#003 - 401K Funds

Investing in: 401k Funds

Risk: Low to High
Return: Low to High
Allocation: N/A

I'm going to post this particular information although I don't count my 401k in my allocation for investing. I see it as one of the primary foundations of my retirement and because of that I rank it in the same location as my house as an asset. As I am not actively managing it due to the nature of 401ks as funds I track it less frequently and don't put it in the same category as my stocks, bonds, and cash accounts.

401ks are supposed to be the new shining star of retirement investing vehicles. Most of the people willing to seek out financial information and finding this blog will probably already know what these are but in case there are some readers who don't know of don't understand what they are and how they work here is the information.

A little history first.

401ks are meant to be retirement funds that replace pensions. Previously if you worked for a company for an amount of time that they felt sufficient a company would give you a pension which is basically a promise to pay you a certain amount of money for either the rest of your life or a set amount of years once you stop working (the same way Social Security is supposed to work). There are two inherent problems with pensions however. The first is the risk of the company itself. We've seen time and time again how over the years big name companies can fall behind the times and vanish from the face of the planet. Sears comes to mind as a company that at one time was huge but is slowly slipping away. Now if you are counting on your company to pay you every month and they have financial trouble or go bankrupt you could see your pension go down or disappear all together. Obviously this has happened over and over again in the US and the 401K mitigates this risk to a large extent. The second problem with pensions is that in today's economy it is very rare to find someone who stays with the same company for 20 years. It is much more common in my experience of reviewing resumes to see people staying between 4 and 6 years with a company. There are exceptions but overall the work force today typically does not stay with a company long enough to qualify for a pension.

Enter the 401K. At its simplest it is a mutual fund account that invests PRE tax dollars from your paycheck into a management corporation that buys mutual fund stocks for you. Typically the management corporation will have a wide range of funds for you to choose and you can allocate your money as you see fit so that a certain percentage of it buys certain funds each paycheck.

So what are the risks?

No investment vehicle is 100% guaranteed and 401Ks are not different. To start with you're investing in mutual funds. These are collections of stocks and assets that financial institutions put together to make money on the stock market. As such, the value will go up and down with the market so you could see high volatility large drops in value given the state of the stock market at any one time. The fund that you are investing in could also collapse from bad management or criminal acts effectively losing all of you money (very rare). You also have to pay the management company to hold these mutual funds for you so these management fees will eat into your profits. Beyond that these funds were designed for what the government had decided is "retirement age" which as of right now is 59 and a half. If by hard work or luck you decided to retire before that and wanted to get your money out of your 401k you would have to pay not only the tax on the money (remember this was pre tax money and the government is going to take their slice) but also a 10% "early withdrawal" penalty. That's a pretty large chunk of your investment right there so be prepared if you want to retire early

And the benefits....

Taxes. 401ks offer a few unique benefits. Firstly it is pre tax money. What this means is that you get the % of your actual paycheck before all of the taxes. You will have more to invest this way which in turn can make you more money through compounding and gains. If you really want to drill down into your finances you may also be able to leverage your 401k to drop you into a different tax bracket. Due to the US tax code's tiered system if you are close to the boundary between a higher and lower tax bracket you could actually invest more in your 401k and end up paying less in taxes over all if you can drop into that lower bracket.

Company Payments/Matching. Better yet, most companies have some sort of 401k program where you can invest in the funds and the company will either invest a given amount for you as well or match what you invest up to a certain percent. VERY IMPORTANT: If your company matches your contributions you NEED to max your 401k to that percentage. Otherwise you are literally losing out on free money.

Management. Mutual funds provide instant diversification and trading potential. You are paying for someone to put together a portfolio of wining stocks and trade them for you so all of your eggs aren't in one basket. This doesn't mean dump your money all into one fund however. You should diversify your funds to compound your coverage of the stock market and provide avenues to prosper from many different sectors of the economy. The management company also reduces the amount of interaction you need to have with your 401k. Often a cursory glance to make sure everything is okay is all that is necessary every other month to ensure you are making good profits.

Flexibility. 401ks have special rules regarding using them for first time home buyers and student loans. Beyond that you can also take a regular loan from your 401k for whatever ever you want. Be warned however, in general taking a 401k loan is not advised and you need to do your research to understand the full implications of taking one before you decide to do so. I may write a post describing all of this later.

Stability. The money you put in is yours no matter what. Even if the company you are working for changes or goes out of business you get to keep it. The only exception is the money that your company puts in or matches to. To claim all of that you will need to become vested. What this means is that you need to work for the company for a set amount of years before all of that free money is actually yours. Most companies have a graduated vesting schedule which means each year you work for them a percentage of the free money becomes yours. So if your company has 20% vesting that means after 5 years all of the money they have given your 401k and future contributions are totally yours.

So where do I invest?

So this is the tricky part. Depending on your management company you may have a completely different set of investment options from the next person. Here is where you need to do your own research. Pick some funds, look them up on sites like Morningstar.com or Google Finance. If you are closing to withdrawing funds it is often taught to stay in lower volatility funds so that the money will be stable for when you take out. Many institutions now offer "Lifecycle" funds that are more aggressive to begin with and slowly become more conservative. They are often labeled with the year that withdrawal is targeted. They can reduce your management overhead even more.

I'll end with my two most important tips for your 401k and things I've actually seen happen.

#1. DO NOT WITHDRAW MONEY WHEN THE MARKET GOES DOWN!!! This is the most important thing I can put on this blog and something I have personally witnessed. When the market goes down yes, your amount of $$$ in the account goes down. This doesn't mean you have lost money, it means you have lost VALUE. You still own the same amount of shares that you did before the price dropped. When people panic they sell low and they lose. You don't lose anything until you withdrawal it from the account. There is a common adage in investing that you may end up hearing that goes like this "Past performance is not an indicator of future success". While this is a cautionary phrase it is not necessarily true. The stock market has survived several depressions, two World Wars, every kind of natural disaster and shortage out there. Chances are much better that it will bounce back then that you will lose everything in your 401k. You may be down for a time, it may even take years, but if you can wait chances are very good that you will see your value return and increase dramatically if you were still buying shares during those low prices.

#2 Ask Questions. Many places provide financial guidance. This is one of many many financial blogs out there and most if not all accept questions. Ask me and I'll respond. Ask a relative, a neighbor, get as much information as you can to make the best decision you can. Your bank, company, or broker may offer classes for a financial advisor. Leverage that if you can (while being weary or a hard sell for their own funds/stocks). The more you know the better your chances of success.

Risks - Covered above

Return - Can vary widely however I've seen between 5% and 10% when the economy was stable. I've also seen -15% during a depression but after a year or two I'd have a huge 25% spike. Just my own experience here.

Allocation - I advocate 10% of your salary should go towards your 401k. That's a lot of money I know but even doing the math I found I wouldn't be able to retire on my 401k and Social Security alone and still have the lifestyle that I wanted at 10%.

Suggested - Your company that you are with typically will tell you which management company they are using and that is the one you will have to use while you are with them.