If your employer offers a 401(k) plan, chances are you’re participating and saving money for your retirement. Over 30 million of us are taking advantage of this employee benefit to help us save.[i] And many of us are finding ways to put away even more of our paychecks. In the last year, 401(k) contributions, on average, have risen by 20 percent.[ii]
For most plan participants, their 401(k) is their primary, if not their only, form of retirement savings (aside from Social Security). And yet, there’s a tendency to give it very little attention, Because the money is taken out of our paychecks automatically, it’s much less visible than our bank accounts or credit card statements. There’s nothing beckoning us to think about it, particularly when the only tangible reminder is a small line item on a pay stub and those bulky statements in your mailbox or email.
The good news is that this invisibility makes a 401(k) plan a relatively painless way to save and accumulate a significant nest egg over time. The downside is that it’s so easy to neglect this valuable asset by not giving it the attention it deserves. That makes it very easy to make mistakes with how you manage your allocations and investments.
Here are 9 of the most common pitfalls to avoid when it comes to 401(k) planning and ways you can become a more savvy plan participant to help you reach your savings goals.
Mistake #1: Not Taking Time to Get to Know Your 401(k) Plan
As a new employee, there are so many decisions to make about your benefits. Perhaps you signed up for company’s 401(k) plan right away or as soon as you’re eligible. But many people don’t know much about their plan and the investment options it offers. Here are a few of the basics: Virtually all 401(k) plans offer a variety of investment options, such as funds that hold equities (stocks) and fixed income securities (bonds). Stocks have more risk, but with a long-term planning horizon like retirement, history tells us that they tend to generate higher returns than bonds. In contrast, bonds are less risky but have lower yields. Most plans offer a number of investment options within these categories, and some plans have blended funds that include a mix of both. As a plan participant, it’s up to you to choose how to allocate your money between stocks and bonds and which funds to choose.
While each person’s retirement horizon and needs are different, one helpful way to think about allocations is the “110 rule,” which subtracts your age from 110 to determine the approximate percentage of your portfolio that should be invested in stocks, with the remainder in bonds.[iii] For example, for a 45 year old, this rule would say to put 65% of your 401(k) money in stock funds.
Mistake #2: Picking a Target Retirement Date Fund, Because It’s Easy
Many plans include a fund based on your target retirement year. Comprised of eight or 10 different funds, the allocation mix continually adjusts based on how far you are from retirement. As the target date grows closer, the amount invested in equities declines and the amount in bonds increases. These funds are popular, because they’re easy.
A target-date fund may be your best option, but it’s a good idea to do some homework before making that choice. A target-date fund can be a good starting point for someone who knows little about investing, but it’s conceptually naïve because it assumes that everyone retiring at the same time has similar investment needs regardless of risk tolerance, demographics and other factors.
Sometimes 401(k) plans offer balanced funds with a mix of investments, often 60% equity and 40% fixed income. This is another easy way to choose investments, but unlike target-date funds, balanced funds don’t adjust over time as you near retirement. While a 60:40 split may make sense initially, it may not if you are within five years of retirement, or if you are just starting out and can take more risk by investing more heavily in stocks.
You may also find something called a model portfolio among your 401(k) options. Often grouped by terms such as conservative, moderate and aggressive, a model portfolio can guide you in selecting your allocations from the funds available. But as an investment option, it’s limiting since it only considers your appetite for risk and not your other needs and goals.
One alternative I like, particularly if you’re a new investor, is to choose investments using the target-date fund as a broad guideline. For example, if the target-date fund for your retirement year has 20% in international equities, you could allocate 20% of your nest egg across one or more of the international funds your plan offers.
Mistake #3: Choosing Investments Based Solely on Fees
Sometimes it makes sense to choose funds based on fees. For example, if there are two international funds with similar performance but one has higher fees, it would not be unreasonable to choose the lower fee fund.
Beyond that, there are many factors to consider. For example, index funds like the S&P 500 are not actively managed (in other words, they hold stocks according to rules, not based on a portfolio manager’s views) and have lower fees compared with managed funds where you’re paying for the manager’s expertise to hopefully beat that index. Interestingly, data shows that few managers are able to beat the market index over the long term, which is why some 401(k) investors prefer index funds. But some managers do outperform the index, delivering more value for that higher fee.
When choosing a managed fund, you’ll want to look at data like past performance, who’s managing it and how long it’s been around. You can readily find this information online or it may also be available through your plan. You could also look at a measure of performance called the Sharpe ratio, that takes into account the amount of risk taken for the return the fund earned.
It’s important when comparing fees to do so across similar asset classes. A manager of international equities is going to have a higher fee than a bond manager, because of the expertise required and the greater number of securities from which to choose.
Mistake #4: Over-monitoring or Changing Allocations Frequently
I’m a firm believer that, once you identify the appropriate mix for you, you should stick to it. It’s not a good idea to look at your account daily, weekly or even monthly. In a down period such as we have recently experienced, there is a temptation to react quickly and make decisions you will later regret.
Mistake #5: Forgetting About Your 401(k) Plan Entirely
Sometimes people put their 401(k) plan on auto-pilot, not monitoring it at all. You’ll want to review your allocations and investments at least once a year. That doesn’t mean you’ll make any changes – it’s more like an annual physical exam. It’s also a good idea to review them when there major life changes or a milestone birthday like 40 or 50. Your allocations will likely be very different at 25 than they are at 45 or 65.
Mistake #6: Ignoring Your 401(k) Plan When You Change Jobs
It’s rare to find a person who works for the same company their entire career. Each time you change jobs you have the option to roll your 401(k) into an IRA. With an IRA, you are not limited to choosing from the funds offered in your 401(k). You have the freedom to invest that money however you’d like, which is particularly valuable if the options in your old 401(k) were not ideal. If you choose to do this, make sure it is a direct rollover; do not have the 401(k) plan send money to you or you will have to pay taxes and penalties that would wipe out a significant percentage of those savings.
Alternatively, you could choose to leave your 401(k) plan where it is if you’re comfortable with the funds available, or if there are perks such as when an employer subsidizes the fees. You will not be able to contribute new funds to that account, but you can leave what you have invested in the plan. The important thing, particularly when you’ve had several jobs, is to ensure you don’t lose track of any 401(k) monies you may have in various accounts throughout your career.
Mistake #7: Letting Your 401(k) Plan Keep You Up at Night
Look at your 401(k) allocations occasionally to see if performance is in line with your expectations. If it’s worrisome that it’s down a few quarters in a row, maybe the mix you chose initially isn’t working for you anymore; perhaps you would prefer more conservative funds at this point. Conversely, if you’re feeling frustrated by performance and you can tolerate a bad month now and then, maybe that’s a signal you can become a little bit more aggressive. Or, if the performance of individual funds is below the return on the market index, it may be a signal it’s time for a change.
Mistake #8: Overlooking the Roth-IRA Option in Your 401(k) Plan
Many people mistakenly believe they make too much money to invest in a Roth IRA. However, some employers offer a Roth option within their 401(k) plan, which is not subject to income eligibility. You won’t get a tax break now if you choose the Roth option, but the funds, including investment returns, are not taxed when you withdraw them in retirement.
This is one investment decision that requires consideration on a case-by-case basis, but for most people, it usually makes the most sense to max out your traditional 401(k) investment before considering a Roth. If you’re maxing out contributions to those other retirement saving options, it may make sense to shift some of your contributions to a Roth. Although you’d be using post-tax dollars to fund the Roth, it helps you save more money, growing tax-free, for retirement.
Mistake #9: Looking at Your 401(k) Plan in Isolation
When choosing your allocations, it’s important to do so within the context of your entire investment portfolio, including IRAs from previous jobs, other savings, real estate, cash, your spouse’s IRAs, etc. If you have a large savings account or significant real estate holdings, this can knock your overall investment allocation out of line compared to where you want it to be.
Many people pay little attention to their 401(k) allocation, selecting some funds when they set up the account and then letting it run on auto-pilot. When you consider that, for most people, their 401(k) is their largest retirement asset, it makes sense to spend a little time studying your options and making investment decisions that will help you reach your retirement goals and enjoy your golden years more fully.
Relative Value Partners advises clients on a variety of investment decisions. As financial planners, we routinely help clients choose allocations and investments for plans they participate in. We can also help answer your questions about 401(k)s and other investment vehicles you’re interested in. For more information, please reach out anytime. We’re here to help you with retirement planning and all your investment needs.
About the Author: Jeff Fosselman, CPA, CFP®, JD
With more than a decade of experience in the industry, Jeff Fosselman is instrumental in delivering financial planning strategies and counsel to high-net-worth individuals. As Senior Wealth Advisor for Relative Value Partners, Jeff provides comprehensive advisory services in estate planning, income tax planning, cash flows, asset allocation
Information contained in this article is obtained from a variety of sources which are believed though not guaranteed to be accurate. Past performance does not indicate future performance. This article does not represent a specific investment recommendation.
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