More Gold For Your Golden Years

The difference between a smart 401(k) and one that just muddles along may not be terribly obvious right now. But it could make the difference between enjoying your golden years in a villa by the sea or a one-bedroom condo in a retirement complex. A little smart tinkering with your 401(k) now will pay big dividends in the future.

And you're going to need that money. The viability of Social Security 30 years out is questionable, and employers are backing away from offering traditional defined-benefit pension plans. That means your 401(k), profit-sharing, or other defined-contribution programs must generate the bulk of your retirement capital. Some people may find they have to supplement their 401(k)s with tax-deferred investments such as variable annuities.

You don't have to be a rocket scientist to earn stellar returns on your retirement savings, but you do have to work your 401(k) harder and smarter. And the earlier you start, the more money you'll make. For people who begin in their 20s, less than 10% of the eventual value of their 401(k)s may come from their and their employer's contributions. The rest comes from the compounding effect of earnings on earnings. Plus, none of that profit is taxed until you start drawing it out when you retire.

THICK CUSHION. The smart 401(k) is built on a foundation of equity investments. Consider this: According to Ibbotson Associates, $1 invested in large-company stocks in 1945 is now worth about $32 after adjusting for inflation; for intermediate-term government bonds, the inflation-adjusted figure is less than $2. And smaller companies, with higher growth rates, sport an inflation-adjusted return that's triple that of large-company stocks. If you're socking most of your money in bonds or "stable value" funds, your 401(k) needs help.

Sure, the stock market is volatile, and stocks periodically take a dive. Remember, however, the smart 401(k) has a long-range view. And the 401(k) takes advantage of dollar-cost averaging: When the market drops, your regular dollar contributions buy more shares--which pays off when the stock prices bounce back.

You'll need a 401(k) that's large enough to produce income to cover your living expenses--at least 60% to 70% of your preretirement income--while leaving enough to remain invested in longer-term investments such as stocks. If you don't, you may not be able to keep up or get ahead of inflation during the 20 or more years most of us will live in retirement.

True, inflation is low now, around 3%, but over the past five decades, the average has been 4.4%. Even if it remains at 3% and you retire a millionaire in 30 years, that's only a little more than $400,000 in today's dollars. Combined with Social Security, that would provide an adequate but hardly upscale retirement lifestyle.

Look at what a 401(k) plan can do for employees who start young (table). Take the hypothetical case of a 27-year-old earning $40,000 a year who enrolls in his employer's 401(k). Suppose he contributes 5% of his income, or $2,000, to the plan, and assume his employers match that 25 cents on the dollar. Figure in 3% average annual growth in wages and contributions. What will it be worth?

It depends on how it's invested. Printed materials that accompany 401(k) plans often have five or six sample "asset allocations"--a blueprint for allocating the dollars between the available investments. Financial-planning software can enable investors to develop a more customized plan and make financial projections.

In the case of the 27-year-old, the software program Prosper by Ernst & Young recommends allocating 35% of the assets to large-company stocks--the investment option that offers an index fund that tracks Standard & Poor's 500-stock index, or an actively managed equity fund that buys such stocks. Then, 21% goes to small-company stocks, either an index or actively managed fund; and 44% goes to bond funds or "stable value" funds offered in most plans. According to Prosper, the 27-year-old would have $2.2 million by the time he retires in 2035--an 11.2% return on investment. If the plan offers the more volatile but higher-return international stocks, he can boost the expected rate of return to 13.2% and potentially amass a $3.6 million portfolio.

In building a smart 401(k), don't confuse owning one stock with owning a diversified portfolio of stocks. They are not the same thing. "I've seen people with $600,000 in their 401(k)--and it's all in their employer's stock," says Elaine Collins of Collins Financial Planning Service in Libertyville, Ill. "No matter how good the company is, that's a risky proposition."

UNKNOWN FEAR. How risky? Take IBM stock, which lost more than 70% of its value from 1987 to 1993. That would have been devastating to any retirement plan that was 100% invested in Big Blue, especially considering that the S&P 500 gained 30% during the same period. Even with IBM's comeback, the stock has made up only about half of its loss. Collins counsels clients with one-stock plans to take a more diversified approach, but many resist. Says Collins: "They don't think their stock is risky because they understand the company. They think the stock market is risky because they don't understand it."

Trying to change the idea of risk is not easy. How much risk people will take is deeply ingrained in their personalities, and most tend to be risk-averse. Asset-allocation programs and workbooks include do-it-yourself quizzes that try to determine your ability to take risk. Most questions ask about age, income, net worth, and dependents--trying to pinpoint how much financial risk you should take on.

But a few try to get inside your head. LifePoints, an educational package for 401(k) investors developed by Frank Russell Co., invites responses to such statements as: "An occasional trip to Las Vegas or Atlantic City could be profitable as well as fun" and "For the right opportunity, I'd quit my job and start my own business." Five responses are offered, ranging from "strongly agree" to "strongly disagree." A person who agrees strongly gets five points on the self-scoring quiz.

As in most such exercises, respondents with high scores are directed toward the most risky--and potentially rewarding--asset-allocation plans. But think about whether you should take canned advice without asking questions the test didn't pose. For instance, if you're in a profession with high job turnover and episodic unemployment, you may want to lighten up on risk.

While questionnaires vary in quality and differ slightly in asset-allocation advice, they point investors in the right direction. "No asset-allocation model is so great that you can say 72% in equities is better than 70% or 75%," says David Huntley of Baltimore-based HR Investment Consultants, which specializes in 401(k) plans. "The point is, you lead people toward that decision."

Indeed, the 401(k) educational materials reinforce the notion that taking calculated risks can make you a whole lot richer. Consider the example of a 45-year-old whose 401(k) is split evenly between large-company stocks and bonds (table). It's a "moderate-risk" strategy with a projected return of 9.7%, according to Prosper. Go up the risk ladder one rung, mix in small-company and international stocks--and the expected rate of return rises to 12%.

Why stop there? Why not invest all the money in small-company or international stocks that might earn even higher returns? The asset-allocation model doesn't recommend the mix of assets with the absolute highest return but rather the most "efficient" portfolio--that is, the mix of investments that delivers the highest return for the risk.

If fine-tuning your 401(k) means reallocating a large sum, don't move it all at once. In our example, a 55-year-old investor has a $200,000 portfolio, 75% of it in bonds. The new plan calls for shifting about $50,000 from bonds to small-company and international stocks. But move it in small pieces, perhaps $5,000 a month. That avoids the risk of putting all his money into an investment the day before it turns south.

And remember, once a plan is in place, it should be monitored. If, for example, one piece of the 401(k) is supposed to be 20% but because of sharp increases in the market value runs up to 30%, you should rebalance the 401(k) to reflect your long-term goals.

If you're a smart 401(k) investor, you stash as much as you can into the plan. Not only do you build the nest egg but the tax code helps, too. Most employers also pitch in by matching part of your contribution. The employee's maximum contribution is now $9,240 a year.

But even if you're financially able to put aside that much money, your particular company plan may bar you from doing so. That's because Internal Revenue Service regulations can limit the amount of money that higher-income employees can contribute if there isn't enough 401(k) participation by lower-paid workers. If that's the case, you'll have to look at several alternatives. Like the 401(k), all defer taxes until the money is withdrawn. Unlike the regular 401(k), however, there's no tax deduction for contributions and no company match.

SEPARATE POTS. The aftertax 401(k)--many large-company plans offer this feature--can be a wise choice for additional retirement savings. There are limits to the amounts of money you can put in, which vary with the plan. But if you like the investment choices of the plan, it makes a lot of sense to stash your additional retirement savings dollars there.

Suppose you contribute the maximum to your aftertax 401(k), and you still want to do more. You can put as much as $2,000 a year in a nondeductible Individual Retirement Account, and there's no limit to the number of brokerage firms and mutual-fund companies that offer them. With this sort of investment, you--not your employer--decide who's going to manage your money. It's also a way to include investments that your 401(k) may lack, such as small-company or international funds.

The downside is extra paperwork. If you have a tax-deductible IRA too, you have to keep meticulous records of which investments were made with deductible and nondeductible dollars. Otherwise, you risk eventually getting hit for tax on your aftertax contributions. One hint: Use separate financial institutions for the deductible and nondeductible IRAs.

If you still need to accumulate additional savings for your retirement, consider the variable annuity. This investment, usually the joint product of an insurance and a mutual-fund company, works in much the same way as a fund--but you don't pay taxes on the dividends or on the capital gains until you start withdrawing the money. And you may stash away as large an amount as you like. The fees are higher than for comparable mutual funds, and the surrender charges can be stiff on early withdrawals. Competition is increasing in this market, so shop around for the best terms.

Building a solid investment plan and monitoring it may appear to be a daunting task. But the reward you get for the effort you invest will be enormous.

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