We help many entrepreneurs improve and manage their 401(k) retirement plans. In doing so, we have the opportunity to educate and advise many plan participants about their investments. We look at six common mistakes that people tend to make repeatedly.
Not Saving Enough This is the biggest mistake with the biggest consequences for people. Most people are not saving enough. The average person saves only about six to seven percent of their salary in their 401(k) retirement plan (excluding any matching). Studies by Fidelity and Vanguard, among others, show that employees actually need to save 12-15% (including any company contributions and profit sharing) over their careers in order to retire with success. Company pension plans are a thing of the past, and social security is increasingly underfunded and at risk. Many companies offer a 100% 401(k) match up to the first 3% of salary, and some offer a match above that level. By participating in your 401(k), at least up to the match amount, you get an instant and guaranteed return of 50% to 100% on your investment. We have not found a better investment than that in 30 years of searching. We recommend that people save as much as they can, even if it’s not at the 12%+ level initially, and then increase their contribution rate by 1% per year until they reach that level. We recommend saving at least enough in your 401(k) plan to get the full company contribution.
not be diversified. Many people own two or three different funds of large US growth stocks and think they are diversified. That’s not a very diversified portfolio. Typically, your portfolio should include US stocks (large and small), international stocks, and bonds.
Not taking the right amount of risk. Many retirement plan participants have no idea how much risk is in their portfolio or how much risk they should be taking. For example, a young person with almost all of their investments in cash and bonds may not be taking the right level of risk. An older person nearing retirement probably shouldn’t be 100% invested in stocks.
Do not rebalance the portfolio. A good strategy to improve returns and prevent your portfolio risk from drifting off target is to regularly rebalance your portfolio to return to preset asset allocation targets on a regular basis. If stocks are doing much better than bonds (like in 2013), it may make sense to rebalance your portfolio by shortening stocks and adding bonds to get back to your target allocation of 75% of stocks, for example. Some 401(k) plans allow you to set up automatic rebalancing.
Chasing performance. Many retirement plan participants look at the year-end performance of all the funds in their plan and then switch their investments to the funds that have performed better over the past 1-3 years. They believe that since those funds have been the best performers in the past, they are likely to remain the best performers in the future.
Don’t make your portfolio more conservative as you age. Most people “set it and forget it” when it comes to their investment allocations in their retirement plan. Often they don’t change at all for 5 to 10 years or more. For many people, it may make sense to gradually become more conservative in your portfolio as you approach retirement age, because your portfolio has less time to recover if there is a big downturn in the financial markets.
What can be done to help people make fewer mistakes and end up with better long-term performance in their retirement plans? We can educate you on these common mistakes and offer you an easier way to invest using target date funds or model portfolios. Target Date funds are portfolios offered in most 401(k) retirement plans and greatly simplify the investment process for employees. We believe they are an excellent investment option for many employees. Target Date funds are a single fund that invests in many other funds, at least one in each of the major asset classes. They are named according to the year in which you are expected to reach the age of 65. For example, if you are currently 49 years old, you are expected to turn 65 in 2030. You might consider investing in the Target Date 2030 fund. You don’t have to choose the target date fund that corresponds to your 65th birthday. You can choose one above or below your actual retirement date. Not all people of the same age will have the same risk tolerance. In addition to age, some of the factors we consider for a target risk level are wealth, income, debt, natural risk tolerance, timing of cash needs, investment experience, financial goals, the risk of other assets and the risk/volatility of your career/income.
Target date funds reduce or eliminate 401(k) investor mistakes two through six listed above. They set their investment allocations on autopilot. You don’t have to watch or worry about them as closely as individual funds. Target Date funds do many of the smart moves automatically for you. By using these funds, you will have a diversified portfolio with about the right amount of risk for someone your age. These funds automatically rebalance, don’t allow you to chase performance, and gradually become more conservative as you age. The only major problem they can’t help fix is that you don’t save enough.
Target date funds are typically 80% to 85% in stocks for younger investors, with the stock allocation gradually tapering down to 50% to 60% for people of typical retirement age (65). ). Studies of actual 401(k) investors show that these target date funds tend to outperform the vast majority of employees who choose their own funds in the plan, and by a significant margin. If you have a professional advisor who can set up a custom asset allocation in your 401(k), you may be able to do better than target date funds. We can often include lower cost funds, more asset classes and a value bias to our custom portfolios.
Traditional 401(K) or Roth 401(K)?
Most 401(k) retirement plans now offer a Roth option, along with the traditional 401(k). The vast majority of people continue to invest in the traditional 401(k) plan. In the traditional 401(k) option, you get the tax deduction now (when the money is contributed), but the money is taxed at its regular tax rate when it’s withdrawn in retirement. The Roth option offers no tax deduction in the year you contribute the money, but you do not pay taxes on the money when it is withdrawn at retirement. It’s helpful to compare your income tax rate now to your estimated tax rate when you retire to decide whether a traditional or Roth 401(k) is better for you. If your tax rate is currently below your estimated tax rate in retirement (as it is for many young people), you may want to consider a Roth 401(k). If your tax rate in retirement is expected to decrease compared to your current tax rate, you may want to stick with the traditional 401(K). To diversify your future tax exposure, you could put part of your retirement plan into traditional and part into a Roth 401(k). You can do both.