution methods in 3 Ways To Make Your Retirement Funds Last are all viable; the one you choose will depend on your personal circumstances.)
- Know Your Fees
Not all funds in your 401(k) plan have the same fees; in fact, some are inherently much cheaper than others. In general, the cheapest funds should be index funds, such as those offered by 401(k) stalwart Vanguard. Vanguard funds typically have expense ratios less than .5% per year. In contrast, specialty funds can have expense ratios of 1.5% per year or higher, which really eats into your returns when added up over several years.
Another good idea is to avoid a type of fund most plans offer, the so-called "life cycle" funds that often have target retirement dates in their titles. These funds try to be a one-stop shop for investors, but they typically cost much more than you can get by just choosing a stock index fund and a bond fund individually. By avoiding the life cycle funds, you're also more flexible to use those free transfers when you need to get your asset allocation where you want it.
- Know Contribution Limits
Typically, the contribution limits rise gradually each year to keep up with inflation, but this year may be interesting because we have no current inflation as far as the IRS is concerned. So, the 2010 contribution limits will be the same as last year: $16,500 for those under 50 and $22,000 for those 50 and over.
If you can take advantage of the catch-up provision for those over 50, it's highly suggested that you do so, even if it means forgoing some taxable investments. The pre-tax boost is too good an offer to pass up.
- Don't Chase Performance
It's a safe bet that we all spent some time in the past month looking over the performance results of all the options in our 401(k) plans. Part of the process is simply out of curiosity, but there is the temptation to take it to the next level and shift investments into the best performers from last year. Avoid this temptation! Economic recoveries move in phases, and a particular fund that used to do well in 2009 does nothing to guarantee success in 2010. Chasing performance is a recipe for disappointment, and many studies of mutual fund managers prove this to be true.
Stick to a plan where you decide where you want to be, then choose the cheapest fund from a reputable manager that gives you the investment exposure you're looking for. Most economists predict that the U.S. economy will continue to recover this year, and that inflation will be tame. They also predict that the dollar will remain at lower levels compared to other currencies, and all of those predictions create a pretty good atmosphere for U.S. large cap stocks, such which can be found in an S&P 500 index fund.
Frustrated with how your 401(k) performed last year? If you are happy, use that momentum to keep you informed and proactive so you can have another productive year. If you missed out on the gains you wish you'd received, understand that you can't get it all back in a day, and stay on the path of measured investment.