The 401(k) has come under fire recently, right here on MoneyWatch and then from both The New York Times and Time magazine. But for all its faults, it may be the single most important asset in your financial future. Until someone comes up with a better way to save for retirement, your only choice is to save as much as you can and invest it intelligently. In other words, love the one you're with. "For most people, this is the biggest bucket of money they're going to have when they retire," says Houston financial planner Gary Busch. "So it's important to be doing a good job with it."
Here are the 12 dumbest mistakes that financial pros say you can make with your 401(k) — or 403(b) — along with our advice on how to avoid them.
1. Missing the Match
First things first: Enroll. It goes without saying that unless you are independently wealthy and you go to the office just for kicks, you ought to be investing in your 401(k) plan. But even if you’ve got a different retirement savings approach — say, a Roth IRA — at the very least, invest enough in your 401(k) to get the full company match. Although 11 percent of employers have recently dropped this feature, most still hand out free money. Take it.
2. Betting on the Company
When Enron imploded in 2001 and its stock became worthless, many employees lost not only their jobs but also their retirement savings. Employees had roughly $1 billion in company shares. And yet investors continue to make the same mistake: In plans where company shares are an investment choice, about a third of employees have more than 20 percent of their money in the stock. That’s putting too much faith in one business and violating a basic tenet of investing: diversification. After all, your income is already tied to your company’s fortunes. If the business collapses — and recent history suggests that no company is invulnerable — you don’t want your retirement to collapse as well.
Bottom line: Never invest more than 5 percent of your 401(k) in the company that employs you.
3. Freezing Contributions
When first enrolling in a 401(k), it’s fairly common for employees to set their contribution level at 6 percent, often the minimum required to get the full match. But if you haven’t increased the contribution despite subsequent raises and bonuses, hop to it. “A lot of people lock in a percentage,” says Cheryl Krueger, a financial planner in Schaumburg, Ill. “But if they get a 3 percent raise, they could easily increase their contribution a percentage point or two and still end up with more money in their paycheck.”
When your salary goes up, boost your 401(k) contribution, too. Some companies allow you to set up your plan so that your contribution increases automatically; if so, take advantage.
4. Cashing Out
Nearly half of employees withdraw their 401(k) savings when leaving one company for another. Big mistake. “People don’t realize that they don’t have to cash out,” says Mike Alfred, CEO of BrightScope, a 401(k) rating site. “We call it ‘leakage.’ They could roll the money into a new 401(k) or IRA.”
Taking the 401(k) cash as an immediate payout means owing taxes on the money plus a 10 percent early-withdrawal penalty if you’re under 55. Not to mention that you’re robbing from your retirement by pocketing the money now.
5. Misusing Target-Date Funds
About a third of 401(k) participants invest in target-date funds (at some companies, these funds are the default option), but many don’t know how to use them. These accounts allocate assets based on the year you plan to retire and are meant to provide one-stop investing. Vanguard’s Target Retirement 2030 Fund (VTHRX), for instance, divides contributions among domestic stocks and bonds and international stocks in a ratio designed for someone retiring in 21 years (now 67 percent U.S. stocks, 16 percent bonds, 17 percent international stocks). But some employees invest in multiple target-date funds with different dates, defeating the purpose.
“I wouldn’t say it’s disastrous, but it just doesn’t make any sense,” says Seattle financial planner David Lamp. Be sure to evaluate the allocations in your 401(k)’s target-date funds before investing to see that they square with your appetite for risk. As MoneyWatch blogger Nathan Hale reported, 2010 target-date funds — designed for investors planning to retire next year — lost an average of 23 percent last year because they were heavy in stocks.
6. Failing to Rebalance
When you first signed up, you decided what percentage of your 401(k) would be in stocks, bonds, and cash. But over time, those percentages have changed, depending on how their underlying investments have performed. If you haven’t rebalanced in recent years, your mix is probably quite different from what you had originally planned. During the market collapse in 2008, for example, your stock allocation shrank in relation to your bond allocation. Yet more than half of 401(k) employees didn’t rebalance, according to retirement plan adviser I-Pension. (About a quarter didn’t even open their statements, but that’s another story.)
Aim to get your 401(k) ducks back in a row annually. Had you rebalanced at the end of 2008, for example, you would have been selling Treasury bonds near an all-time high and adding more exposure to stocks, which started to rally in March.
7. Taking Too Much Risk
Inertia can be a force for good if it keeps you from trading too much and chasing winners, but it can cause problems if you don’t adjust your investment mix as you age. “As you get older, your allocation should change. You want to put less money into stocks to get a more conservative allocation,” Krueger says.
Remaining aggressive could mean delaying retirement or reducing your post-work standard of living if your retirement date coincides with a bear market. Go too conservative, however, and your nest egg might not be big enough. Talk to a planner to determine the proper mix or do your own calculations with tools such as the Asset Allocator at Sink or Swim and this investor questionnaire at Vanguard’s Web site.
8. Ducking Out
When the market collapsed last year, taking your 401(k) portfolio with it, panic was a perfectly understandable reaction. But the key is to make investment decisions based on logic, not emotion. Employees who resisted the flight response and consistently participated in their plans from 2003 through 2008 had an average annual return of 7.2 percent, even including 2008’s losses, according to the Employee Benefit Research Institute.
“Emotional investing decisions are almost always bad decisions,” says Chicago financial planner Chris Long. “To be a good investor, you can’t make short-term decisions for long-term money.”
Remember: One of the great things about a 401(k) plan is that you are dollar-cost averaging into the market — investing the same amount at regular intervals — so you end up buying more shares when they’re cheap and fewer when they’re expensive. If you stop buying during a trough, you’re missing the bargains. “Most stuff is still cheaper now than it was in November 2007,” says Busch.
9. Holding On to Lousy Funds
Don’t stick with a 401(k) fund that has performed worse than its peers year after year because you hope to recoup your losses someday. The test: If you wouldn’t want to buy the fund initially today, you probably shouldn’t own it anymore. We’re not suggesting that you dump your stocks — only that you look for another portfolio, preferably a low-cost index fund.
10. Getting Socked by High Fees
Your 401(k) provider loves telling you about its funds’ investment styles, and you may get to see performance numbers, but it’s not easy to figure out what fees you’re paying. If the funds in your 401(k) have a high expense ratio, your returns will be snipped substantially. Your best bet is almost always a low-cost index fund; the cheapest charge less than 0.1 percent of assets. If you must invest in actively managed funds, try to stick with expense ratios below 1 percent. But since fees vary by type of fund (bond funds are typically cheaper than stock funds, for instance), compare within asset classes as well.
“The key is to look at fund expenses relative to others in that asset class, rather than on an absolute basis,” Busch says. Your benefits department should be able to get you fee information, but also check BrightScope’s “Total Plan Cost” for your company to see how its 401(k) fees (which you are paying in addition to fund expense ratios) compare with the universe of plans.
11. Treating Your 401(k) Like an Island
It’s essential to be sure your plan’s holdings fit properly with the rest of your portfolio. Otherwise, you may have too much of your wealth tied up in one type of investment. Busch, for example, recently discovered that a client had a brokerage account invested in the same types of large-cap stocks that made up his retirement portfolio. “I had to adjust the allocation in his retirement plan,” Busch says.
12. Borrowing from Your Future
When money’s tight, it can be tempting to dip into your 401(k). After all, you’ll just be paying yourself back with interest (current rate: about 4.25 percent), right? Wrong. For one thing, if you lose your job or take another one, you must repay the money within 30 to 60 days. If you can’t, the IRS considers the money you’ve taken out to be a withdrawal, and charges you taxes and penalties on it. Keep your mitts off your 401(k) and you’ll thank yourself when retirement arrives.
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