Managing Risk in 401k Plans

There is really only one goal to retirement investment, and it’s essentially the same as with other types of investing: maximize the return on your investment while minimizing risks. There are a myriad of ways to get there though, and just as many pitfalls and risks that will prevent you from recognizing your goal.

First, let’s consider the risks. A good investment advisor will be able to manage risk such that once you you start building significant assets, you won’t lose them due to market corrections or recessions. Of course risk is inherent in any type of investment, so it’s important to understand your risks you have, and how to control them. Here are a few examples:

Risk: Pension Funds. Putting all your eggs in one basket

For those people that own managed pension funds, the risk is that it will be underfunded or at worse, insolvent.  The same goes for corporate 401k funds that invest heavily in the company’s stock.  If you were an employee of Enron, you saw your entire retirement savings vanish. Years of retirement savings were wiped out in one catastrophic event caused by lack of diversification.

This is one of the first lessons for retirement planning, and arguably the most important:  Avoid the danger of relying too heavily on one investment. If you’re a career employee with an organization that provides a pension, don’t plan your retirement expecting that the pension will pay out in full. Unfortunately, it’s all too common for pension funds to be underfunded, raided or bankrupted. Common sense dictates that you diversify.  

Risk: Corporate 401k. Multiple fees erode gains

If you’re like many corporate employees, you’re enrolled in your company’s managed 401k fund. These funds are usually managed by a large entity such as Fidelity or Vanguard. You may have a dozen or more investment choices. Funds span the range of time-horizon, small/mid/large cap, International, and money market. The plan will also show you glowing 1/5/10 year performance summaries, made even more impressive since the 2009 market low.

The problem with many of these funds is that you get hit twice by fees. You or your employer pays a management fee, and the funds also have a built-in(load) fee for the individual funds. The load fees may only appear to be 1 or 1.5% per year, however that adds up to significant money over a 15-25 year retirement saving window.  Just how much?  In 2008, Bloomberg magazine held a poll of pension consultants and found that annual fees for 401(k)’s exceeded $89 billion. That’s roughly $300 annually per capita, or $1,200 for a family of four. If both spouses are saving the full $17500/year, that’s equivalent to a 3.5% fee! The delta for the return on investment between 5% & 8.5% looks like this:

If you start with $150,000, a 3.5% difference in return adds up to close to a quarter million dollars over 15 years!

The bottom line to the risk of corporate 401ks is that due to high built-in fees, you limit the upside; aka you don’t get maximum growth. You could lose out on a quarter to half a million dollars of assets by the time of your retirement.

Risk: Managed 401k/IRA. Fees and limited contributions

According to a 2012 report by the Bureau of Labor Statistics, average employee tenure is 4.6 years.1  Assuming most people are 30 yrs old by the time they begin contributing to retirement plans, they will either change jobs or find themselves unemployed at least six times during their career. The trend for younger workers is to change jobs even more frequently.

When you leave a company that offers a managed 401k plan, the investment company offers to keep your retirement savings. However you may find that the investment options change, or fees increase. Unless you really like the performance of the plan, it may be better to roll it over to a self managed plan, or to roll it into the plan offered by your new employer.

The other pitfall of changing jobs is that unless you are switching on January 1st, you likely won’t have contributed the full $17500 to your 401k, and the new employer may have a delay before you can enroll in their plan. You want to contribute the fully allowable amount if at all possible.

Risk: Self Managed 401k/IRA: Research Time & Market risks

The other option when switching jobs is to roll your existing 401k balance into a self-managed 401k, such as ones offered by most of the online brokers (Scottrade, E*trade, etc..). Most have no annual fees, and low trading charges. If you invest reasonably well, you can outperform the managed 401k funds just by avoiding their management fees.

We like this option a lot, but only consider it if you want to be actively involved in investing. You get the benefit of purchasing stocks and ETFs, but also the risks that go with them.  Market corrections impact all stock/bond investments, and can be especially harrowing when your retirement is on the line. It’s important to follow the rules of decreasing risk as you approach retirement.

 

In summary, all investments have risk, so we’re not recommending that you should pick any particular investment method. The key is to understand the risk so you minimize loss and maximize gain.