Updated: Apr 12
In this week’s financial topic we’re going to stick with the theme from last week’s episode, and talk about investment allocation in retirement plans regarding 401(k)’s, Roth 401(k)’s, 403(b)’s and 457(b)’s.
In lasts week’s podcast episode #45, we reviewed the traditional 401(k) and Roth 401(k)’s. In that discussion, we covered how they work and what the benefits are as a building block for your retirement nest egg.
So this week we are covering another common question when enrolling in your employer sponsored plan which is, how should I invest my contributions based on my budget? Now hopefully, your employer is bringing in 401(k) representatives to discuss the importance of your plan enrollment along with the best way to align your allocation, but for those who skipped that meeting or day dreamed through the mandatory one, let's give a refresher to people that don’t have the knowledge of how to allocate their investments.
So that’s why you have us provide this personal finance education.
Okay let’s run through some stats to wet your whistle:
According to Fidelity:
-Roughly 85% of employers offer a retirement plan contribution to their employees.
-$7,270 is the average contribution rate over a trailing 12-month period ending Sept. 30, 2020. In addition, the average employer contribution during the same period was $4,010. So this means that the savings rate was 13.5% of income.
-A record 441,000 IRA or 401(k) accounts it manages, had balances of $1 million or more.
-According to Statista.com About 5.32 million individuals in the United States had financial assets worth at least one million U.S. dollars in 2018.
401(k) Investment Options
So why don’t we start with some basics.
When you contribute to a 401(k) typically you’ll have two options to invest your money. One is mutual funds and the other in company stock; however, is all dependent if it is offered by your employer.
So let’s start with the mutual funds. These are financial vehicles that take money from investors or in other words, pools of money collected and the fund invests in securities including bonds, stocks and money market instruments.
A mutual fund is administered by the fund managers and their job is to invest the fund’s assets with the goal to yield capital gains or income. In short, the fund typically consists of several companies or investments. In return, they charge a fee called an expense ratio to manage the assets.
So in simple terms, the mutual fund behaves like a stock does in that it has a price attached to it that goes up or down on a daily basis otherwise known as the net asset value or NAV.
So as the bulk of 401(k)’s consist of mutual funds, how do you know where to invest?
Knowing Your Asset Allocation
The first thing that you need to look at, or understand is asset allocation, meaning, how do you divide your contributions between the cash/money market (oftentimes a stable value fund), bonds and fixed income, and stocks.
Once you decide that, how do you diversify between those asset classes?
The first question depends on what your risk tolerance is as well as factoring your investment time horizon.
Let’s walk through the common types of funds that you’ll see in your company's plan.
Common Types of Mutual Funds
Large-cap fund: As it may sound these types of funds tend to invest in companies that have large market capitalization. These companies are well established, have a great reputation and provide stability.Typical companies that may be in these portfolios are those included in the S&P 500 index such as Microsoft, Amazon, Apple, Alphabet, Tesla, GM and the list goes on.
Mid-cap fund: This type of fund invests in companies that have market capitalizations in the middle range. The goal is to seek greater growth potential than large cap stocks and that comes with more volatility but are less risky than small cap stocks.
Small-cap fund: This type of fund invests in companies that have market capitalizations typically between $300 million and $2 billion. Small cap stocks may provide more gains than mid and large cap stocks; however, they can be more volatile.
International fund: This type of fund invests in foreign markets outside of the United States. These funds may come with caveats such as currency risk or economical, regulatory and political conditions. At times, these funds can have large swings in value; however, they can be a valuable part of a portfolio especially in emerging markets.
Value fund: This type of fund invests in stocks seen as undervalued based on their fundamentals. These can be items such as cash flow, P/E ratio, return on assets and forward looking guidance. The goal is to seek companies that are considered as emerging with a high potential for growth.
Bond fund: This type of fund primarily invests in bonds such as convertible, corporate, municipal and government. They also invest in other types of debt such as mortgage-backed securities (MBS). In low interest rate environments more than likely, returns are typically small.
Money market fund: This type of fund invests in near-term instruments that are liquid meaning that the holdings can be converted into cash very quickly. Along with cash, the fund may contain high-credit rated cash equivalent securities and debt-based securities with a short-term maturity as namely with bonds and U.S. treasuries.
Balanced fund: This type of fund typically contains holdings in bonds, stock and perhaps a money market component. Hence, having this mix can be a stable way to generate modest returns without having small and large changes in their overall value.
Target-based fund: This type of fund is unique in that they are centered around time frames. The goal is to focus on an investor’s capital needs at a future date. As time passes, each fund is managed to gradually shift from higher-risk investments (such as stocks) to lower-risk investments (such as bonds and cash equivalents).
You may want to consider your options, and your ability to manage your portfolio before you simply invest your 401(k) in a target-date fund. Although, I have to say, if you are not a sophisticated investor or don’t want to play an active role managing the funds in your 401(k), this may be the best option to consider for the long term.
The fund rebalances its portfolio to become less focused on growth and more focused on income as it approaches or passes the target date.
For example, these funds are designed to evolve as you move closer to retirement meaning for a typical retirement age of 65. So if you’re 30 right now and choose a target date fund, you’d likely choose a target date ffund for 35 years from today.
On the other hand, I am 50 and it is 2021 and if I’m planning on retiring in 15 years, I’d choose a target-date fund that matures in 2035. This means, if someone is young and has a long investing time span, his/her exposure to the stock market will be much greater as opposed to someone that is set to retire in the next 1-5 years.
As we’ve talked in the past, the average life expectancy rate is 81 and the required minimum distribution (RMD) rate has gone up to 72 because people are living long and working longer. If you think you will work beyond 65, then you may want to choose a target date fund that is 5 years out to age 70.
Let’s Do a Recap
A high majority of 401(k)’s only contain mutual funds; and these are financial vehicles that take money from investors or in other words, pools of money collected and the fund invests in securities including bonds, stocks and money market instruments, and other assets.
Cindy #2 The first thing you need to look at when analyzing your retirement plan is to understand your asset allocation, meaning, how do you divide your contributions between the available fund choices. David #3
This leads into one’s risk tolerance meaning how aggressive or conservative is someone choosing to be. Typically, the younger people are, the tendency is to invest more aggressively and as they age the plan is to become more convesative. However, this depends on an individual's comfort level.
Cindy #4 It is common that many people don’t have the knowledge regarding their investment choices or they simply do not manage their money. This is why we talked about target-date based funds because their goal is to balance out the short term highs and lows of the markets by diversifying your portfolio by investing in several asset classes at once.
So as you begin or modify your journey, spend an hour or so and look at the available funds in your plan to see what’s offered. Look at historical returns, the expense ratios, a fund's scoring against its peers and what the company is invested in. After that, take a peek every month or so to see how things progress with your investment choices. Remember, with this type of investing it is the tortoise that wins the race; not the hare.
When it comes to your retirement plan we always say that making 7% annually on your money over time is achievable and the longer that you invest, it increases the odds of reaching this goal. We always say it is never too late to start.
Imagine when you were 25 or may be in that age range now . . . just investing $100 per month for 40 years at that 7% interest will accumulate $$256,331.
So start investing or increase your contribution amount and let that money grow!
If you want to learn more about stock appreciation as it relates to mutual funds listen to podcast #31 How to Use Stock Dividends to Build Your Retirement Nest Egg