Getting Your 401(k) In Shape

You may think a 401(k) means freedom of choice. True, it gives you the power to decide how much to save and where to invest. Like most 401(k) participants, you probably face a bewildering assortment of investment options. But no one is watching to make sure you make the right choices in order to have enough money to retire on. Most workers, in fact, are woefully in need of reliable information about how to invest their 401(k) assets. When in doubt, many choose their company’s stock, sometimes on top of the company shares they get as matching contributions. In doing so, employees and their companies are violating the three most important tenets of modern portfolio theory: diversify, diversify, diversify.

SAVE MORE–STARTING NOW

Overconcentration of 401(k)s in company stock isn’t the only problem we face. Many workers are also falling short saving for retirement now that the bull market is no longer doing the job for them. After 18 years of rising markets, during which time it was easy to accumulate assets in a 401(k) account, many savers suffered their first losses in 2000 and 2001, and now must learn to set aside more of their income. Even worse, millions of workers who are eligible to participate in a 401(k) are not doing so, either because they must take care of more immediate needs or because they think there will always be plenty of time to save for retirement.

In passing President George W. Bush’s 2001 tax-cut bill, Congress allowed workers to shelter more of their income through tax-deferred 401(k) contributions. But if employees don’t take advantage of these opportunities, especially now that the baby boom generation is nearing retirement and the Social Security system may become strapped, many could find themselves in severe financial straits in old age.

My hope is that you will avoid some of the common mistakes people have made in managing their accounts. Whether you are a rank beginner or already know the 401(k) ropes and need a refresher course, this article can help you. To make it easier to follow, the information appears in question-and-answer format.

How much can I contribute?

Under President Bush’s tax-cut legislation, passed by Congress in 2001, the contribution limit for an individual is $11,000 as of January 1, 2002. This limit will rise by 1,000 annually until reaching $15,000 in 2006. Today, the average worker’s 401(k) contribution is 8.6% of salary, according to the consulting firm, Spectrem Group.

The new tax-cut law also allows those age 50 and over to “catch up” and make extra contributions. The extra amount is $1,000 for 2002, rising to $5,000 extra in 2006, and adjusted for inflation thereafter.

The same law also requires faster vesting, shortening the early years of participation during which companies don’t allow workers to take company matching funds with them if they change jobs. Until 2002, companies could stretch the pre-vesting period to seven years, but now that period is limited to five years.

As Congress considered the tax-cut legislation, some groups expressed concern that its benefits were tilted too far in favor of higher-income workers. For instance, only those [who are] able to afford to contribute the maximum amount will typically be able to put away even more under the new limits. These workers are likely to be higher-, not lower-, paid. To defuse political opposition, the act added a new tax credit for certain low- and middle-income individuals who contribute to 401(k)s or other plans. The tax credit, ranging from 10% to 50%, depending on salary, is on contributions up to $2,000 for income below $25,000 for singles, $37,500 for heads of households, and $50,000 for married couples filing jointly. The credit is not available to students or dependents. You should find out if you qualify and make sure you take advantage of these tax credits if you do.

If you are contributing the maximum and you want to save even more, you may be able to make after-tax contributions as well. While the earnings on after-tax money will grow tax-deferred, the contributions aren’t likely to be matched by your employer. And if you choose to withdraw your after-tax contributions early, you must also withdraw a proportionate amount of the earnings the money has generated–and you’ll have to pay taxes, plus a 10% penalty, on the earnings (though not on the after-tax contributions themselves).

Is my employer required to match my contributions?

No, but most do. The consulting firm Hewitt Associates reports that 97% of employers provide some form of match or contribution to employees’ 401(k) plans. Typically, employer matches are set as a percentage of worker contributions, or based upon company profitability. Many companies, for example, put in 50 cents for every dollar of employee contributions; other companies match dollar-for-dollar, and some even match two-for-one.

Six years ago, the William M. Mercer benefits consulting firm found that 85% of plans with some form of employer contributions matched at least one-half of worker contributions. By 2000 that number had risen to 89%. But in response to the slower economy, lower profits and cost-cutting pressures, many companies contributed less money to 401(k) programs in 2000 than in 1999.

What happened to 401(k) assets in the 2000-2001 bear market?

The bull market of the late 1990s covered a multitude of 401(k) investor sins and it wasn’t hard to be a big winner. In fact, about 80% of the growth in 401(k) assets from 1995 to 2000 was due to market appreciation, according to consulting firm Cerulli Associates. Today’s market leaves no room to hide.

In August 2001, EBRI and the Investment Company Institute, the Washington, D.C.-based trade group for mutual fund companies, reported that the average 401(k) account balance declined by 12% in 2000, to $48,988 from $55,502 in 1999. This marked the first year ever in which 401(k) assets declined.

Why can’t I just lock in my gains by cashing out when the market is turning down, then get back in when the market is turning up?

This is called market timing and it rarely works. When investors try to get all the upside and none of the downside, they usually end up buying high and selling low–not a very savvy investment strategy. Markets are unpredictable, and even the smartest market watchers can’t predict sudden rallies and declines.

The dangers of market timing are especially true when your 401(k) assets are in mutual funds, as they should be. For example, if you switch your 401(k) assets out of a small-cap mutual fund and into a large-cap fund because of an attractive rally in large-caps that day, you may already have missed the action. That’s because mutual fund shareholders get a price, called net asset value, or the value of one share in the fund, that is calculated at the end of the trading day. Instead of getting in on a rally, you may be buying after it, at the peak. Similarly, you may have sold the small-cap shares just as they were about to head up.

Ibbotson Associates calculates the effects of market timing this way: If you had invested $1 in an S&P index fund in 1980, that $1 would have been worth $18.41 at the end of 2000. But if you had missed just fifteen of the best days in those twenty years, you would have had only $4.73. It’s impossible to predict which fifteen days out of 5,200 will be the best. Jumping in and out of the market is likely to cause you to be out of the market precisely when you need to be in it.

So how should I be investing my 401(k) money?

Only you can answer this question. But forget about trying to make a killing in the market because of a well-timed purchase of a hot stock or a well-placed tip. You may as well expect to win the lottery. And just owning a bunch of investments is not the same as having a retirement strategy. Only a well-planned strategy will see you through economic good and bad times and help you build a nest egg that will suppor
t you to the end of your life.

To get started, you must decide two basic things: in how many years will you retire, and what is the minimum income you can get by on in your retirement years? For many, the answers will be educated guesses, but that’s better than nothing. A good goal to aim for is having a nest egg that provides you with 70% to 80% of the salary you were receiving at the time of retirement.

Here’s an example: Bob is now 35. His annual salary is $45,000. He has $20,000 in an Individual Retirement Account and he expects to receive about $14,500 a year from Social Security after retirement. His hope is that he can retire at age 65 with about $40,000 a year in retirement income. What will he need in his nest egg at retirement? The answer: $378,000.

To get there, Bob will need to save about $7,500 a year. You can do a similar calculation by going to the American Savings Education Council Website, www.asec.org. Click on the “Ballpark Estimate” retirement planning worksheet, and plug in your own numbers.

Now you’re ready to take the next crucial steps: determining how much risk you can tolerate and how to allocate your funds among the many investment options. Risk tolerance and asset allocation go hand in hand. Risk is the possibility that your investment won’t produce the level of returns that you were expecting. All investments are risky, and some are riskier than others. But in general, the higher the risk, the greater the potential reward. Higher risk also carries higher potential for loss and greater uncertainty about the level of return.

Asset allocation is the process by which investors find the best possible returns for the level of risk they are willing to accept. In general, stocks are riskier than bonds, and thus have greater potential returns. Because younger people have a longer time horizon before retirement and can thus accept higher levels of risk, they should allocate a greater percentage of their overall portfolio to stocks. If you are near retirement age, and can’t afford to risk much of your savings, then you will want to allocate more of your portfolio to bonds.

There are rules of thumb to help you allocate your assets. Here’s one: subtract your age from 100, and put whatever the answer is into stocks. So if you are 35, you would put 65% into stocks and 35% into bonds. But such rules of thumb are not foolproof and are meant only as rough guides.

My company offers a brokerage account under my 401(k). Should I use it?

Emboldened by the easy money to be had in the late-’90s stock market boom, some employees pressed for even more choice, with the result being the Self-Directed Brokerage Account as a 401(k) plan option. This allows employees to pick investments almost as freely as they can outside their 401(k) plan. Typically, companies select a brokerage house to handle employee trades. To establish an account, workers transfer a lump sum out of their 401(k) account. They then allocate an amount to be transferred to their brokerage account from each 401(k) payroll contribution. Workers can buy stocks, bonds, or mutual funds with the transferred money.

What fees, hidden or otherwise, am I paying on my 401(k)?

For 401(k) plans a key issue is fees. What might seem to be low fees expressed in tenths of 1% can easily cost an investor tens of thousands of dollars over a lifetime. Loss of assets to fees automatically reduces the amount invested and thereby reduces returns. The compounding nature of returns can make fees a very expensive proposition.

Fees reflect two costs: plan administration and investment management. Those who closely follow 401(k) plans say it’s difficult to compare fees among plans. Fees vary for obvious reasons, such as types of investments offered, the number of participants, and the size of each 401(k) account. But they also vary for less apparent reasons, such as whether a 401(k) plan provider expects to get additional business if workers roll 401(k) balances into Individual Retirement Accounts. A very rough rule of thumb might be that expenses ought not to exceed 1% of assets in a moderate-sized company.

You should carefully study differences in management fees among different investment options. You should also press your company for information on administrative costs, if it’s not already provided. Administrative costs include sending out quarterly statements, paying auditors and lawyers, answering questions, and maintaining account balances.

At first, companies paid the bulk of plan administration expenses, but now they are increasingly passing those costs on to participants. For instance, in 1999 participants picked up 38% of record-keeping fees, up from 29% in 1995. Workers paid 41% of trustee fees, up from 33%, and 4% of miscellaneous fees, up from 18%.

Meanwhile, some companies are pressing the money managers and mutual fund providers handling their workers’ 401(k) funds

to grant rebates or revenue-sharing agreements. These considerations can offset a company’s administrative costs. Or they can be provided in the form of additional services to workers, such as an investment education program.

But such practices raise ethical concerns. Workers’ contributions fund the 401(k) system, and so workers should get their fair share of any rebates. But very few workers know of these arrangements, and employers are not required to disclose the details. This is not right. You should press your company to itemize any administrative fees and any rebates received from a fund company.

If I need cash, should I borrow from my 401(k)?

Borrowing from yourself might sound attractive, but remember: There can be service fees, both one-time and annual; the money must be paid back; the interest rate is high–usually one or two percentage points above the prime rate. Here’s the kicker: If you leave the company with a loan outstanding, you must pay it back immediately, and if you can’t, the amount is considered a premature withdrawal subject to taxes. You’ll owe a 10% penalty as well.

If you borrow from your 401(k), your money can’t earn returns while you have borrowed it. True, you will be paying yourself back, with interest, but it may not be as much as what your money would have earned if left in the 401(k). In addition, if you stop making contributions to your 401(k) while you are repaying your loan, as many participants do, you are losing out on the earnings your own contributions would have made. You are also giving up any company match and earnings on the match, for the life of your loan.

Before you borrow from your 401(k), consider that a home equity loan may be a less expensive way to obtain funds, especially since the interest payments on most home equity loans can be deducted from your income taxes. The interest on a 401(k) loan is not tax-deductible. There may, however, be times when borrowing from your 401(k) makes sense, depending on the interest rate you’ll pay and whether leaving your money alone would produce greater returns than borrowing from it. Luckily, there are several Web-based calculators to help you decide. One such tool can be found at the Website of the mutual fund and 401(k) advisory company T. Rowe Price, at www.t roweprice.com. Once at the site, click on “Retirement Investing.”

My advice: borrowing from your 401(k) is a bad idea unless you are in severe financial difficulty.

I’m only in my twenties. Why is it so important that I start saving for retirement now?

Today, about 25% of employees working for companies that offer 401(k)s don’t use them. This is like turning down free money, and presents a worrisome public policy issue. Indeed, the number of workers who say they are saving for retirement dropped in 2001 after years of steady growth. The annual Retirement Confidence Survey released in May 2001 by EBRI, the American Savings Education Council, and Matthew Greenwald & Associates showed that the number of people saving for retirement declined from 75%
in 2000 to 71% in 2001. Moreover, there is growing evidence that many Americans are willing to drain their already-inadequate retirement reserves. This is sheer folly and reveals a lack of understanding of the power of saving regularly from an early age.

The beauty of a 401(k) comes down to two things: compound interest and dollar-cost averaging. These are easy concepts to understand. Compounding simply means that the returns you earn today get plowed back into your 401(k) so that you make returns on your returns.

The other great attraction of 401(k)s is that they force you to do what is known as dollar-cost averaging. This happens when you invest a fixed amount of money at regular intervals. By contributing, say, $100 a month every month, you will be buying more shares in a fund when the share price is low, and fewer shares when the price is high. Any drop in price lets you buy more shares with the same amount of money. When share prices go back up, you’ll benefit again because you will have more shares. Most investment advisers agree that dollar-cost averaging is the best way to invest.

How do I know my savings will be safe?

In 1974 Congress passed a law called the Employee Retirement Income Security Act, or ERISA. The law sets standards for pension plans, including 401(k)s. Who is eligible for a plan, minimum performance standards, rules on vesting, how investments must be selected, and how plans are funded are all spelled out in ERISA. The law, administered by the Department of Labor, is there to protect your retirement income from abuse or misuse. For example, it says that your money must be deposited into a custodial account, which walls it off in case your employer goes bankrupt or is sold. The IRS also requires your employer to send you regular account statements (usually once a quarter) explaining how your investments performed, as well as educational materials about the investment choices available to you.

10 Warning Signs That Your Funds Are In Danger

1. Your 401(k) or individual account statement is consistently late or comes at irregular intervals
2. Your account balance does not appear to be accurate
3. Your employer fails to transmit your contribution to the plan on a timely basis
4. There is a significant drop in account balance that can’t be explained by normal market ups and downs
5. You receive account statements that do not show contributions from your paycheck that were made
6. Investments listed on your statement are not what you authorized
7. Former employees are having trouble getting their benefits paid on time or in the correct amounts
8. Your account statement or a letter from your employer reports an unusual transaction, such as a loan to the employer, a corporate officer, or a plan trustee
9. There are frequent and unexplained changes in investment managers or consultants
10. Your employer has recently experienced severe financial difficulty

What Sources of Advice Are Available on the Internet?
Scores of Websites offer financial and retirement information today. The following is a short list of what’s available. Some require registration and/or fees depending on the specific information you are seeking.

More than one hundred financial planning calculators, including many for retirement, are available at www .choosetosave.org, a Website developed by the American Savings Education Council and the Employee Benefit Research Institute. The education council also has the “Ballpark Estimate” retirement planning worksheet available at www.asec.org.

The Department of Labor, the Small Business Administration, the Chamber of Commerce, and Merrill Lynch & Co. offer www.selectaretirementplan.org 

401(k) Checklist
Now you should know more than enough to get started. Here’s a quick checklist that summarizes what you’ve just read:

• First and foremost, participate in your company’s 401(k) plan if one is offered.
• Sign up as soon as you can, even if it’s your first job and you’re still in your twenties. The younger you are, the more time your savings have to compound, and the less you’ll have to contribute to reach your retirement goals.
• Contribute as much as you can, but at least enough to get your company’s matching contribution.
• Diversify among investments, but don’t be too conservative. To get the greatest returns and stay ahead of inflation, you need to have some exposure to stocks.
• If your company requires you to accept its matching contribution in the form of company stock, do not invest your own contributions in company stock. If your company matches in cash and you want to own the stock, keep no more than 10 percent of your 401(k) assets in company stock.
• Resist borrowing from your account. Although most plans allow you to take a loan from your 401(k), the money cannot grow if it’s not in your plan. Fees and penalties can make the cost higher than it might seem.
• If you change jobs, don’t cash out your 401(k) plan. If you do, you’ll pay taxes and penalties, and have less money invested for your retirement. Instead, roll the money over into an Individual Retirement Account or into your new employer’s 401(k) plan.
• If you chose a “lifestyle” or “life-cycle” fund, remember that it’s not simply another fund option, and that selecting it along with other investment choices can defeat the original purpose.
• If you are automatically enrolled in a 401(k) plan, remember that the contribution levels and investment options must be adjusted, based on your personal savings needs and attitude toward risk.
• Remember to rebalance your portfolio occasionally so that the mix of investments you originally chose–the proportions of stocks and bonds in your asset allocation plan–is maintained.
• Don’t over manage your 401(k). Even if your employer provides you with Web access to your account and allows you to change your investment options as often as you wish, it’s a bad idea to drop whatever went down yesterday in favor of whatever is going up today.
• Focus on the long term. Even if your 401(k) is not performing as well as you’d like today, remember that saving for retirement is a marathon, not a forty-yard dash.

From the book Take on the Street, by Arthur Levitt ©2002 by Arthur Levitt. Reprinted by arrangement with Pantheon Books a division of Random House Inc. (Log on to www.black enterprise.com to order a copy.)