| 401k Advice That Everyone Could Use |
|
Getting proper 401k advice is essential to maximizing your retirement savings. 401k advice offered by professional advisors is likely to come with exorbitant annual fees attached which will significantly reduce the amount you will have saved by retirement. In this article, we try and give you some 401k advice that will make a meaningful impact on how you invest and grow the money in your 401k.
What is a 401k?
A 401k plan is a cash or deferred arrangement under which a covered employee can elect to have a portion of his or her compensation contributed to a qualified retirement plan as a pre-tax reduction in salary (however, some plans also accept after-tax contributions from employees). 401k plans are named after the section of the Internal Revenue Code in which they appear, and apply to private-sector employers. Similar salary-deferral retirement plans are authorized in the tax code for public-sector employees (known as 457 plans) and nonprofit-sector employees (known as 403b plans).
In a 401k, assets may be invested in a wide variety of investment vehicles such as stocks, bonds, guaranteed investment contracts (GICs), cash-equivalents, or a diversified portfolio of these and other investments. The pre-tax contributions as well as earnings on an account are taxed only when withdrawn. However, employers have the discretion whether or not to make matching contributions to their workers' 401k accounts.
Easy 401k Advice: Start Investing Now!
401k plans are so powerful because they harness the power of compound interest. Every year that you delay investing in a 401k plan will significantly reduce the amount of money you will have available in retirement.
This chart, courtesy of the Motley Fool, really shows you the power of compound interest. If you contributed only $5,000/yr for 10 years at starting at age 25, you would have almost $800,000 by retirement at age 65 (assuming an 8% compound rate of return). If you started contributing the same amount, starting at age 45, you would only have $170,000. In both cases, you only contribute $50,000 of pre-tax income, but the major difference is the amount of time that the $50,000 gets to grow at 8% a year.
Our advice to you is to start investing now, if you're 25 -- great, you can have a sizable nest egg when you retire with minimal effort. If you are 45, don't wait until you are 55 or later, because you still can end up with over 3 times the amount of money invested by age 65.
Take Advantage of Currently Low Stock Prices
Although many people have been recently hurt by the recession and the plunge in the stock market, the current environment presents an perfect opportunity for those looking to start a 401k. If you are investing for the long-term, now couldn't be a better time to buy stocks as they are likely to appreciate at more than 8%/yr for the next 20 years, since the current levels are so depressed. For those without a 401k -- start now!, and for those already with a 401k -- contribute more (as long as you don't need the money for living expenses in the next 5 years).
401k Investment Choices
401k plans offer investment choices that usually number between 8 to 20 options with the average plan having around 15. The typical investment choices in a 401k plan are likely to be:
- Money market funds
- Stable value accounts (guaranteed investment contracts (GICs) or bank deposit accounts)
- Bond mutual funds
- Stock mutual funds
Money market funds and stable value accounts are considered to be the safest investments, but will produce very low returns. Bond mutual funds will produce higher returns, but will produce significantly lower returns when compared with stocks (bond mutual funds have less risk). Stock mutual funds will produce the highest returns (averaging 8-10%/yr), but can experience significant volatility on a yearly basis. Yearly returns from stock mutual funds have been as high as 50% and as low as -40%.
Diversification Isn't Always the Best Option
Most investment advisors will tell you to be diversified, but this is the wrong 401k advice. The amount that you diversify your portfolio is directly dependent on the amount of years you have left until retirement. If you are young and have twenty years or more to save for retirement, you should be putting your money into stocks. Because you have over 20 years to save for retirement, it is not worth sacrificing lower returns for lower volatility. If you have less than 20 years to retirement, you should be much more diversified. Common rule of thumb here is to have a 70-30 or a 60-40 mix between stocks and bonds. A better rule is to increase the proportion of bonds, money market funds, and stable value accounts in your 401k every year that you get closer to retirement. For example, 20 years out you might have an 80-20 mix, 10 years out a 70-30 or 60-40 mix, and 2 years out you may have all your money invested in money market funds and stable value accounts.
Due to the 2008 economic crisis and subsequent stock market decline, many 401k investors lost their shirts because they were not properly diversified. Unfortunately, most of these individuals had 100% of their money allocated to stocks even though they had 10 years or less until retirement. As a result of their losses, many of these people are now forced to postpone their retirement, or perhaps not retire at all. This is a classic example of why that, as you move closer to retirement, the return "of" your money is more important than the return "on" your money.
Only Invest in Index Funds
It's a well known fact in academic circles that most mutual funds underperform their tracking indices. This is why when a mutual fund outperforms its index, it is so well publicized and people flock to the fund. However, picking a fund that will outperform its index is very difficult and if even if a fund outperforms its index for one or even a couple of years, how likely is it going to consistently do that over a 20 year or even 40 year period? With the advance of exchange traded funds (ETF's) that track indices, it doesn't matter.
Index funds are offered as an alternative to mutual funds in most plans and if your plan doesn't offer one, ask or request that it does; there is too much money at stake. It's extremely important to invest in an stock index fund if you are allocating money to stocks, but there are also index funds that track bond markets as well as money markets. Perhaps the best stock index fund to invest in is one that tracks the S&P 500 (SPY); just put your money in there and check your account balance in 20 years. Index funds also charge much lower fees when compared with mutual funds since they are not actively managed.
Another reason not to invest in mutual funds offered by 401k plans is that the quality of the fund is typically mediocre to average at best when compared with other funds in their category. Because most 401k investors are financial novices, these funds use big, sexy words to make their funds sound sophisticated and to attract investors. They flock to 401k plans in order to promote their product since they would have a hard time attracting investors otherwise, due to their poor performance. If you have to invest in a mutual fund, we recommend using Morningstar to help you select one; its a great free research service for mutual funds and exchange traded funds alike. On Morningstar, you can see the past performance of each fund and Morningstar assigns its own rating based on a variety of factors (not just performance).
Limit Amount Of Company Stock
Have you ever heard of a little piece of advice that goes: "dont put all your eggs in one basket"? By having a 401k plan that is heavily invested in company stock you essentially put all your eggs in one basket. Even though you have to pay a penalty if you withdraw early, many people use the money in their 401k's to pay for living expenses after losing a job and being unable to find employment after an extended period of time. If you lose your job, like many have in the 2008 recession, it is likely due to problems at your company which would be accompanied by falling share prices. If you over invest in company stock, your 401k may be worthless at the time when you may need it the most. However, if your employer provides a subsidy for purchasing company stock into your 401k, by all means take advantage of it, but still diversify.
Understand What Fees Your 401k Plan Charges
Most people don't understand what fees they are paying as part of their 401k plan. A 2007 survey by AARP entitled 401k Partcipants' Awareness and Understanding Of Fees, found that 65 percent of 401k enrollees believed they were not paying any fees. When told that fees were commonly charged in 401k plans, an estimated 83 percent of participants acknowledged they did not know how much they were paying.
It is very important to understand and possibly reduce these fees because losing a couple percentage points each year due to fees can significantly impact the amount of money you will have saved by retirement. To understand the impact that 401k fees have, lets look at the following example:
Assume that you are an employee with 35 years until retirement and a current 401k account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.
401k plan fees and expenses generally fall into three categories:
Plan Administration Fees
- The day-to-day operation of a 401k plan produces expenses for basic administrative services that are necessary for administering the plan as a whole. These administration costs may be paid directly by the plan and are either allocated among individual accounts in proportion to each account balance or passed through as a flat fee against each participant’s account.
Investment Fees
- Are the largest expense associated with 401k plans. Fees for investment management and other investment-related services generally are assessed as a percentage of assets invested and are deducted directly from your investment returns. Your net total return is your return after these fees have been deducted. For this reason, these fees, which are not specifically identified on statements of investments, may not be immediately apparent.
Individual Service Fees
- In addition to overall administrative expenses, there may be individual service fees associated with optional features offered under a 401k plan. Individual service fees are charged separately to the accounts of individuals who choose to take advantage of a particular plan feature. For example, individual service fees may be charged to a participant for taking a loan from the plan or for executing participant investment directions.
Selecting a Mutual Fund in Your 401k Will Produce Additional Fees
In addition to fees associated with the 401k plan itself, each of the investment alternatives within the plan are likely to have associated fees as well. Index funds will produce the lowest fees, which is one of the reasons why we prefer index funds when compared with mutual funds. If you are going to be choosing a mutual fund in your 401k plan, make sure it meets the following criteria:
Low management fees (below 0.75%)
- Management fees are annual fees charged by all funds. Index funds typically charge about two-tenths of one percent of the assets, and actively managed funds currently average about 1.6% per year. Any fund that has management fees above 1% per year can be expected to underperform the total returns offered by an index fund.
No sales charges (also known as loads or commissions)
- Sales charges come in various forms and sizes. There might be a charge for buying into the fund (a front-end load), or selling the fund (back-end load, deferred sales charge, or redemption fee). All of these should be avoided. If you have to buy an actively managed fund, buy the fund with no sales charges at all. Funds that normally have sales charges sometimes waive them or have reduced sales charges for large 401k accounts.
No 12b-1 fees
- 12b-1 fees are yearly charges that the fund takes out of your money so that it can market itself. You don't want to be paying those at all. Any fund with a 12b-1 fee above 0.25% can be excluded.
Where Can I Get Information About the Fees Charged by My 401k Plan?
If you have questions about the fees and expenses charged to your 401k plan, the best person to contact is your plan administrator. The plan administrator should provide you with copies of documents describing investment management and other fees associated with each of the investment alternatives available to you (i.e., a prospectus). The plan administrator should also provide a description of any transaction fees and expenses that will be charged against your account balance in connection with the investments you direct. You should also consult the summary plan description (SPD) that will tell you what the plan provides and how it operates. It may tell you if administrative expenses are paid by your plan, rather than by your employer, and how those expenses are allocated among plan participants.
60 Minutes Chronicles the Recent 401k Fallout
Recently 60 Minutes ran an exposé entitled "401k Recession" that chronicled the fact that in the current recession many people's retirement dreams have disappeared with their 401k's.
"Trillions of dollars have evaporated from those accounts that have become the prime source of retirement funds for a majority of American workers, affecting their psyche and their future. If you are still young enough, there's time to rebuild and recover, but if you are in your 50s, 60s or beyond the consequences can be dire, and its drawing attention to the shortcomings of a retirement system that has jeopardized the financial security of tens of millions of people."
In our mind, the video is a must watch and touches on a lot of the things we have discussed here. The recession cannot be the sole source of blame for the losses that these people have taken in their 401k's. The lack of solid 401k advice has hurt them as well. Good 401k advice would have told those individuals in their 50's or 60's to have at least 30% of their money in bonds to help insulate themselves from a stock market crash. Good 401k advice would have also prepared them to be aware of and reduce fees that their plan may be charging. It's clear that a lot of these individuals did not have good 401k advice, but you do.
That's it, now go have our 401k advice make you money!
| Next >Types of Funds |
|---|
|
|
Recommended Reading
