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New Choices for a More Balanced 401(k) Plan

Uncle Sam is helping to build a better mousetrap out of 401(k) plans--and at the same time increase the allure of mutual funds for these worthwhile retirement programs.

According to proposed federal guidelines, companies that offer 401(k) plans to their employees must provide a reasonably well-rounded choice of investments from which workers may pick. Mutual funds help fill this selection gap.

All this is good news for people who have access to 401(k) plans at work. Compared to IRAs, they let investors sock away much more money each year, and in many cases companies will make matching contributions--all on a tax-deductible basis. Couple that with tax-deferred growth, and someone who sticks with a 401(k) program long term has the potential to build a truly eye-popping nest egg.

Mutual funds work particularly well in 401(k) programs. With any long-term investment, you want diversification. The typical mutual fund, which holds from a few dozen to a couple of hundred stocks or bonds, fits the bill nicely. Also, most fund companies offer a range of stock, bond and money market portfolios. “You need diversity of choices as well as diversity within each choice, as you get with a mutual fund,” says Steve Cordill, director of special products for Alliance Capital Management in New York.

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If the Labor Department guidelines become law, as many pension specialists predict, employers will be required to make available at least three investment choices, each with a different risk level. Most likely, 401(k) plans will have to include a capital appreciation and an income selection, as well as a vehicle whose price doesn’t fluctuate, such as a money market fund or a guaranteed investment contract (GIC).

The proposal aims to provide for more diversification within 401(k) plans while reducing any potential liability of employers by giving them guidelines to follow.

“The regulations tell the plan sponsor that it could enjoy some protection by offering a minimum of three investments along the risk-reward spectrum, excluding the company’s own corporate stock,” explains John Mulligan, a senior vice president and 401(k) specialist at State Street Bank in North Quincy, Mass. “It happens to fit well with what plan sponsors are already doing.” The regulations are making an impact even though they haven’t been enacted, experts say.

With a 401(k) plan, investment responsibility lies with each worker, not the employer. So it’s your fault if, for example, you choose an aggressive growth fund that drops 20% one year. This perhaps explains why about 50% of all 401(k) money is invested in GICs, which resemble certificates of deposit except that they’re issued and backed by insurance companies, not banks. “Participants have a big appetite for what they perceive as safe, fixed-income options,” Mulligan says. Another 20% is invested in the common stock of companies that offer 401(k) plans.

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Unfortunately, neither GICs nor a single company’s shares offer much diversification. Besides, critics charge, GICs aren’t as safe as people might believe. They’re backed by the strength of the insurance company and come with no government guarantees. “Realistically, you have to look at them as you would a corporate bond,” Cordill says. “Examine the insurance company issuing the GIC and ask yourself, ‘How solid is it?’ ”

One further criticism of GICs is that they’re income-oriented and thus perhaps not the best choice for people with a long-term horizon, especially younger workers. You can do much better over time with growth vehicles such as a stock mutual fund.

A nice feature of 401(k) plans is that they let you invest money gradually over a year, thereby benefiting from dollar cost averaging. “This addresses everybody’s big problem with stock funds--the danger of buying in at the top of the market,” says Douglas Fabian, co-editor of the Telephone Switch Newsletter in Huntington Beach.

If you don’t have a 401(k) program at work, inquire about getting one started. These are relatively inexpensive pension plans for a company to adopt, especially because there’s no requirement to make matching contributions. Currently, small companies are the fastest-growing market for new 401(k) programs, if only because nearly all major corporations have some type of pension plan in place. Many financial firms, including mutual fund families, can help your company set up a 401(k) plan.

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If your company has a plan but you don’t like the investments offered, find out about adding a choice or two. “Companies do seem to listen to employees and will occasionally make adjustments,” Mulligan says. After all, most want their workers to be satisfied with their fringe benefits. Many experts consider three to six choices to be sufficient, as a larger number might just confuse people.

Besides selection, a good 401(k) plan will also feature the ability to switch periodically among investments, preferably as often as once a month, Fabian says. Jennifer M. Rello, a pension consultant in the Newport Beach office of Charles Schwab, stresses the need for good communication in educating and keeping workers informed. “I’ve seen plans die where people didn’t understand the investment options.”

Considering the large chunk of 401(k) money in GICs and single-company stock, it seems the education process has a ways to go.

401(k) Fundamentals * What are 401(k) plans? Company-sponsored retirement programs, named after a section in the Internal Revenue code, that let people sock away much larger amounts than they can in an IRA. Also, employers are allowed to contribute money on behalf of workers, and most do. * What are the tax benefits? The amount invested, by you and by your employer on your behalf, is deductible. That money then grows tax-deferred until withdrawn. * How much can a person invest? The 401(k) limit for an individual is $8,475 in 1991, with the amount adjusted annually for inflation. However, you and your employer can invest up to a combined $30,000, or 25%, of your pay, whichever is less, assuming that certain requirements are met. * How do 401(k) plans work? You select the amount you want deducted from each paycheck and decide where to invest the money from among choices made available by your employer. * Why do mutual funds make sense in 401(k) plans? With any long-term investment, you want diversification. The typical mutual fund, which holds dozens of stocks or bonds, provides this safety in numbers. Plus, the larger fund companies offer a wide selection of stock, bond and money market portfolios from which to choose--another form of diversification.

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