If your employer
offers a 401(k) savings plan, consider yourself fortunate. Participating in
a 401(k) allows you to lower your current tax bill while building
tax-deferred savings for retirement. This powerful combination makes a
401(k) one of the best opportunities available under the current tax laws,
especially if your company matches the contributions you make.
But managing the assets in your 401(k) account can be tricky, because
every plan is different. Some allow you to invest in just a handful of
mutual funds — perhaps as few as three — while others make dozens of
funds available. One plan may offer funds from a single mutual fund family,
while another lets you choose among several. A few plans don't offer mutual
funds at all, but instead offer a selection of unregistered investment
funds.¹ Some plans include company stock; others do not.
Whatever combination of investment alternatives your company's 401(k)
plan offers, it probably doesn't give you the same range of investment
choices that you enjoy outside the plan, as in a regular brokerage account
or an IRA. If your investment flexibility within the plan is limited, you
may not have the luxury of choosing among several growth funds or an array
of income funds, for example. Indeed, you may like a fund that is simply not
available within your 401(k) plan. How do you invest when your choices are
limited?
Asset allocation is the key
Research has shown that more than 90 percent of investment performance is
attributable to asset allocation — rather than investment selection or
market timing.² In other words, the percentage of your portfolio that you
allocate to different asset categories — like stocks, bonds and cash —
is ultimately more important than choosing one equity mutual fund over
another or one bond fund from many, or even choosing the right time to buy
or sell.
A landmark study conducted in 1986 (by Gary P. Brinson, L. Randolph Hood
and Gilbert L. Beebower) found that 93.6 percent of the total variation in
portfolio results was attributable to asset allocation. A follow-up study in
1991 (by Brinson, Beebower and Brian D. Singer) confirmed this result,
indicating that asset allocation explained 91.5 percent of variation in
returns. These results underscore the importance of a well-thought-out asset
allocation strategy, whether you are investing within your 401(k) plan or
outside of it.
Focusing squarely on asset allocation, then, can help make up for a lack
of investment choices within your 401(k) plan. No matter how limited the
number of investment choices may seem, federal law mandates that you are
given investment options to enable you to diversify your 401(k) assets
across different categories. Section 404(c) of the Employee Retirement
Income Security Act of 1974 (ERISA) requires that your employer's 401(k)
offer a minimum of three investment choices (most plans offer more), each of
which is diversified, and that collectively enable you to allocate your
portfolio to achieve a broad spectrum of risk and return characteristics.
With at least this minimum number of investment choices built in, your
primary task is to decide how you will allocate your assets among them.
Allocating your assets
The exact allocation you choose will depend on your own personal objectives,
time horizons and attitudes toward risk. Individuals with long time horizons
and high risk tolerance may opt for an aggressive asset allocation plan that
emphasizes stocks or stock mutual funds. Investors with a shorter investment
time frame and/or who are more averse to risk might choose a more
conservative plan that includes a higher percentage of bonds and money
market funds.
The charts below exemplify possible asset allocation plans, ranging from
conservative to aggressive.
If you have not developed an asset allocation plan for your retirement
assets, or you need to update a previous allocation, it's best to sit down
with a professional financial advisor who can help you pinpoint your
objectives, time horizons and tolerance for risk. There are also asset
allocation tools available on many Web sites, including Charles Schwab.
To find out what investment choices are available within your 401(k)
plan, contact your employer's benefits department.
