There has been a significant trend regarding retirement benefits over the past few decades. More employers are offering defined contribution (DC) plans such as 401(k) retirement plans, instead of defined benefit (DB) pensions. Consequently, there has been an increase in participation.
Reasons to Participate
According to the Bureau of Labor Statistics 2008, "From 1980 through 2008, the proportion of private wage and salary workers participating in only DC pension plans increased from 8 percent to 31 percent …". Because 401(k) plans may be the only retirement benefit available to employees, the importance of participating and investing wisely falls on the employee.
The earlier a person starts contributing to a 401(k) plan the better. That greater time horizon allows for more growth opportunity of those assets as well as accumulating larger contribution amounts. Trying to catch up later in life can be a huge challenge.
Many companies offer a matching benefit to those who participate in a 401(k) plan. For example, if the employee contributes five percent, the employer matches five percent, for a total contribution of 10 percent. When matching contributions are offered, it is best for employees to set their contribution level high enough to receive the full matching amount.
Factors That Impact Investment Decisions
Employees may find it confusing and have little guidance available to sort through the number of investment choices that are available within their 401(k) plan. An average plan may offer as many as 25 investment options, according to the Investment Company Institute report of 2014.
Making a retirement investment decision depends on many factors and financial advisers would insist on a complete financial review before making suitable investment recommendations. That review would cover a discussion of current investments, prior investment experience, financial responsibilities as well as other goals.
The age of the investor is a key factor in determining the number of working years ahead. For example, younger investors typically select an investment for long term growth. Those just starting out in their career have a long time ahead. The investment strategy will need to be adjusted as an employee nears retirement age. Older investors want to move to more conservative investments as they prepare for taking withdrawals from the 401(k).
The longer holding period for retirement assets will help to ride out the market fluctuations that occur with any investment. Typically, an investment timeline of 20 years or more will allow for growth in a retirement account. A shorter period of fewer than 10 years will impact investment choices and offer less growth opportunity.
Each investor has a unique reaction to how an investment performs and the ability to accept the fluctuations. Other factors influencing risk may include a review of financial resources such as savings and non-retirement assets. The importance of job stability, as well as family responsibilities, play a role in investment risk. Married couples may want to concur over they investment strategy when setting retirement goals, for example, one spouse may be more aggressive in their retirement investments than the other.
There are many types of investments typically found within a 401(k) plan. And 401(k) contributions can be made as a percentage or dollar amount allocated to more than one investment category.
This option may be available to those employees who work for a publicly traded company. There could be an opportunity to buy the stock at less than market value. This partial ownership shows a shared commitment to the success of the company, but it is important not to let this be the only investment within a retirement account because of the risk exposure. It is also a vulnerable position if the company does not succeed. Be sure to diversify company stock along with a mix of other investments to create a diversified balanced portfolio.
Target Date Funds
This type of mutual fund allows for a balanced approach by combining stocks, bonds, and cash within a single diversified account. The portfolio management will adjust the underlying holdings in this fund from an aggressive growth approach in the early years and move to a more conservative mix over time. For example, Vanguard has Target Retirement Funds that offer a range of choices depending on the age of the investor or years till retirement, (from Target 2015 to Target 2060). This has become a popular retirement option for all ages because it offers an easy to follow approach by just selecting the target retirement year. It has been called a "set and forget" type of investment.
This is a low-cost mutual fund option because it tracks the same underlying holdings of an index such as the S&P 500 and is not an actively managed portfolio requiring frequent trading of securities. Investors should consider a combination two or more index funds to create a balanced approach for the retirement assets.
Domestic Equity Funds
There are many actively managed domestic equity mutual funds offered by names such as Fidelity, Vanguard, and T. Rowe Price. The equity mutual fund selection may include portfolio holdings of large U.S. companies, small companies or a blend of categories and range from aggressive growth style to balanced funds. It is best to look at the investment style and historical performance of equity funds and consider a diversified mix of investments.
International Equity Funds
Mutual funds holding foreign stocks offer some diversification in combination with domestic equity funds and bond funds. Foreign companies can be large, well-known brands or emerging markets from developing countries. There are unique risks to foreign holdings that include political instability or fluctuating currency exchange rates. So international equity funds should be combined with other investment categories to create a diversified portfolio.
Bond mutual funds invest in a portfolio of debt instruments such as government and corporate bonds and mortgage-backed securities. Bonds generate income and can range from short term to long term and vary in credit quality. Typically bond funds help to diversify against equity or stock funds and offer income rather than growth. Building the proper asset allocation using stock, bonds and cash is one way to create a balanced portfolio. Bond investors are typically looking for a more conservative strategy than stocks, so this may appeal to those nearing retirement age.
Exchange-Traded Funds (ETFs)
Exchange-traded funds are similar to index funds because they track a basket of underlying securities but trade like a stock. The holdings in an ETF can be a variety of assets such as stocks, bonds, gold, real estate, foreign currency, etc. Most ETFs have lower costs than mutual funds, and there is a wide variety of types to choose from. Some examples of ETFs are those that mirror the market indexes such as the S&P 500 or Nasdaq 100. Retirement investors would select ETFs as part of a diversified combination of investments. Investors using ETFs need to have some financial experience and be attentive to the changing markets.
Self-Directed or Brokerage Accounts
If the investment options listed above were part of a restaurant menu, then the self-directed option would be like going into the kitchen and becoming the chef. All the ingredients or securities are available in a self-directed account and can be invested in any combination or portion to create a unique portfolio.
This option is appropriate for those investors who want to hold individual securities and to manage a customized portfolio for themselves. It requires attention and monitoring as market conditions change and securities go in and out of favor. This option suits those with a financial expertise and the desire to actively manage their retirement assets. It allows for a full range of investment choices, so it gives an investor maximum control over their retirement holdings.
Other Factors to Consider
- Use the resources offered by the 401(k) sponsor, such as online calculators, asset allocation tools, investment objectives and performance history. Most plan sponsors offer investment guidelines and details regarding each investment option.
- Monitor the investment selection within the 401(k) at least once a year or more often as needs or circumstances change.
- Consider all retirement goals and focus on ways to maximize other retirement accounts such contributing to a Roth IRA or Traditional IRA in addition to 401(k) plans.
- Avoid making withdrawals from 401(k) assets.
- When there is a change of employment, rollover those 401(k) assets into a retirement plan with a new employer.
There is no single investment strategy that fits all investors nor is there a way to place investors into convenient categories under a retirement goal. It is important to take the time to explore all the options available within the 401(k) investment menu. All investments have some merit when put into a portfolio mix that is appropriate for the goal and the investor.