By Robert Powell, MarketWatch
When it comes to investing the money in your 401(k), or any similar employer-sponsored retirement plan, there’s plenty to consider, and much that could overwhelm you.
In this MarketWatch and Learn piece, we’re going to do our best to help you understand what you need to know, and only what you need to know — and do so without making your eyes glaze over.
401(k)s and 403(b)s are two common workplace plans. Putting money in these plans immediately cuts your tax bill because your contribution comes out of your paycheck before taxes. You don’t have to pay tax on your 401(k) savings until you withdraw the money in retirement.
1. Pick your investment carefully
Your investment choices will likely include money-market funds, bond and stock mutual funds, target-date funds and your employer’s stock. Choose the investments that meet your goals. (See below how to figure out those goals.)
How to manage your 401(k)
Here's what you need to know to manage your 401(k): Make sure you get the most out of any company matching contributions and choose your investments carefully. Follow these simple steps for the biggest reward.
If your plan seems complex, or you can’t spend a lot of time researching investments and your retirement goals right now, then just contribute the most you can, make it automatic and choose the appropriate target-date fund for when you plan to retire.
2. Does your employer offer a match? Free money!
If you don’t contribute to your plan, you’re turning down free money. Don’t miss out on that. Even if you think you can’t afford to contribute very much to your plan, at least put in the amount that will get you the most from your company’s matching contribution. What other investment guarantees you will double your money?
3. Withdrawals: Watch out.
You may be able to take out a loan to buy your first house, or in case of some economic hardship. Usually, loans have to be paid back within five years, with interest.
There are two real risks to borrowing from your retirement plan: First, you’re shortchanging your retirement by a lot; it’ll be difficult if not impossible to make that up. You’re better off having a little savings put aside for emergencies. Next, if you leave your job, you have to pay that loan back almost immediately. If you don’t, or can’t, there’ll be a tax bill, plus a 10% penalty for early withdrawal.
Let’s review the basic questions you need to answer to really make the most of this powerful retirement savings plan.
What’s your investment goal?
How much are you trying to accumulate in your nest egg? $1 million, $2.5 million, or something else? This “number” is, of course, how much you’ll need, when combined with other sources of retirement income such as Social Security, a pension if you’re lucky enough to have one, and earned income, your standard of living in retirement — your living expenses.
It’s best to calculate this number using an online tool such as one found on MarketWatch.
But if you don’t have the time or inclination to crunch the numbers consider using some rules of thumb.
Multiple of salary: Plan to have least 11 times your final salary set aside in all your accounts earmarked for retirement.
The income replacement ratio, or IRR: Plan on replacing at least 80% of your income in retirement from a variety of sources, including your assets, earned income, Social Security, and pensions. To be fair, many experts aren’t so fond of using the income replacement ratio any more. That’s because high-income investors might need to replace less than 50% their pre-retirement income while low-income investors might need to replace more than 80%. That 80% IRR is the benchmark many defined-contribution plans use for better or worse when attempting to tell you whether you’re on track for retirement or not.
What’s your time horizon?
When do you need the money and for how long? Most people saving retirement use their retirement date as their time horizon. That’s certainly the date when you might start withdrawing money you’re your retirement account. Think target-date funds here.
But consider some other time horizons and some statistics. One, what is your life expectancy and, if you have a spouse, his or her life expectancy? And two, what are the odds of you, or your spouse, living to certain ages?
Remember, there’s a 50% chance you’ll live past your life expectancy. Half of the world’s population will die before the average and half will die after the average. Which half will you be in? We don’t know either, but guessing wrong could throw a big wrench in your retirement plans.
So, a better way to plan your time horizon and how long you’ll need your money to last is to look at the odds of you, and your spouse, living to certain ages.
Consider, for instance, what Fidelity Investments had to say the odds of living past life expectancy: “An American man who’s reached age 65 in good health has a 50% chance of living 20 more years, to age 85, and a 25% chance of living to 92.
For a 65-year-old American woman, those odds rise to a 50% chance of living to age 88 and a one-in-four chance of living to 94. The odds that at least one member of a 65-year-old couple will live to 92 are 50%, and there’s a 25% chance at least one of them will reach age 97. And recent data suggest that longevity expectations may continue to increase.”
People are living longer because they are healthy, active and taking care of themselves:
|65-year-old man||65-year-old woman||65-year-old couple|
|50% chance of living to age:||85||88||92|
|25% chance of living to age:||92||94||97|
What’s your risk tolerance?
Many experts suggest that you get a sense of how much risk — how much volatility — you are willing to take with your investments earmarked for retirement.
Often, you’ll complete a questionnaire of one sort or another and, at the end of this exercise, you’ll learn whether you’re an aggressive, conservative, or moderate Investor.
Aggressive investors can seemingly tolerate more volatility (more ups and downs) in their portfolio and thus are told to invest a higher percentage in stocks than bonds. And for that they can expect to generate a higher return on their money than moderate or conservative investors. Remember the old investing phrase: The greater the risk, the greater the expected return. Well, it applies here.
By contrast, moderate investors are told just the opposite. They are seemingly can’t tolerate volatility in their portfolio and are told to invest a lower percentage in stocks than bonds. And for that they can expect to earn a lower return than aggressive or moderate investors.
Here are links to some risk tolerance questionnaires: Investment Risk Tolerance Quiz: Personal Finance ; Risk Tolerance Questionnaire - Morningstar ; and What is my risk tolerance? | Calculators by CalcXML .
Here are two things that you need to know about risk tolerance.
Tradeoffs are required. All else being equal, your time horizon and your investment goal, the more aggressive your risk profile, the less you might need to save. And vice versa. The more conservative your risk profile, the more you might have to save.
And this means that you might have to make some tradeoffs when it comes to investing your 401(k): You might have to lower your investment goal, or save more, or take on more risk, or extend your time horizon or so on if it looks like you’re not going to reach your original investment goal.
You see, saving and investing for retirement is not an exact science nor is it a set-it-and-forget it exercise. No one ever launches a spaceship to Mars without having to make adjustments along the way, and the same is true of your retirement portfolio. You are going to have to take an active role in managing your nest egg.
Behavioral economics 101: It helps knowing how your brain thinks about risk and reward. In the world of behavioral economics, losses hurt twice as much as gains. And that, in essence, means that your brain is wired to avoid risks. In other words, your brain is likely telling you to be more a more conservative investor than you ought to be.
And that brings us to this somewhat controversial but important idea. We think risk tolerance is a bit irrelevant when it comes to saving and investing for retirement. We think, when trying to figure out how much to save, and how to invest your 401(k), that you might not bother with the risk tolerance questionnaire.
Instead, focus on your goal, your time horizon, and your saving rate. Those three factors will dictate how to allocate your assets, how much to invest in stocks, bonds, and cash.