401k Investments- Picking the Best Funds for Your Own Long Term Retirement Planning

Life used to be easier in the area of retirement plans. This does not mean it was better, just easier. There were fewer decisions to make. A person worked their entire life, retired and received their pension. The company controlled all aspects of the pension plan and investments, and assumed all risk. If the Pension Fund investments did not perform as expected, the Company either made up the shortfall, if there was a loss or was able to reduce future contributions if there was again.

When 401 k plans came on the scene in the early 1970s, they were viewed as additional work incentives or PERKs. While plan participants had to make some decisions under the 401(k) plans, such as asset allocation decisions, and picking the best funds for their financial situation, these decisions only applied to the perceived Incentive or PERK portion of their overall retirement assets. They still had their pension as the major portion of their long-term retirement planning assets. Many people used the 401k assets as short term savings plans (not advisable) rather than to meet their long term retirement needs, and thus developed short term investment goals. For instance many people saved to buy a house, a new car, etc.

As we all know, over the years corporations have either reduced pension benefits, changed the Pension plan to a Cash Balance Plan(which for most was a reduction in benefits), or eliminated them altogether due to the heavy long-term liabilities. They placed more emphasis on the 401k plans as the main retirement asset for their employees. This has placed a lot of stress on people in that they are now forced to make decisions that affect their long-term retirement goals and keep them wondering if there will even be a retirement. Now employees are in full control, for better or worse, of their long-term retirement security. Indeed, an employee's ability to retire at the desired time is dependent upon the investment decisions the employee made over the years.

The suggestions and remarks I give you below are based on my 25 or so years representing the major commercial banks as Trustee of large corporate pension and 401k plans. In this role, I came in contact with numerous CEOs, 401k Investment Directors, HR Directors, and company employees. It is the employees that I am concerned about in discussing 401k investments.

401k Participants with no Investment Background are Forced to Make Investment Decisions

Most people are not taught much about money and investing as they are growing up. Their exposure to investments, and experience as an investor, is limited to savings accounts, bank CDs, an occasional US Savings Bond, and money market accounts. Maybe they have a Mutual Fund or ETF but still do not know what these are. When they start working and become covered under a 401(k) plan, they are now told to start making investment decisions which will affect their long-term retirement security. Since most people are risk adverse, they tended to invest all their 401(k) assets in low risk investment vehicles such as money market funds, GIC funds, or short-term bond funds offered under their 401k plan. The 401k trustees, the 401(k) investment managers, the 401 k plan sponsors (normally the company), and all other individuals with investment background understood quite well that employees were not taking enough risk to meet their long-term retirement goals. As a result, prior to 2008, companies went all out in trying to educate employees about investments, asset allocation, Modern Portfolio Theory, the investment options available, and investment discipline. The result of this education blitz and watching the stock market rise steadily was that people listened and began allocating their 401k investments into riskier funds such as stocks and long-term bond funds.

Employees were quite pleased until 2008 when the stock market took a severe downturn and the average employee lost almost 60% of his 401(k) assets. Unfortunately, employees without investment discipline began withdrawing their remaining assets from the riskier investments and placing them back into the money market funds. This was a classic “Buy high, Sell Low” scenario. Markets go up; people get confident and buy into the stock market. Markets go down; people get scared and withdraw their investments from the market. This is the exact opposite of what they should be doing, which is “Buy Low, Sell High.” As the markets again rose 2009 and 2010, these employees had their remaining assets caught in very short term investments. The unfortunate result of all this is that many baby boomers will not be able to retire at age 62, or 65, or even 70 since they do not have sufficient time assets.

The Average 401 k Plan Investor Has Not Been Taught Investment Discipline

The above problem, which continues today, is not caused by making the decision to allocate 401k investments into Stock funds. The problem is caused by moving money into stock funds and then transferring these assets back to safe investments at exactly the wrong time – the Buy High, Sell Low syndrome. Most people do not have the discipline to leave the assets in the selected investments for long periods. If they did, their investment portfolio would be fine today in 2011. Even with the huge market drop in 2008, those investors who left their assets in the same investments would have made back all or most of their investment losses. Remember, these assets are invested to reach long term goals and should be invested as such.

You might think that I am blaming the employees for not making the right investment decisions. I am not. I really blame the corporations who have placed all the investment decisions for retirement security squarely on the shoulders of the employees who have no background in investing. I would not be saying this if these corporations did not cut back or do away with the Pension Plans and make the 401k plans the primary company retirement plan. To make this even worse, the corporations introduced the company stock funds into the 401(k) plans and required employees to allocate a good portion of their 401k assets into company stock. This investment was not initiated by the finance committees or the trustees or the investment managers under the plan. The implementation requirements of company stock funds came down from the very top where CEOs viewed the 401k plans as a good method of propping up the company stock price. The CEOs put the word down that they wanted as much money as possible to go into the company stock funds. From an investment viewpoint, the company stock funds are totally undiversified and many times an extremely risky investment depending upon the financial health of the company. For this, I believe the CEOs of many large corporations should be horse whipped, if not brought up on legal charges, if possible, for mandating that employee retirement assets be invested in the Company stock. Company stock investment options in a 401k plan should be banned by Congress.

Be it as it may, employees still need to make the investment decisions, so let's look at some non-technical 401 k investing basics.

The Investment Fund Options Normally Offered in 401k Plans

Every 401k plan has an array of investment options and they are all different. Some Plans will offer 5 investment fund options, others will offer over 25 funds options to choose from. However, most, if not all, 401 k plans will generally offer a smorgasbord of:

1. Common Stock funds-

o A fund investing inlarge fortune 500 companies(“large cap stocks”)

·Growth stock fund– strong companies that should grow faster than the overall market

·Value Stock fund- good companies, but are undervalued for a variety of reasons

·Mixed Stock Fund- a mixture of both Growth and Value stocks

oSmall Company fund(“small cap stocks”)- invests in smaller US companies

§ May have funds spit into Small Growth stocks or Small Value stocks

oInternational fund– invests is larger companies all around the world

2. US Treasury or CorporateBond Funds-

o Ashort maturitybond fund – bonds mature on average in 5 years or less

o A medium term bond fund – bonds average 10 years or so

o Along termbond fund –bonds mature in 20-30 years

3. Cash type funds (funds only earn interest, no gain or loss of principle)

o Money market fund

oGICfund or Guaranteed fund

4.Company StockFund – invests only the common stock of your employer

5.BalancedFunds – simply a pre-determined mix of stocks and bonds

6.Other

o Emerging market bonds – don’t bother

oSelf Directedfund Option – this is not really a fund but a way of allowing you to pick your own individual stock investments. Stay out of this option unless you are an experienced investor

Form of Fund Options

The funds descriptions will reveal some differences in the form of the funds.

o Actively managed – means the manager is constantly reviewing and trading the stocks in the fund

o Index fund – the investments track a market index such as the S&P 500 and so there is very little trading in the fund

o Mutual Fund Vs. ETF vs. Commingled Fund vs. Funds of Funds – for your purposes in 401k investing, ignore the differences and do not worry about it

Selecting the Best Funds for your own long term retirement planning

One of the most common allocation methods I observed over the years as a 401k Trustee is that the average employee would allocate his or her 401 k assets equally among all of the fund options under the plan, whether the plan had 5 or 25 investment fund options. Why? The employee has no idea what the funds are, what the risks are, and which to select, so he would invest equal amounts in each fund on the assumption that the Plan sponsor knew what he was doing in offering these funds. While not a good technical method of investing, this investment decision actually served to diversify the 401k assets among large and small stocks, short and long term bonds, company stock, and short term GIC or money market funds, assuming the 401 k plan had a normal array of fund offerings. The employee’s assets are actually allocated across all the major asset classes. This is actually a better method than trying to blindly pick a few funds based only on past performance.

A Better Risk/Return Method for Investing your 40k assets in the Best Investment Options

I am not going to go through all the investment theory behind stocks versus bonds versus cash versus real estate versus anything else. The plan participant has limited investment choices and the fund lineup was most likely selected by investment professionals. The important points to understand in long term investing in a 401k plan are;

1. Diversification- Spread assets among stock, bonds and cash, then further spread the Stock allocation among large, small, international funds if such choices are in your plan.

2. Invest for the long-term – over 10-20 years, equity investments or stocks will outperform income investments or bonds which, in turn, will outperform cash type investments or money markets and GICs.

3. Do not trade more than a few times per year – and definitely do not pull out of the stock funds or bond funds because the market has fallen. If anything, move your money into safer investments when the market has risen dramatically, and then when the market falls dramatically, buy back in to the riskier investment funds.

Your Asset Allocation Model to Divide Your Assets Among the Fund Options:

The suggested Model below is for employees who are under age 50 - 55. If you are in your upper 50s, you should start reducing the stock portion of your investments and increasing the safer investments such as short term bond funds and the GIC or Money Market funds.

· The majority of the 401(k) assets, 60 to 70%, should be allocated among stock funds:

o 50% of the stock allocation should go to large US stocks

§ If your fund options are Large Value stock fund and Large Growth stock fund, put equal amounts in each fund

o 30% should go to small stock funds

§ Again, if value and growth funds are offered, put equal amounts in each

o 20% should go to the international stock fund

§ If you have a international small company fund option, put 30% in the Small international stock fund and 70% in large international stock fund

· A good portion of the total assets, 20% to 30% should be allocated among bond funds:

o 60% of the bond allocation should go to medium, 10 year maturity, bond funds

o 20% to long term bond funds

o 20% short term bond funds

· 10 to 20% should be allocated to cash type investments.

o All of the cash or cash equivalent allocation should go into the GIC fund or money market fund, whichever is earning more.

The above mixture of stocks and bonds and cash should provide a better risk/return model than either all stocks or all bonds or all cash investments. Periodically, some rebalancing in this model will be required to reflect current or expected economic conditions. However, the employee should never put his or her money into the markets or take money out of the markets based on current emotion. This is a no-win scenario.

2011 comment

Bond funds have had a great run over the years. Most professional money managers expect bonds and bond funds to either have no growth or fall in value in 2011. You might consider putting the Bond Allocation above into the money market or GIC fund until after bonds fall in value over the coming year.

Force yourself to keep emotions out of your 401k investment fund selection

- Do NOT listen to CNBC every day – you will end up moving assets around in your 401k based on current emotion which is always a losing proposition

- Do NOT get caught up in the short term emotional trading – let other people panic. Learn discipline and have faith that the markets will return to normal

- Invest for the long term – The market just dropped 30%. So what? You are investing for your retirement down the road. The market will rise again

- Adjust quarterly – review your asset allocation and adjust your investing model based on changing economic conditions. Do not reallocate based on what you hear at the water cooler or from your brother-in-law.

- Read up and learn about market cycles – this should determine how you reallocate your assets each quarter.

- “Regression To the Mean” – this is a fancy age old investment and statistics term which means “return to average”, or What Goes Up, Will Come Down, or What Goes Down, Will Come Up. Over a very long term, the stock market has, and is expected, to return roughly 10% per year gains. If the stock market drops 50% as it did in 2008, you can expect it to Return to Average, which it did in 2010 and 2011. If the market soared to elevated levels, as it did in each decade, it will Return to Average and drop. Essentially, you cannot consistently beat the overall market, but you can identify the periods when the markets are at one extreme or the other, and take appropriate action to adjust your asset model.

Enjoy your Retirement!