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