Many employees a generation ago could look forward to a predictable pension at retirement. Employers were responsible for investing the monies set aside for these “defined benefit plans;” employees could focus on more pleasurable tasks.
Today, most employers have ditched pensions in favor of “defined contribution plans” a/k/a 401Ks or, in the case of public/nonprofit sector employees, 403Bs. That makes us responsible for instructing our employers to deduct sums from our paychecks for our retirement, and largely puts the headache of how to invest those monies into our laps. That responsibility carries it with peril, if we mismanage those investments, or opportunity, if handled wisely.
While each 401K plan has its own set of investment choices, review of countless plans reveals recurring opportunities and pitfalls. While there’s no substitute for a careful review of the details of your plan, here are twelve pieces of advice likely to be helpful:
1. Fill it Up ASAP
Needless to say, you can’t profit from your 401K unless you contribute to it. Many companies match contributions. If so, that’s an immediate 100% return on the amount you contribute! You’re further incented since it may cost you as little as 60 cents of current cash flow for each dollar invested because contributions are typically tax deductible.
What’s more, all earnings are tax sheltered, so it behooves you to accelerate contributions. Indeed, if your employer will let you, have your entire paycheck contributed in the first few months of each year until you hit the maximum amount the tax law allows you to sock away – generally in the 20% of salary area. In 2012, the dollar cap is $17,000 for most employees and $22,500 for those aged 50 and older.
Actually, it’s not the nuances of the tax law that make the 401K so valuable. The more important aspect is that it serves as a virtual piggy bank. Whatever you can get into the 401K is unlikely to come out for that whimsical purchase, and is also shielded from creditors. The 401K is a great tool to enhance financial discipline.
2. Roll It Out and Consolidate
Many 401Ks are owned by ex-employees, and were “left behind” when the employee cleaned out his desk to leave the job. If that’s you, transfer it to an IRA without delay. It’s typically costless and tax free.
In an IRA you’re not limited to a 401K’s restricted list of investment options. Even better, you’re not limited to funds, so you can sidestep the fees, the opaqueness, and the duplication that fund investing can entail. With the right IRA broker, nearly every investment imaginable is available to you.
By consolidating this rollout with any other IRAs you may have you can reduce account proliferation. That can help focus plus potentially reduce costs further, as you’ll have a bigger account to work with. It also reduces the risk the account is forgotten, either by you or your heirs after your death.
3. Integrate it With Your Other Holdings
Don’t invest your 401K in a vacuum, as if that’s the only account you own. That’s the problem with settling for many default options, based only on your age. For example, you may have plenty of stocks elsewhere, and need to focus on fixed income. A healthcare oriented mutual fund may not make sense if you’re set to inherit a boatload of Merck stock. Your financial profile may be stronger or weaker than is typical for your age, so accepting a one size fits all investment program in your 401K, even if customized for your age, may be the wrong approach.
The correct approach is to create a spreadsheet of your assets. Then, develop a game plan for the entire nest egg. Only then can you invest your 401K so it plays the right supporting role.
4. Reduce the Diversification
The usual mantra is diversify, diversify when it comes to investing. Not so when it comes to mutual funds. That’s because each mutual fund typically contains hundreds of stocks. It’s typically managed to be a stand-alone portfolio; single stock risk is virtually diversified away.
So, adding another stock mutual fund to your 401K typically results in duplicated positions. Fund A may own Merck and decide to sell while Fund B buys. The left hand doesn’t know what the right hand is doing. You end up paying for transactions that are not sharpening focus but merely canceling each other out.
The problem can even occur with a domestic fund and an overseas fund, because so much of investment return is driven by the sectors involved, not the location of the companies. Thus, if domestic Fund A decides to buy Exxon to take advantage of rising oil prices, international Fund B may be selling BP in anticipation of falling oil prices. At the end of the day, your portfolio’s focus is dulled but expenses are higher.
So, make sure each fund in your 401K is truly necessary. Less is more when it comes to your 401K funds.
5. Prefer Cheaper Funds
Examine carefully the operating costs of your 401K fund choices. Gravitate to ones sporting lower costs. As the fund researcher Morningstar’s study found: “In every single time period and data point tested, low-cost funds beat high-cost funds." Or, as fund company Vanguard states: "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision.”
In many cases index funds are less expensive and are good 401K picks.
6. Avoid Strategies You Don’t Understand
It is common for 401K sponsors to offer many exotic and or hedge fund strategies among your 401K fund choices. Avoid them.
They are often touted as a way to reduce volatility yet provide returns superior to fixed income. Yet, you may already have that if you have a well-diversified 401K portfolio.
Novel strategies by definition don’t have long track records, so predictions are harder. Novel strategies are premium choices; fees will be higher, and many less apparent ones, like borrowing costs and trading commissions, greater.
The names of funds of this ilk often include the phrases “hedged,” “long-short,” “futures,” “tactical,” etc. The promise is always less risk, more return. Bet against that being the reality.
Bottom line, if you can’t explain the strategy to your spouse, steer clear.
7. Asset Allocate and Rebalance
Your 401K should include a fixed income selection and an equity fund selection. A case can be made for an allocation to overseas as well as small cap securities. The theory is you reduce your risk if you diversify widely, and your portfolio experiences less volatility overall if you include some asset classes that typically zig when others zag.
Whatever is the bottom line allocation, commit the percentage allocations to writing, and rebalance whenever there’s a material skew from the initial allocation. This will happen as some funds’ values change relative to the others.
Rebalancing forces you to sell some of the outperformers and add to the laggards. That’s a sound strategy to reduce risk and enhance returns but it’s tough to execute unless you develop a written asset allocation plan and adhere to it. Some 401K plans allow you to sign up for automated rebalancing, and we think that makes sense.
8. Don’t Market Time and Avoid Trading
We all occasionally pick up the newspaper, read a horrific article, and instinctively want to take cover with our investments. Don’t. Here’s why. First, if it’s in the newspaper the news is already widely disseminated. The prices of your investments are bound to reflect the implications.
Any trade of your investments assumes there’s another party willing to take what you want to unload. Don’t assume they are suckers.
That is not to say that if there’s a change in your financial picture, either a negative one, say a health setback or a job loss, or a positive one, say an unplanned inheritance, that it’s not appropriate to rethink your investments with a view to rejiggering your risk/reward profile.
9. Avoid the Big Wall Street Names
Many 401K plans include funds choices from different sponsors. Some are Wall Street names which have been in the news amid allegations of not putting the client first. Others are extremely heavy advertisers. Funds sponsored by names in either of those categories are suspect: They are more likely to be linked with novel strategies or charging high fees to pay for that advertising, etc. Avoid.
Investor owned sponsoring organizations, a/k/a “mutuals” are less likely to commit those sins, and more likely to offer lower fees. Vanguard is an excellent example, and their funds often make great 401K choices.
10. Don’t Chase Performance
You can’t buy past performance. You want to buy low and sell high. Yet most 401K owners invest in the top recent performers. Unfortunately, the research shows all strategies, portfolios, managers and asset classes have periods of underperformance. By jumping in after the good times, and bailing after the bad, investors set themselves up for sub-par returns.
Choose intelligent asset classes and strategies without regard to recent performance. Indeed, consider funds with intelligently constructed portfolios after a period of sluggish performance. Your 401K provider typically has carefully screened your fund choices, so jumping into a fund after a period of weak performance will often make more sense than the opposite.
11. Avoid Cash
Most people on the planet hold cash because what little they have is needed for short term needs. As a 401K owner, you’re one of the luckier ones who have some resources that can be invested for longer term goals. Don’t invest in a way that suggests you have to devote the money to next month’s rent.
This is particularly true today, with yields on money market funds, a/k/a cash, nil. Oh sure, you might get lucky and time the market and be able to use the cash to pile in after a market selloff. But, that’s unlikely. Stay invested.
12. Consider Tax Inefficient Strategies Best Avoided in Taxable Accounts
Long term capital gains on stocks, as well as their dividends, enjoy a reduced tax burden if held in a taxable account, but no tax advantage if held in a tax sheltered account. Nearly every other type of income producing security, save for municipal bonds, receives no tax advantage when held in a taxable account, but is completely sheltered from taxes in a 401K.
Accordingly, if preferred stocks, CDs, high yield, corporate, foreign, Federal, or agency bonds, or convertible securities are part of your overall strategy, you’ll maximize the tax sheltering benefit of your 401K if held there. Any high turnover equity strategies would also be more strategically held in your 401K. Finally, some commodity based funds are taxed less favorably than traditional equity funds, so may also be better held in 401Ks.