Restrain yourself. This is the time of year when many employers ask us to sit down and fill out all those bothersome 401(k) investment forms. As you do, remember: your job is to implement a plan, not outwit a fiendishly unpredictable market. Self-discipline will be paramount this year because the future is so cloudy. Will the economy continue to serve up that golden elixir–robust corporate profits mixed with quiescent inflation–that makes the market dance? Or must all good things, bountiful economies and spectacular stock markets included, come to an end? And now that we’re high-return junkies, what are the alternatives to U.S. stocks?
Picking the right investment is only half the battle. The way you operate–and withdraw from–your 401(k) counts just as much in crafting a successful retirement. To help you navigate this year’s decisions, here is NEWSWEEK’S guide to 401(k) management, the markets, mistakes to avoid and new wrinkles to watch for.
Power Moves for Your 401(k): Two strategies are crucial. Yet most 401(k) investors don’t exploit them. The first: know how much money you want to have amassed by the time you retire. Yes, it’s a ridiculously large figure filled with commas. But every other investment decision flows from it: the return you need to earn, how much to save and how much risk you should assume. Call a financial planner, buy some retirement software or use one of the low-cost services offered by banks and brokers to snare your number. Investing your 401(k) without this target is like following a road map with no destination in mind.
Second, if your company offers a range of investment options, you should follow a technique from professional investors called asset allocation. Here’s how it works. First decide how much of your retirement pot should go to stocks and how much to bonds. “The most conservative split is 40 percent in bonds and 60 percent in stocks,” says Harold Evensky, a financial planner in Coral Gables, Fla. You can get more conservative or aggressive depending upon how you further divide those portions into mutual funds. The stocks of large U.S. companies are less volatile than those of small companies, but their return is not as big, either. A 45- to 55-year-old should own a good chunk of such solid biggies. But 25-year-olds, who have plenty of time to wait for the short bursts of high returns associated with risky investments, might devote half of their stock portfolio to small stocks and emerging markets.
The next step in allocating your assets is even more important: to rebalance your portfolio annually. This means siphoning off money from the investments that sparkled and putting it into investments that did less well. The goal: start every year with the same percentages of money in each fund. The beauty of asset allocation is that no single investment places first in the investment derby every single year. By spreading your money into different categories, according to your master plan, you’ll capture those stellar returns consistently.
What If Your Plan Is a Clunker? But how you divvy up your money also depends on what kind of options your plan offers. The trend, for example, is to offer an escalating number of choices. That’s fine if you’re a fund groupie. If not, consider asking a financial planner to help you choose. You could have other difficulties if yours is an “average” plan, which might limit your options to six traditional choices. Whatever you do, don’t assume that dividing your money among all the investment choices is the right way to allocate your savings.
The toughest situation: restricted plans like the one here at NEWSWEEK, which offers five fairly conservative stock, bond and money-market funds. You can lobby for an expanded offering, or be practical. Choose the funds that come closest to fitting your blueprint and fill in the gaps with investments outside your 401(k). If you can afford to, steer your non-401(k) investments toward tax-free securities, such as municipal bonds, or stock funds that aim for capital appreciation. By all means, look at overseas funds, which haven’t seen the run-up that domestic stock funds have experienced.
How to Watch the Markets: Michael Price, one of the most famous investors of our time, thought the stock market would stink this year. Ned Johnson, owner of fund behemoth Fidelity Investments, cautioned fundholders not to expect another year of outsize gains. Standard & Poor’s forecast a tepid 7 percent return.
If folks like these can’t forecast the market, we’d be crazy to try. But we can tell you something almost as useful: which markets are way out of whack from where they should be. The accompanying table has two bars. The first shows the yearly return that an investment, such as international stocks, earned on average over the last 26 years. It’s what you might reasonably expect to collect over the next 26 years. The second bar shows you the return each investment produced during the first 10 months of this year. You’re interested in the ones that are far off track from where history says they should be. The theory: eventually those errant investments must return to their “normal” habits. For example, this year only the 500 stocks in S&P’s index are outperforming their historical average. They did the same thing last year, of course. But eventually, the U.S. market’s returns must fall–by a lot–to produce the historical average of 12.1 percent. Which investments should rise? International stocks and long-term corporate bonds, which are lagging their historical returns by 9.3 percentage points and 9 percentage points, respectively.
Investing by statistics may seem a little too coldblooded. But there’s other evidence that foreign stocks and corporate bonds will look a lot prettier next year. Profits at European companies have been steadily recovering. Now they’re poised to blossom. “I think 1997 will see the best synchronized worldwide expansion since 1988,” says Michael Metz, an investment strategist at Oppenheimer & Co. Long-term bond prices aren’t likely to shoot up as they did in 1995. But a half-percentage-point decline in interest rates, forecast by William Gross, a managing director at PIMCO, would produce a 10 percent gain or better for the year.
The Biggest 401(k) Blunders: There’s $675 billion socked away in 401(k)s today. Much of its potential is wasted because of a handful of common mistakes. Sidestep them:
Don’t load up on company stock. It seems like the loyal thing to do, but putting too much of your retirement money into your employer is a giant mistake. It’s too big a bet on a single stock. And you don’t need the exponential risk. If the company starts sucking wind and lays you off, both you and your 401(k) will be flattened. Amazingly, some 42 percent of 401(k) assets at large companies are vulnerable in this way.
Don’t neglect stocks. A shocking number of people use their 401(k) like a bank, stowing their savings in interest-bearing investments rather than stocks. But collecting a fixed rate of return–with no chance of appreciation–simply won’t swell your retirement accounts fast enough. The 7 percent offered in many 401(k)s today is only 4 percent after inflation. If you have at least 15 years before retirement even starts, you can weather the stock market’s gyrations.
Don’t refuse free money. True, no one actually waves a wad of cash at you. But when employers match a portion of your 401(k), it really is free money. Think of it as an instant, risk-free return of 50 percent if your company matches 50 cents for every dollar. Take advantage of your firm’s largess.
Don’t chase last year’s hot number. Don’t you hate seeing the 401(k) option you didn’t pick outgun the one you did? But switching funds every year can quickly derail your nest egg’s momentum. Outstanding performance in one year is often followed by a lackluster showing. Also, fund-chasing prevents you from following your blueprint–so you’re less protected against risk.
What if You’re Near Retirement? Most 401(k) owners are still trying to coax their account toward critical mass. But for those nearing or already in retirement, some quick decisions are in order. Starting in January, a new law will suspend for three years a 15 percent excise tax on annual retirement-account withdrawals above $155,000. Should you bite? The short answer: yes, if you’re planning to withdraw a big chunk of money just after the three-year window shuts. The long answer: consult an accountant or financial planner. You have to consider the effect of the excise tax upon two key issues: how the IRS requires you to withdraw your retirement money and how special taxes will affect that nest egg once you die.
The rest of us need to start paying attention to the tangle of rules and taxes on withdrawals, too. Why? A new National Bureau of Economic Research study by John Shoven and David Wise suggests that the wonderful tax-shelter features of 401(k) plans could backfire for millions of prudent investors. Why? Because large withdrawals are subject to federal and state taxes, as well as the 15 percent excise tax, once it’s reinstated in the year 2000. The combination could drive your marginal tax rate up to 61.5 percent. Marginal rates on retirement money left to your heirs can climb to a staggering 92 percent. Advice: once your retirement accounts hit a size that will trigger the excise tax, the authors suggest you may be better off saving money outside of your pension accounts. If you’re already retired and your nest egg is more than $1.2 million, you should consider drawing down all of your retirement funds over your remaining life, even if it means paying the excise tax. Then you can avoid the extraordinary taxes that would be levied on your pension money after you die.
Having an overstuffed 401(k) account may seem a distant problem–even more distant if the Dow deep-sixes on us. But chin up: that’s OK. For now, your job is to fill out those forms with your personal game plan in mind. Do that, and your account will eventually take care of itself–and you.
