Getting The Most From Your 401(k)
People who invest heavily in their 401(k)s expect to have enough money to retire. Many are surprised when they come up short—a topic Frontline recently covered in "The Retirement Gamble." What is going wrong?
The show cited mutual fund fees, a topic we tackled in depth in our special report The Top 10 ETFs to Replace Your Expensive Mutual Funds. In addition to fees and some basic number-crunching, there are fundamental issues that determine how well our 401(k) and other retirement accounts perform.Boost Your Mental Game
The mental game is as important to investors as it is to professional athletes. As legendary investor Benjamin Graham often noted, active investors generally do better than passive ones. They keep learning about investing, and they manage their own money. Passive investors, on the other hand, stick their money in CDs, bonds, and other fixed-income investments that require less time and financial expertise. These folks should expect a lower return in the long run.
Investors tend to become more passive as they age. After all, the older we are, the fewer years there are to plan for. That's a dangerous approach, and it just won't work today. As most seniors and savers already know, high-quality fixed-income investments don't even keep up with inflation. Committing—or recommitting—to active investing will have a huge effect on how well your retirement accounts perform.
In the episode I mentioned above, Frontline interviewed several people about their 401(k)s. The fear and confusion they relayed drives home why active investors come out ahead. Here are a few of their comments:
- Debbie Skoczynski, Computer Leasing Agent: I had no idea. I was so confused. I came out of that meeting, and I was, like, "Oh, my God." It was just—it was overwhelming for me, the knowledge that you had to have in order to invest.
- Crystal Mendez, Teacher: I really was kind of clueless. I didn't know what I wanted to invest in. I really didn't know anything about it. I had learned somewhere—some—I had heard something about, if you're young, you should be more willing to take risk. You have time. So other than that, I really knew nothing.
- Mark Featherston, Former Sales Manager: They showed you the plan. You either had your choices between an aggressive investment, moderate, or conservative. You know, there was nobody there managing my money. It was all up to me.
Many employees invest in their own company's stock through 401(k)s. Employers put tremendous pressure on their employees to do this. Corporate culture pushes employees to go in whole hog, especially if the company's stock is performing well. No one wants to end up the sole non-millionaire in the office because of a silly thing like diversification.
If you've felt that pressure, consider a statement Frontline shared from an Enron shareholders meeting: "Should we invest all of our 401(k) in Enron stock? Absolutely. Don't you guys agree? [laughter]"
There is always subtle pressure to invest in your own company's stock and a sense that it's disloyal not to. But hear me out, folks. A dear friend retired with a sizable 401(k) he'd built up over a few decades. It was 100% invested in his company's stock. In 2008, the stock tumbled, cutting the value of his 401(k) by one-third. My friend had no control over the 2008 crash, but he could have controlled its effect on his nest egg.
Investing solely in your own company isn't the only problem. One of our analysts lives in Texas, where a lot of energy companies are headquartered. He's shared similar stories of friends investing nearly everything in energy companies because that's what they know. Furthermore, they are doubly exposed because they work in the energy sector as well. If the sector tanks, they could lose a sizeable chunk of their retirement funds and their jobs. That's far too many eggs in one basket. While it's good to invest in a sector you understand, sector diversification can be as important as stock diversification.
401(k)s should be diversified from day one. If that day has passed, start now!What If Your 401(k) Investment Options Are Limited?
When my own 50-year-old son called to go over the investment choices for his 401(k), I sensed he wanted a quick answer. "Just tell me which box to check, Dad."
His company's program allowed him to select from several different mutual funds, described in a brochure as "index, conservative, aggressive, mid-cap, large-cap, or moderate." He had no choice other than these mutual funds. I told him the free money from his employer's matching contribution and the tax benefit made his 401(k) contributions more than worthwhile. However, he still needed to select good mutual funds and monitor their performance, so I passed along the following tips:
- Look at the fees. Some mutual funds charge up to 2% to manage your money. That's a heck of an obstacle to overcome in a tough market; you have to earn 2% just to break even. Only a terrific performance can justify those high fees.
- Five-Point Balancing Test. Look at each fund in light of our five criteria for investment selection. Go online and see how the bulk of its investments stack up.
- Don't be fooled by the name. The name of a fund does not necessarily match what it invests in. When the name includes a word like "balanced," check to make sure it is truly balanced. When a name includes "yield," it may mean it allocates a too-high percentage to junk bonds, thereby compromising safety. Do a little research on your own.
- Diversify. If your company has more than one investment option, diversifying among funds is not a bad idea, particularly if some are specialized funds—small-cap, energy, etc. If you can, instruct your fund manager on what percentage of your money to put in each fund; that's even better.
- Index Funds. In 2012: 65.44% of the large-cap active managers lagged behind the S&P 500; the S&P MidCap outperformed 81.57% of mid-cap funds; and the S&P SmallCap 600 outperformed 77.73% of the small-cap funds. Over the last five years, approximately 24% of domestic equity funds, 22% of international equity funds, and 15% of fixed-income funds merged or liquidated. When in doubt, index funds are the better route.
- Don't set it and forget it. Any plan should allow for annual adjustments. Take the time to review its performance, and make any necessary changes each year.
I took my father-son coaching opportunity to add something I felt was even more important: a 401(k) is not a pension. Its value can go up and down just as the market does, and there's no guaranteed payout. We have to manage it on our own if we want it to last.
While my son could only invest his 401(k) in certain mutual funds, many retirement accounts are more flexible. Still, some folks stick their money in mutual funds because they are unsure of the alternatives. If that sounds like you, it's time for a close look at how much those mutual funds cost.
There's a good chance you're being gouged, but I have good news: you can change that. Our timely special report, The Top 10 ETFs to Replace Your Expensive Mutual Funds can help cut your fees by as much as 91%. Click here to find out more.