Fifty-one million American workers have an active 401(k) account, and Smart Money Magazine estimates the balances in these plans accumulate to $4.3 trillion. Without a doubt, 401(k) — or their brethren, 403(b) — plans are the primary retirement vehicles for the majority of American employees.
Not so long ago, retirees relied on pensions for their retirement, but the traditional defined benefit pension program is nearing extinction. Of the pension plans that still exist, some are so financially strained that their futures are uncertain.
The 401(k) industry has come under heavy criticism since its advent, much of it well deserved. Increasingly, however, such cynicism also is an excuse for inaction among plan sponsors (employers) and plan participants (employees). Although many plans are extremely flawed, they are almost always workable and worthy of employee participation.
Instead of getting hung up on the investments within the plan, employees should focus first on how much they are able to save. After all, this is the part the employee can control. In our view, obsessing over the investment choices before maximizing your savings harks back to the old expression about putting the cart before the horse.
Many employers offer a match to encourage 401(k) savings. For example, if you save 6 percent of your pay, your employer might match your contribution 50 cents on the dollar and therefore put an additional 3 percent of “free money” into your 401(k). For legions of people, this is a strong incentive to contribute up to the match.
Ironically, though, clients we talk to often cite the employer match as a disincentive as well. In other words, people think, “Why should I save more than my employer will match?”
The answer is simple: taxes. Employees defer federal income taxes on traditional 401(k) contributions (Roth 401(k) plans have different rules) until the money is withdrawn during retirement, so middle-income earners can save 25 percent in current taxes on the money they contribute (high-income earners can save
35 percent). Not a bad return, especially in a world with near-zero interest rates.
Even if the plan’s investment options are less than ideal, the employer match and the tax benefits of contributing to traditional 401(k) plans are in and of themselves a sound investment. Remember, too, that all of the dividends, income and appreciation that occur within the 401(k) plan are also tax-deferred until the time you withdraw the funds.
Make no mistake that the first line of retirement savings should be maximizing 401(k) contributions. This is the “no brainer” route to retirement success. While some plans may restrict annual contributions below government limits for certain reasons, the maximum legal contribution in 2012 for traditional 401(k) plans is $17,000 and employees more than 50 years old can make additional “catch-up” contributions totaling $5,500. Sophisticated plans allow for even greater tax-deferred savings through safe harbor and profit sharing add-ons.
After maximizing 401(k) contributions, your savings options are less compelling and more complex. Of course, you can only save what you can afford, but “paying yourself first” — the withholding of your pay to automatically invest in your 401(k) — is an ideal route to disciplined savings.
After maxing out savings, it is time to turn to the investment side of the 401(k) equation. Our first rule of investing your 401(k) is “don’t be too clever.” A disciplined and consistent fund allocation over a long period of time — especially in a situation where you are adding money with every pay period — has a high probability of success.
Determine your stock and bond mix based on your age, retirement year and risk tolerance, not based on your personal forecast for the global economy or your political outlook. Invest in a diversified basket of funds; don’t attempt to be tactical. Find lower cost funds with limited portfolio turnover; these two traits are amazingly prescient indicators of long-term performance.
Although seemingly self-serving, we cannot overemphasize the importance of getting professional help with your 401(k) investment strategy. You don’t fill your own cavities or pull your own teeth, so don’t be coy about getting assistance with your retirement.
Seek advice from your investment manager or your financial planner. Coordinating your 401(k) investments with your other assets is crucial. If you don’t have a full-time financial professional working with you, then consider a fee-only planner you can compensate on an hourly basis to examine your 401(k) and recommend an allocation.
Many employers — about 60 percent, according to consultancy Aon Hewitt — offer investment recommendations to employees through a 401(k) provider. One word of caution, however: It is critical to definitively determine if the 401(k) provider’s compensation is linked to the funds that you pick. Be sure to walk into the consultation with your eyes open.
For a variety of reasons, perfection within a plan is an impossible utopia. The best plans have reasonable and fully disclosed fees and dedicated service providers who have a fiduciary duty to act in the best interests of the plan sponsors and participants. Plans should offer a variety of investment choices but not every investment strategy under the sun.
Regardless of a plan’s specific limitations, the benefits of tax deferral, company match and systematic savings almost always make 401(k) plans a vital endeavor.
Ben Atwater and Matt Malick are partners at Atwater Malick LLC, a registered investment adviser, which has offices in Lancaster and Dauphin counties. Email them at [email protected] and [email protected].