Proactive Investor

Diversification Within Your 401(k)

Russ Allen

Many participate in employer-sponsored, defined-contribution pension plans.  It is important to make the most of any money invested in those plans.

Defined-contribution plans, like 401(k)s, 403(b)s and similar plans, have largely replaced the defined-benefit plans that were common between World War I and the 1970’s. With those plans, the company promised a certain (defined) benefit amount per year to retirees who worked for the company for enough years to qualify. How it got the money to pay those pensions was the company’s problem.

And it was a problem because in the late 1960s and early 1970s, some big employers failed to fund their pension plans adequately. They were also able to “manage” their reported earnings by contributing a greater or lesser amount to their pension funds in a given year. This and other issues led to the Employee Retirement Income Security Act of 1974 (ERISA). Among other things, ERISA put tough new funding standards in place to ensure that employers adequately funded their defined-benefit plans.

As many ambitious regulatory projects do, this one brought about unintended results. Employers responded by phasing out those defined-benefit plans over the years and replacing them with defined-contribution plans with less onerous requirements.

Planning for retirement

With a defined-contribution plan, the company makes no promises of any particular pension payment amount. Instead it contributes a certain (defined) amount to your pension fund each year, usually in the form of an employer match to amounts that you contribute yourself, up to a limit. You then decide which of several investment choices you want to use for your own pension fund. Your eventual pension amount will depend on how much money is in your fund in the future, including your contributions (if any), your employers’ contributions (if any), and the gains (or losses) resulting from your investment choices. Whether the pension payments are enough to support you, or whether in fact there is any money at all in your pension fund when you retire, is your problem.

This means that as employees, we now bear the full risk of having enough retirement income.

This is both a blessing and a curse. The blessing part is that we do have some choices as to how our pension money is invested. The curse part is that we are forced to make those choices, whether we feel qualified to do so or not. And if we make the wrong ones we could end up broke.

One of the decisions we must make is the choice of what investment vehicles to select from among the choices offered by our particular plan. Usually we are offered a few mutual funds from a single mutual fund family. These will often include funds in the following categories:

  • Free Trading WorkshopStock funds – actively managed
  • Stock funds – passively managed, like index funds
  • Bond funds
  • Blended funds including both stocks and bonds, including target-date funds
  • Money market funds
  • Occasionally, precious metals funds

It is important to realize that any mutual fund can either lose money or make money in any given year. None have guaranteed returns. Stocks have good and bad years, and so do bonds and precious metals.Tweet: Stocks have good and bad years, as do bonds and precious metals. Virtually all stock funds will lose money in a down market year, whatever specific stocks they include. Most bond funds will lose money in a year when interest rates rise sharply. Gold fluctuates from year to year.

So, it is important that some of your eggs are placed in different baskets, so to speak, in terms of asset classes. It’s rare that stocks, bonds and gold are all down in any one year, so it’s a good idea to have some money in each one. How much of each to have is a choice that is individual to each person. Those with a very short time horizon, because of approaching retirement, will need to have a heavier mix of short-term bond funds for safety and some cash flow. Those with decades to go can afford to be more aggressive, allocating larger percentages to stocks and possibly precious metals.

There’s a lot more involved to dynamically managing your 401(k), as taught in our Proactive Investor class. For more details, contact your local center.

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.