This article applies to all “defined contribution” plans where the employee is tasked with choosing investments within an employer-sponsored retirement plan.
Ever since 401k plans started replacing pension plans in the 1980s, employees have been given the challenging responsibility of making investment choices that could make or break their retirement years. Given that investment professionals spend years learning about designing a proper investment portfolio, this is asking a lot of the average employee.
I remember filling out my first 401k application in the early 1990s. I did what any intelligent, college-educated person would do: I picked the one fund with the best recent track record. As you may guess, this is not a good strategy. Different types of investments go through very different cycles, and yesterday’s winner may easily be tomorrow’s loser.
In this article, we’ll walk you through how to make investment decisions in your plan to match your time horizon, achieve sufficient diversification and avoid the hidden costs that drag down many funds.
The main objectives when investing in a 401k plan are:
- Contribute enough to meet your income needs in retirement
- Appropriate asset allocation (weighting in stocks and bonds) for your age
- Minimizing fund expense ratios
Starting Point - Keeping it Simple
Let’s start with keeping this as simple as possible and then addressing deviations from this plan when/if warranted.
- Contribute 15-20% of your pay. If this is not possible, start with what you can (at the very least, contribute enough to take advantage of your company match) and every time you receive a raise, increase your contribution by 50% of your pay increase.
- If you have a Roth 401k option, during the first half of your working career you should contribute to the Roth. Use the traditional 401k option for the second half of your career (when your income will put you in a higher tax bracket and the pre-tax contributions will be of more value). If you’re beyond mid-career and do not have any Roth assets, choose this over traditional. It will be very beneficial in retirement to have Roth assets.
- Choose a target retirement fund that falls between your 65-70th birthday. For a 47-year-old born in 1976, use “Target 2045” (1976+65=2041). This fund will provide the necessary diversification across different types of asset classes and will become more conservative as you get closer to retirement age. Ideally your plan has an “index” target date fund. These funds carry very low expense ratios and have proven to outperform their “active” and more expensive counterparts.
- Do not worry about any fluctuations in the value of the account. You will be in great shape when you need the money in retirement. The message here is to stick with your investments through all market conditions without making any changes other than increasing your contributions.
For various reasons you may not be able to (or want to) follow the simple plan above and may need/want an alternative plan. Below are a few reasons to deviate and what to do.
Amount of Contribution
At the very least, you should take advantage of any employer match. If your employer provides a 100% match on the first 2% you contribute and then matches the second 2% at 50%, make sure you contribute 4% to receive every free dollar available.
As mentioned above, if you need to start small, you should still do what you can to increase the contribution amount when you receive pay increases.
Not all mutual funds or investment options are created equal. The number one determinate of a fund’s future success relative to its benchmark comes down to fees. The lower the fee, the higher the expected return. Both the Vanguard 2045 fund and Schwab 2045 have an expense ratio of 0.08%. On the other hand, the Fidelity Freedom 2045 charges 0.75% per year – almost ten times the others. This fee drag can mean a significantly lower balance when it’s time to retire.
If the expense ratios of the fund options are high in the plan, and if you qualify for an IRA, you may want to contribute only to the match and invest additional dollars outside the plan. Anything over 0.25% is high. Many plans offer funds significantly below this and ideally these lower cost funds should make up the majority of your choices.
No Roth 401k Option
If there is not a Roth 401k option and if you are not over the income limit, a Roth IRA may be a good option. Consider opening up a Roth IRA and contributing to this after meeting the company match in your work 401k.
No Target Retirement Funds
Most plans today have target retirement funds as options. As long as these are created with low-cost index funds, they can be a very good option. If your plan does not offer these options, here is a simple guideline for selecting funds:
- Opt for index funds as much as possible.
- 70% of your equity exposure should be in a total market index fund.
- 30% of your equity exposure should be in a total international equity index fund.
- The fixed income portion of your portfolio should be in a total bond index fund.
Your Time Horizon & Asset Allocation
Your time horizon is basically from now until the end of your life, and your time horizon is directly related to how much risk you should take in your investment portfolio. More stocks/equities equal more risk but a higher return. The rule of thumb is that the longer your time until retirement, the more you should have invested in equity (stock) funds. A good formula for your asset allocation is to subtract your age from 120 and this should be your percentage in equities. Example for a 50-year-old: 120-50=70% in stocks.
This is just a guideline and can be influenced by other factors such as how much you have saved outside of the plan and what the allocation is with those assets. The main point here is to have enough in equities and to stick with it through all market conditions.
Some 401k plans offer company stock as an investment option. This is not a good option for your dollars. Working for a company and betting your retirement dollars on that same company isn’t a good idea.
Investing Outside of Your Employer Plan
If you have a plan that does not offer good investment options (many 403b and 457b plans fall into this category), it is often best if you only invest up to any employer match and then invest outside the plan. The main risk of going outside of your plan is actually doing it. Once you have something set up, we recommend automating it as much as possible so that it acts similar to your work plan. Here are the steps:
- Once you determine how much you wish to contribute outside of your plan per pay or per month, have that amount of your paycheck go into a separate savings account at your bank. Your HR dept should be able to help with this.
- Open an IRA online at Schwab, Fidelity or Vanguard.
- Set up a monthly transfer from your bank account to your new IRA account.
- Choose a target retirement fund with the guidelines above for your investment dollars and have your contribution purchase this fund each month automatically.
There are a number of income and contribution limits with IRAs that you will need to be mindful of. If you do not qualify for an outside IRA or would like to contribute beyond the maximum contribution amount, first, make sure you’re contributing to your Health Savings Account if you have one, and then a taxable investment account is always a good final option with no income or contribution limits.
Just like everything else in personal finance, there are many different scenarios and it’s difficult to cover everything in a short article. Doing a little homework can put the odds in your favor, and we hope this gets you started in the right direction.