Putting Together Right 401(k) Investment Mix
It’s that time of year again, when many employers allow you to change the investment mix in your 401(k) company savings plan. Unfortunately, some people--scared of the stock market--are getting overly conservative with their 401(k) allocations, forgetting the primary purpose of these popular plans as long-term retirement vehicles.
To avoid this mistake, be sure you choose a 401(k) investment mix most appropriate for your age and financial goals and don’t be swayed solely by short-term market movements.
Decisions about how to invest 401(k) money are no small matter. Many people have amassed tens of thousands of dollars in their plans. No wonder: They are one of the best retirement savings vehicles around. Offered by nearly all large employers and many small ones, 401(k)s allow you to invest before-tax wages in a retirement account that will accumulate earnings on a tax-deferred basis until withdrawn. Many employers match your contributions 50 cents for every dollar you kick in.
The plans are bound to get even more attractive in the wake of higher tax rates for some high-income individuals included in the federal deficit-reduction law just passed by Congress.
Most employers give you several choices for where to put your 401(k) money. The most common alternatives include stock mutual funds, employer stock, government bond or other fixed-income funds, money market funds and guaranteed investment contracts (GICs). The latter are issued by insurance companies and usually pay slightly higher rates than certificates of deposit. Most employers allow workers to change their allocations quarterly or semiannually.
Workers have chosen to put most of their money in what they perceive to be the safest alternative: GICs. A survey by Hewitt Associates, an employee benefits consulting firm, shows that among companies offering GICs as an investment option, workers on average invest nearly two-thirds (64%) of their assets in GICs. That’s nearly twice the amounts in employer stock (33%) and balanced stock and bond funds (28%).
And now, thanks to the lackluster stock market, the balance in favor of GICs may be increasing even more. Charles Salisbury, a managing director of T. Rowe Price Associates, a firm that manages money in 401(k) accounts, estimates that about 10% to 12% of 401(k) money invested in stocks is being shifted into fixed-income choices such as money market funds or GICs.
That shift could continue because 401(k)s are still relatively new and thus many account holders have never faced investment allocation decisions in a recessionary environment. There is a tendency in bad times to get conservative and forget the long-term view.
But being overly cautious in a retirement plan can be a big mistake if you are still many years before retirement.
Although stocks may look rocky in the short term, they almost always do better than GICs, money market funds or other fixed-income investments in the long run. During the past five, 10, 20 and 50 years, for example, large-company stocks have outperformed corporate bonds, Treasury bills and inflation by wide margins, according to Ibbotson Associates, a Chicago-based investment research firm.
Further, GIC rates are not as attractive as they have been, says Mike Horton, consultant in the Santa Ana office of Hewitt Associates.
Thus, by putting too much of your money in conservative investments, you probably will deprive yourself of a bigger retirement nest egg over the long haul.
“You should not let recent events or uncertainty impact your long-term decisions,” Salisbury says. “If you are in your early 30s or 40s, equities are more appropriate than GICs or money market funds.”
Further, the automatic payroll deduction method of investing money in 401(k)s--under which you invest a little every paycheck, a form of dollar cost averaging--tends to reduce the risk of investing in stocks. Your investment is spread out over time, thus reducing the chance that you may be buying only at the peak of stock prices.
Even still, you don’t want to put all your 401(k) money in stocks. How much is right for you? Here are some rules of thumb:
* Choose your mix based on your age and how close you are to retirement.
Generally, the younger you are, the longer you can leave your money invested, and thus the more you can afford to invest in higher risk assets that have the potential of earning a higher return over time. On the other hand, if you are retiring within five years, you’ll want to be conservative because you don’t have much time to recover from any short-term losses.
Jonathan D. Pond, president of Financial Planning Information Inc., a Watertown, Mass., financial planning publishing firm, suggests as a general guide that investors in their 40s or younger have about 50% of their 401(k) money in stocks. Investors in their 50s might consider only 40% in equities, whereas those within one or two years of retirement might opt for no more than 20% or 30% in stocks.
* Go for diversification.
Be sure that your stock investments are diversified and not overly concentrated in certain industries or even in the United States. Definitely avoid putting too much of your money in your employer’s stock. If your company has severe financial problems, its stock could suffer a big decline that could wipe out much of your 401(k) nest egg.
* Look at your 401(k) in conjunction with your other investments.
If you’ve got all of your non-401(k) money in municipal bonds and Treasury bills, it might make sense to invest a higher percentage of your 401(k) in stocks, Pond suggests.
* Choose heavily taxed investments for your 401(k).
Because 401(k)s are tax-deferred, it makes sense to put into them investments that would otherwise incur heavy periodic tax burdens. That includes mutual funds and fixed-income investments other than municipal bonds.
Keep in your non-tax-deferred accounts municipal bonds or low-dividend-paying individual stocks. With these you’ll incur little or no tax liability unless you sell.
