401(k) plans have come a long way, baby.
The creation of the 401(k) plan in 1978 represented a dramatic shift in the way individuals became involved with saving for their retirement. Responsibility for choosing and monitoring investment performance of retirement-fund assets 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 guesswork out of designing plans and choosing investment options.
This article offers a good start to helping you invest like a professional and making the most of your plan's potential. (To learn about the basic concepts, see The 4-1-1 On 401(k)s.)
Benefits of 401(k)s
There is no shortage of information heralding the benefits of contributing to an individual retirement account, whether it's a 401(k), IRA, SEP IRA or any other qualified 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which can reduce your annual tax bill, and the fact that the investments grow tax deferred until they are withdrawn.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.
You may also have personal control over the types of investments to use inside the plan. 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. (For help with that, see What Your 401(k) Can Look Like in the Next 20 Years.)
Back to basics
Picking assets for your 401(k) is as easy as following the methods the pros use. Before investing or rebalancing your portfolio, 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 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 semi annually (at least). 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 How to Rebalance 401(k) Assets.)
401(k) Investment Options
Inside the Funds
For those who enjoy spending the weekend reading a mutual fund's prospectus distributed by the fund managers, all power to you. 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 they are greater than the fund is worth. You may also pay more for international investments as global funds tend to charge higher fees. It is likely that a professional firm has determined that the fees 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 Yield Means
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 of the instruments within, but it does not indicate the fund's actual return.)
What's in a Name?
When examining various funds available, 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 your firm'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 stuff, as it may be discounted in price and have fewer transaction fees (see Get The Most Out Of Employee Stock Options). It may also align your goals with the company's goals: You work hard, the company does well and the stock goes up. Everybody wins.
On the flip side, by investing in your own company inside your 401(k) plan, you may be increasing the risk for your portfolio. Its fate becomes tied to the firm's. Just look at those unfortunates who invested in Enron stock while working there (see What Enron Taught Us About Retirement Plans). If you already have employer stocks, you may find interesting.
The Bottom Line
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 your choices for investments before you started contributing. Most plans take most of the guesswork out of choosing the basic groups of funds and have provided what they feel are good categories. Your job is to act professionally by coming up with an asset allocation and sticking 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.