How to Invest Your 401(k) Money

Image of 401K - Green Office Folder on Background of Working Table with Stationery and Laptop.Are you confident you know how to invest your 401(k) money?

A lot of people I talk to and meet are not. Most companies provide scant little help to guide their participants.

Financial advisors often don't offer much help, especially if they can't get paid for the advice.

Printed material leaves a lot to be desired. Many of the funds are similar in their descriptions. If you are a younger investor with no experience, it can be even more difficult.

Not to mention the fact that many funds offered inside these plans have higher fees than funds available outside the program.

And how do you know how much to save to get you to your desired retirement age? Do you have one?

I'll discuss these topics, offer some advice, and a great tool that can help you.

First things first

Too many people save far too little in their retirement plans. Don't be one of them. Click to Tweet

Before deciding on how to invest your funds, choose how much to contribute.

The maximum amount you can contribute in 2018 is $18,500. If you're over age 50, you can add another $6,000 in what the IRS calls a catch-up provision. That brings the total to $24,000. If you can max out the contributions, you'll be way ahead.

Most people aren't in a position to contribute the maximum. That's OK.

It's likely that your employer offers a matching contribution. In other words, if you contribute, they will add an equal dollar amount up to a certain percentage. A typical match might be 100% up to 3%, or 50% to 6%.

Whatever the number, make that your very minimum contribution. Why? You're leaving free money on the table if you don't.

Let's say you make $50,000 a year. Your company has a 50% match up to 6%. You decide to contribute 3% ($1,500). The company would add $750 to your contribution (50%).

Here's that math.

With your contribution and the match, you're putting in $2,250.00 annually. Let's assume that earns 7% annually. At the end of thirty years, you've accumulated $212,537.00. Not bad, right.

Look what you left on the table.

Contributing the 6% and getting the maximum employer match means instead of $2,250.00, you're putting in $4,500.00 ($3,00.00 + $1.500.00 match). At a 7% return, you will have $4125,074.00 in thirty years.

In other words, you'll have double the amount of a 3% contribution!

Always, always, always start with the amount that meets the employer matching percentage. Too many people leave free money on the table.

Increasing contributions

Maybe you're not in a position to do what I just described. No matter what your age or circumstances, contribute something. If the company match is 100% up to a limit, your 1% becomes 2%. Your 2% becomes 3% and so on.

You can't leave that money on the table. You've got to find a way to contribute.

Many plans have automatic enrollment. I'm a fan of this feature. It's likely with auto-enroll, you won't even miss the money. Click to Tweet

Every year you have the opportunity to make changes to your contribution amounts. Increase that amount by 1% per year every year. It's a minimal change that can have a tremendous impact over time.

And you won't miss the money.

Be vigilant about contributing to these plans. With few exceptions, we're all responsible for funding our retirements. Take advantage of the benefits offered by your company.

Save as much as you can. Maximize contributions if possible. I know that's not an option for most people.

So, as a minimum, contribute up to the amount the company matches.

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Investment options

In most cases, information about the fund options is available via a website. You will find written material about general investment principles, risk, types of funds, etc. In most cases, fact sheets are available for the various funds. Fact sheets are a summary of each fund.

Fact sheets include things like the investment strategy, the types of securities they buy, returns, and expenses. These summaries are a great way to learn about the funds.

In most cases, you can complete some a short questionnaire to help determine your “risk tolerance.” Risk tolerance means how much loss you can take without panicking and selling your investments.

I call it passing the stomach test. If you look at a drop in dollar value and it makes your stomach queasy, you're taking too much risk.

That exercise helps determine your asset allocation (how much money you put into stocks and bonds). There are a lot of ways to break this down. For this discussion, I'm going to keep it simple.

Asset classes

Asset class descriptions can get a bit confusing. Start with broad asset classes (stocks, bonds, real estate, commodities, cash, etc.). These broad asset classes appear in both U.S. and Foreign markets.

The stock category (U.S. and Foreign), is further broken into sub-asset classes based on the size of the companies. They are large, mid-sized, and small. You'll see them described as large-cap, mid-cap, etc. Cap stands for capitalization. It represents the company's stock market value; the number of publically traded shares times the market price of each share.

From there, you can go another layer down and look at growth and value.

The same thing goes for bonds. There are short, intermediate, and long-term bonds. You may also see high yield or junk bonds. Another option might be something called floating rate bonds. I'd ignore most of these. Stick with short and intermediate term bonds to keep it simple and less risky.

You can get pretty granular with this if you want. My advice for your 401(k), don't. Keep it simple.

I sometimes think the goal of some of these funds is to keep investors as confused as possible.

Choosing funds

Index funds

U.S. Stocks

Look for funds in the line up that represent broad asset classes. The funds that do this the best are called index funds. Index funds invest in every stock in their given selection criteria. The most recognizable index fund is the S & P 500.

The S & P 500 is made up of the 500 largest publically traded U.S. companies. The weight, or amount of dollars each company represents in the index, is based on how big the company is (its market cap). So the larger companies have a more significant impact on stock performance than the smaller companies.

Because it only includes the 500 largest companies, it doesn't represent enough companies for a broad market. The S & P 500 is a large-cap index.

A broader index would be something like the Russell 3000. The Russell 3000 index represents the 3000 largest companies in the U. S. market. Investing in this index offers exposure to all three sizes (large, mid, and small) and both growth and value stocks. It's far more representative of the U. S. stock market.

How do you know? Look at the fact sheets I mentioned earlier. When it tells you what they invest in, the description will say something like “the objectives of the fund are replicate the returns of the Russell 3000 (minus fees and expenses) by investing in all of the stocks in that index.” It will be much more lawyerly than that, but you get the picture.

Foreign stocks

You'll find the same choices in foreign stocks. Look for funds that replicate the FTSE developed markets index, the EAFE, or a World, Ex-U.S. index (meaning no U. S. stocks).

Be cautious with the World Ex-US. Depending on the fund, it can include as much as 20% in emerging markets stocks. These stocks offer higher expected returns and greater potential losses. That's OK if you understand it. Most people don't.

With bonds, look for a fund like U.S. aggregate bond market. How much you put in each fund depends on the results of the risk test you took earlier.

Though unlikely in 401(k) plans, you could build your portfolio with three or four funds.

Target-date funds

If you don't want to choose your funds, consider the target-date funds.

Target-date or lifestyle funds offer the chance to invest in one fund that includes a broadly diversified portfolio of stocks and bonds, U.S. and Foreign, large, mid, and small sizes. They also choose the fixed income (bonds) and percentages in each.

Managers choose the investment mix based on the year you plan to retire. Different funds choose that year differently. It may be age 65, or another age. For this discussion, we'll assume the retirement age is 65.

If you're age 35 now, in this example, you have thirty years until retirement. The target date fund name for you would be something like Target Fund 2048 or Lifestyle 2048. The year, of course, is the year in which you said you wanted to retire.

In general, the longer you have to retire, the more money in stocks the fund will have. The shorter the period, the less in stocks. The general idea is that you can take more risk in stocks (which offer higher expected returns) in longer investment time horizons. And thirty years is a long time horizon.

Understand the glide path

There may still be a significant risk in target-date funds. People nearing retirement found that out the hard way. Click to Tweet

The selling point of target-date funds is the idea that as you approach retirement, the manager reduces the amount of money in stocks. The technical term for that is the glide path. The glide path is the method the fund manager uses to reduce your risk.

In the last financial crisis, many investors assumed that the glide path would reduce the amount in stocks to minimal levels when they approached their retirement year. That glid path is the fund TO retirement path; meaning that stocks get reduced to minimum percentages laid out in the fund prospectus) at that date.

The other option is a fund THROUGH retirement. In that path, the idea is that you will hold the fund through your retirement, which could be estimated by the fund as up to twenty or thirty years. In that glide path, the fund would hold a much higher percentage in stocks to keep you invested through retirement (another twenty or thirty years).

For many target date shareholders in the financial crisis, their funds were fund through retirement. Instead of holding thirty or forty percent in stocks, many of the funds held sixty or seventy percent in stocks. The losses on those portfolios forced many to work several years past their retirement date to make them up.

These are great options and most every retirement plan offers them. My caution is to be sure you understand the glide path, how they reduce the risk, as you approach retirement.

If all of this makes your head spin, let me offer a great option to consider.

Have someone do it for you

Blooom, Inc. is a company who will take on the management of your employer retirement plan for you. Whether its a 401(k), 401(a), 403(b), 457 or  TSP, Blooom can handle the task.

Two of the founders of Blooom were guys who spent most of their careers chasing wealthy investors with large portfolios. They became frustrated with that business model (I can relate) and its inability to help average investors who needed it. That prompted them to enlist one of their buddies, a technology wizard, to help them come up with a technology to help the little guy manage their retirement portfolios online.

That's how Blooom started. Here is the how it works.

You can hire the team at Blooom to analyze your retirement plan portfolio for you. Bloom looks at the funds you own, relative to the choices available. They examine returns, investment style, expenses, hidden fees, allocations, and a myriad of other factors to prepare the analysis.

You'll get a report showing your current investments and offering better options, if available. In most cases, investors have portfolios that are not diversified with high expenses. Blooom builds an alternative portfolio and compares that to what you currently own.

The cost? $10.00 a month for any sized portfolio. That's it.

In addition to implementing the portfolio, they provide ongoing monitoring and rebalancing. Rebalancing helps reduce risk by keeping the investments in line with the agreed upon risk tolerance and allocation. When markets go up or down rapidly or over time, it usually means you will have more money than you're supposed to in a given asset class (like stocks).

Rebalancing sells shares in those funds and investments them in other funds that dropped below their agreed upon amounts.

It's the best option I've seen to manage your retirement portfolios.

Final thoughts

Investing your retirement plan contributions can be a confusing and challenging task.

I've offered a process here to help you make some decisions. That process is only as good as the information provided by the plan.

Many plans offer limited information and tools to help. That leaves you to figure things out on your own.

Blooom, Inc. is a reasonably inexpensive way to hire someone to do it for you. They work within your plan options and choices to provide a better portfolio to match your needs. They can help keep costs low and offer ongoing monitoring to keep things in check.

In the interest of full disclosure, I'm a Blooom, Inc. affiliate. That means I get paid a small commission when someone opens an account via links on this blog.

Affiliates I represent are companies I either use or have checked out thoroughly. My reputation is not worth compromising to make a buck. I believe in Blooom and the work they do.

Most advisors won't help you invest your 401(k) funds. They don't get paid for it. It's something that's always bothered me as an advisor.

That's what motivated the founders to start the company. If you enjoy choosing your investments, managing and monitoring them, by all means, continue doing that.

For those who are not inclined to do that for whatever reason, consider hiring Blooom, Inc. to do it for you.

Now it's your turn. Are you comfortable choosing your retirement plan funds? Do you feel you have the right funds and the proper allocation for your needs? Are you confident you have the lowest cost options? Let me know what you think in the comments below. 

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