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Don't miss out on a 401(k) plan

A 401(k) can run almost on autopilot, but only if you program it well. Every 401(k) plan is different. Some may have very few investment options while others may have a dozen or more. Some may have a dollar-for-dollar matching contribution from the employer while others may not.

Nonetheless, certain fundamentals always apply when you're setting up your account.

"The first consideration is how much to contribute," says Fred Siegel, president of the Siegel Group in New Orleans and author of the upcoming book "401(k)s For Cowards." "My feeling is (you should) contribute as much as you can."

To "pay yourself first" with tax-deferred contributions is a valuable opportunity that shouldn't be squandered, he says.

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Experts agree that you're best off contributing as much as you can afford to a 401(k), especially when your company will make a matching contribution.

Whether it's a dollar-for-dollar match or a smaller ratio, "Don't give up free money," urges Craig Brimhall, vice president of wealth strategies with American Express.

You have to consider a number of factors before deciding how best to divvy up your 401(k) contributions among the investment options in the plan.

How much risk can you handle?
"Before you can decide how to allocate your contributions, you have to determine your risk tolerance," Siegel says. "What is your tolerance for volatility?"

The factors that affect your tolerance include how close you are to retirement, the value and security of your other assets and your personal inclinations. In other words, how conservative or adventurous you are.

"Younger employees tend to be more aggressive and have more risky investments," says Murray Cleaner, national sales manager for 401(k)s at Franklin Templeton Investments. "As they get older, they should shift away from those to more-conservative investments to protect the earnings they've made through the years."

After all, the closer you get to retiring, the less time your risky investments have to recover from a slump. More conservative investments, while they don't bring huge returns, tend to not suffer huge losses either, and so they offer a comfort zone for those closing in on their golden years.

Assets outside your 401(k) can affect your risk tolerance within it.

"You should look at your 401(k) as one part of your overall investment portfolio," Cleaner says. "Maybe you have an IRA with a large balance invested more aggressively, so maybe you need to be more conservative in your 401(k) so that when they're blended, you're right where you want to be in the risk-rewards spectrum."

Your personal inclinations are just as important to consider in determining your risk tolerance, Siegel adds. If you're conservative by nature and try to invest in a volatile area, you may not be able to stand the ups and downs.

"You might sell because you decide you can't take it anymore and take a loss as a result." That's bad because "you want to commit (your money) for a long term, and you want to keep contributing in good times and bad."

"You don't want to become one of these people watching your funds day in and day out," agrees John Siciliano, vice president of global accounts at Dimensional Fund Advisors. "The biggest problem among investors is a lack of patience. The bad thing about this e-mail and cell-phone age is we tend to think we need to respond immediately (by adjusting investments). Years ago, you weren't allowed to respond immediately and that was good."

Many 401(k) programs offer tools (online calculators, worksheets) for determining risk tolerance, but perhaps no tool is better than a competent financial adviser, Cleaner says.

Managing the money
A trusted professional adviser can explain the ins and outs of your company's plan and help you craft an allocation plan to meet your retirement goals.

It is possible to do the research yourself, Siegel says, especially by using investment Web sites to review the performance of the funds that your company's plan offers.

But let's face it, Brimhall says, "Most people don't do enough research. Most are under diversified, under saving for retirement and overestimating what their returns will be. An adviser will have a less emotional, objective viewpoint on your investments."

The adviser will use asset allocation models and knowledge of your risk tolerance to spread your 401(k) contributions over several asset classes.

For example, a very limited 401(k) plan might offer a fixed-income fund, a company stock fund and a domestic stock fund. An adviser would probably suggest the smallest percentage of the contribution be placed into company stock, and then balance the remainder among the other two.

The percentages would vary according to your risk tolerance. A younger investor would probably be urged to put a larger percentage in the domestic stock fund, which has the greatest prospects for long-term growth, while the older investor would likely be advised to invest more heavily in the fixed-income fund because it offers more stability, protecting assets in the interim before retirement.

Experts generally agree that young or old, risk tolerant or intolerant, you should resist any company siren song to invest heavily in your employer's stock. They disagree on rules of thumb, though. Some say 5 percent is the limit, more put the limit at 10 percent, and others say 15. Brimhall points out that if your employer pays matching contributions in company stock, you probably have about as much as you need. As always, this goes back to the Investment 101 principle: Diversify to spread risk.

The taxability of your asset classes is another issue to consider, according to Chester Spratt, professor of finance at Carnegie Mellon University.

"The research my collaborators and I have been pursuing on asset location has demonstrated the tax advantage of locating the highest yielding assets, typically bonds, in the tax-deferred context -- as the investment returns there are effectively not taxed -- and lightly taxed assets in the taxable account."

It's an idea that's not completely accepted, Brimhall says. He points out that tax law changes from year to year and that may prompt knee-jerk buy and sell decisions that may erode long-term investment growth.

"It's something worth pondering, although I wouldn't make wholesale changes," he says. "People should have that conversation with their financial adviser."

Once you have established the asset mix in your 401(k), you don't need to micromanage it because you've established a long-haul strategy that shouldn't fall prey to market fluctuations.

"Don't get discouraged when the market's down," Siegel says. "Keep investing because of dollar-cost averaging [you're able to buy more shares when the market's down], and check on your performance every so often. Once a year's perfect."

Cleaner and Brimhall agree that once a year's enough for you to see whether you need to rebalance, although Siciliano prefers funds that rebalance each quarter. To rebalance means to bring the percentage of each asset class back in line with your allocation model.

For instance, your model may call for 33 percent in stable fixed interest investments, 33 percent in stock funds and 33 percent in bond funds. If the bonds perform better than the other two, the percentages will change, so you shift funds to bring the percentages back in line.

"What we might do is rebalance by selling some bonds and buying some stock," Brimhall says.

During the annual review, you can also adjust your investment strategy based on life events (you've had a child, you've bought a house, etc.) and your changing risk tolerance as you get closer to retirement.

"Come retirement, you need to seriously go through the exercise of whether you should leave your funds in the 401(k) or roll them over into an IRA," Brimhall says. "There are pros and cons to both. You are not an owner in a 401(k) and you do not have unlimited access to the funds ... With an IRA, you're a full owner. The beneficiary treatment on a 401(k) is different from an IRA ... There are no right or wrong answers."

-- Posted: May 20, 2004

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