07242017

Is This the Biggest Weakness of 401(k) Plans?

Photo credit: J Dennis/Shutterstock

Knowledge is power, and understanding how their money works will help your employees make better 401(k) plan decisions.

A new client stopped by recently and asked if I could review his company 401(k) plan for him. I could see that his portfolio was badly underperforming, and before long, I could see exactly why: The investments he chose for his plans were far too conservative for his age, time frame, risk tolerance and goals.

“I wasn’t really sure what I was doing when I set this up,” he explained. “The guy from the company providing the plan stopped by and talked about investing for about 20 minutes, and most of us didn’t know what he was talking about. So I just picked a couple of funds and submitted it to HR.”

That’s actually an explanation I hear regularly from people who are not familiar with investing but have to do something with their company retirement plans. A quick overview of investing doesn’t do much good when there are people in the audience who aren’t even sure what a mutual fund is. 

These people are not alone in their confusion. A recent retirement readiness survey by Schwab Retirement Plan Services showed that nearly 47 percent of those surveyed said the information they receive on the menu of 401(k) investment options is even more confusing than the materials that explain their health benefits. Of those surveyed, 67 percent said they would like some help and guidance in choosing their plan investments, and 49 percent believe their investment performance would improve with that help.

What can an employer do about this? Certainly they can work with a plan provider who is committed to regular communication with your employees and who provides a clear, understandable basic education on how to maximize the potential growth of your employees’ plans. If these lines of communication are not easy for employees to access, or if the employees are not confident that they have learned enough to make educated choices within their plans, the plan provider must be held accountable.

Here’s a simple 401(k) investing lesson an employer can provide its employees. First, when we invest, we usually invest in stocks and bonds.

A bond is a loan.

When you invest in a Treasury bond, you’re loaning money to the federal government. Municipal bonds loan money to cities, and corporate bonds to corporations. In a portfolio, bonds are non-correlated, meaning they don’t usually go up and down with the stock market. The good news, then, is when the stock markets drops big, your portfolio may not drop as much. However, it also means that it won’t go up as quickly as the market either. The fewer bonds you have in your portfolio, the riskier it is, but it also means your potential for growth is higher.

A stock is a piece of a corporation.

Take Google, Ford, IBM and Microsoft, for example. In general, the better the company does, the more the price of its stock will usually go up, as does your portfolio. When the value of the stock drops, so does the value of your portfolio. Remember, just as there are huge companies in which you can buy stock, there are smaller companies you’ve never heard of that you can buy stock in as well. And there are stocks available from companies all over the world.

So what is a mutual fund?

A mutual fund is an individual company that employs a team of analysts to look at stocks and bonds and help the fund manager decide which stocks and bonds to buy and sell. The fund doesn’t invest in just anything, though. It has its own internal set of investing guidelines that tells it what it can invest in. It may be a growth fund, one that invests in companies that are growing quickly, or it may be an international fund, one that invests in other countries, or a technology fund, one that invests only in technology-oriented companies – and virtually every combination therein.

It’s usually important to diversify, meaning investing in multiple funds so that you get a wider range of companies in your portfolio. So, a typical retirement plan portfolio might include four to six different funds, and virtually all 401(k) plans offer a menu of funds from which to choose.

Remember, in general, a higher percentage of stock funds in your portfolio means more risk of short-term loss, but more chance of potential long-term gains. What is your risk tolerance? Will a short-term market drop cause you to lose sleep, or are you more likely to just stay the course during the tough times with an eye on long-term gains?

What is a target date fund?

Some investors want to keep it simple, and these funds are a great way to do just that. One important rule of investing is that, the closer you get to retirement, the less risky you want your portfolio to be. So, in a target date fund, the mutual fund company slowly adds bond mutual funds to lower your risk.

Target date funds usually have a date in their name. This is the date you’ll use to estimate your retirement date. For example, if you are planning on retiring in 2040, you might just invest in one fund, the Target 2040 Fund. Since that’s still years away, the fund will be investing mostly in stocks. But each year, the fund will automatically add bonds without you having to do anything. This is a good “set it and forget it” approach for those who don’t want to worry about picking funds.

These are your retirement dollars we’re talking about here, and having a basic understanding of what your money is doing is a very good and responsible idea. You certainly don’t need to be an investing expert, but understanding what a mutual fund is, and the concepts of risk and diversification, will benefit you in the long run.

To that end, expecting regular and open communication with the company providing your retirement plan is an important piece of the puzzle.

Disclosure: The content of this article is not, nor should it be construed as, tax, personal financial planning or financial advice. Please consult a qualified professional about your personal situation before taking any action. The content of this article is not intended to provide tax, legal, accounting, financial or other professional advice, and readers are advised to seek out qualified professionals who can provide specific and personal advice on these issues. Neither Alpha Financial, Alpha Management Inc., nor Ryan P. Urban are responsible for decisions made or actions taken based on this content.

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