What to Consider When Investing 401(k) Funds

Last month, John Smith’s employer got out of the pension planning business. That put Smith, whose name has been changed for this article, in a sticky spot.

Smith, who has worked for the firm more than 20 years, assumed that he would get a set monthly stipend when he retired. Now the amount and the duration of that payment will depend on how well he invests the $80,000 his employer distributed to him when the company dissolved its pension plan.

Smith’s dilemma is becoming increasingly common as a growing number of companies opt to shift pension responsibilities to their workers. By and large, companies are doing this by eliminating or reducing traditional pension plans and offering workers so-called 401(k) plans instead, benefit experts say.

An indication of the scope of this trend: A whopping 93% of the nation’s employers offer 401(k) plans today versus only 36% in 1984, said William J. Arnone, director of financial and retirement planning at Buck Consultants in New Jersey.

The trend concerns benefit consultants because 401(k) plans can present dangers as well as opportunities.

Ironically, the worry is not that workers will put their retirement at risk by investing poorly or too aggressively. The biggest concern is that workers, afraid of risking their principal, are investing too conservatively. The conservative investments don’t earn enough interest to see workers through their golden years in comfort.

Companies typically offer workers several investment options, ranging from growth stocks to real estate to Treasury bills. Most employees put their funds into the lowest-risk accounts, which also earn the lowest rates of return, experts maintain. Workers avoid stock funds, which are riskier but tend to earn higher returns over time.

In the end, many will find that the monthly stipends they are counting on are far smaller than they’d hoped.

Consider, for example, two workers who each contribute $4,000 annually to 401(k) plans. One earns 5%, the other 10%. At the end of 30 years, the first worker has accumulated $279,043, according to Capital Consulting Group in Livonia, Mich.

The second worker has more than twice that--some $723,774. (It’s worth noting that between 1946 and 1991, stocks earned an average annual return of 11.8%, while Treasury bills earned about 4.9%.)

Let’s say these workers don’t want to dip into the principal of their accounts at retirement. If they each earn 8% on their money and withdraw only interest, the first individual will get a $1,860 monthly payment, while the second will take home $4,825.

Still, no one suggests that workers dump all their 401(k) money into stock funds either.

So how should you invest your retirement money?

Some suggest that you follow set formulas that are based on your age and ability to tolerate risk. For example, Capital Consulting says conservative 35-year-olds should invest 50% of their 401(k) assets in stocks, while conservative 55-year-olds should have only 30% in the stock market.

Meanwhile, aggressive 25-year-olds should have roughly 80% of their retirement money in stock funds and only about 20% in more conservative options.

These models can be helpful to those who need a rule of thumb. However, some advisers maintain that there is no one-size-fits-all formula for investing. Instead, individuals must consider their 401(k) as part of an overall plan and earmark different investments for particular purposes.

Your savings account, for instance, might be earmarked for a down payment on a home, while a portion of your 401(k) money might be borrowed to help your children finance college.

Someone who has significant assets outside of a 401(k) should invest differently than someone who does not. If you can borrow out of your 401(k) plan--about 74% of the nation’s 401(k) plans allow employees to borrow at least a portion of their savings without penalty--that could affect your investment strategies too.

To invest properly, workers must consider when they’ll need the money and how much they’ll need. Then they must consider historic investment performance of the various options, keeping in mind that performance encompasses volatility as well as return.

Money that could be needed quickly probably should not be invested in stock funds, since stock prices are volatile. But at least a portion of the money that won’t be needed for many years--a decade or so--should go into a stock fund, experts maintain.

One caveat: Beware of investing too much money in your own company’s shares through company stock funds. Since your job is tied up in the company’s prospects, investing in its stock puts a lot of eggs in the same basket.