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Randall Financial Group News

11-Sep-04

Managing Your 401(k)

401(k)s, take care of yours now and it will take care of you later.

It has been said that a comfortable retirement should be built upon a three legged stool. The first leg in that stool is social security. Despite what many people think however, social security was never intended to be the sole means of support for retirees. And depending on your faith in the Federal Government, counting on it being here when you need it could be a risky proposition. The second leg of retirement should be personal savings. Your ability to put your own money into IRAs and other personal savings vehicles will often make the difference between just getting by and having the ideal retirement.

The third leg of a comfortable retirement is the company sponsored retirement plan. At one time the most common type of retirement plan offered by employers was the pension or defined benefit plan. It's called a defined benefit plan because, depending on your length of service and earnings, you are promised a set monetary benefit at retirement. It's up to the company to make sure they contribute enough money and invest it wisely in order to pay benefits to their retired workers. Although this arrangement has its advantages and still exists today at many companies, it also has some drawbacks. Employers are taking a big risk when they pledge a set benefit, and employees who change jobs may never build up sufficient tenure with one company to take advantage of the pension plan.

For these reasons, defined contribution plans, where the employer promises the amount they will put in but not the benefit, have become a popular alternative to the traditional pension. Top among these plans is the 401(k)/profit sharing plan. Named after section 401(k) of the internal revenue code, these plans allow employers and employees to contribute funds which are then invested to provide for the employees retirement. How these funds are invested is left up to the employee. Although 401(k) plans offer portability that is not typically available with a traditional pension, they also shift the burden of managing the money to the employee. If you have a 401(k)/Profit Sharing plan available to you through work, here are some tips to make sure its ready when you need it.

Make sure you use it. It may seem simple, but often employees don't participate in the plans when they're available. If you don't, you're passing up a significant opportunity. First, your contributions to the plan are not taxed when you make them. This means that if you make a contribution of $100 it may only reduce your take home pay by $80. The other $20 is money that would have gone to taxes. The government is subsidizing your retirement savings. Second, if your employer is making contributions to the plan and you don't participate, then you're leaving free money on the table. Unless you think you're already being paid enough, that is a bad idea. Finally, employers will often match employee contributions up to a maximum amount. For example, your employer may offer to deposit 50 cent for each dollar you put in up to the first 3% of your pay you contribute. Well, if you don't put in at least 3% of your pay, you're passing up that free money. Make sure you take full advantage of any matching contributions.

Because 401(k)s are self directed, they require you to make decisions about where your money should be invested. The biggest investment mistake 401(k) participants make is being too conservative. Your 401(k) probably has a guaranteed fund or capital preservation fund that offers a fixed interest rate with no risk of loss. While this may sound appealing, long term growth is your best friend when investing for retirement. Fixed interest accounts simply won't provide enough of that growth. So invest some portion of your money in stock funds. Start with a domestic fund that buys blue chip stocks. As your account value grows consider adding medium size and smaller company funds as well as an international fund. How much to invest in stocks is a personal decision, but one rule of thumb is to subtract your age from 100. The number you have left is the percentage you might invest in stocks. The balance can go to bonds or guaranteed accounts. The moral to the story is, the younger you are, the more stocks you should own.

The second biggest mistake 401(k) investors make is investing too much of their money into the stock of their employer. While owning stock in the company you work for is not a bad idea, owning too much can be a disaster. Employees of Enron and WorldCom are the latest to fall victim to this mistake. Many saw a lifetime of savings become virtually worthless. You may work for the greatest company of all time but putting your retirement nest egg in one basket is gambling not investing. If employer stock is available, limit it to 10% of your total portfolio. This includes options you may have as well as company stock you own outside of your 401(k).

Avoid trying to out guess the market. Trying to predict which way the market is headed and investing your money accordingly may be tempting. But few if any, even on Wall Street have demonstrated a consistent ability to get it right. Meanwhile, you run the risk of missing the long term gains you'll need. With the significant market decline we experienced beginning in March of 2000; many 401(k) investors began to get frustrated with declining balances and stopped making contributions. It may make you feel better in the short run but the move usually comes too late to do any good and so does the decision to get back in. Since October of last year, the market is up about 35%. If you didn't stay in, you might have missed the recovery.

Defined contribution plans like 401(k)s provide an excellent opportunity to build up the third leg of your retirement stool. But they also require the employee to make some important decisions. With the help of these suggestions you'll be well on your way to the ideal retirement.

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