Eighty percent of success is showing up
—Woody Allen
A journey of a thousand miles begins with a single step. And so it is with your retirement planning. 401(k) plans are a fabulous way to save and invest for your future, but far too many investors delay that all-important first step—setting up and contributing annually to a 401(k) plan. The impact that tax-deferred 401(k) contributions can have on your net worth is nothing short of amazing. By maximizing the amount of your tax-free or tax-deferred investments you also maximize the final value of your portfolio.
The Tax Man Cometh
The bite that taxes take out of the terminal value of your portfolio can be enormous. Yet, much like with the effects of inflation, few of us consider what a huge negative impact taxes have on our wealth. In chapter 2 we saw that one dollar invested in 1927 grew to $187 at the end of 2004, a real return of 6.98 percent. But a major part of that growth is due to the effects of compounding, allowing you to earn money on prior gains. When Uncle Sam extracts his pound of flesh, you have less capital available for reinvestment. The effects of a 28 percent capital gains tax are staggering. At that 6.98 percent growth rate, one dollar invested in the S&P 500 grew to $187 by the end of 2004. If you had been forced to pay an average annual capital gains tax of 28 percent, that same dollar would be worth a mere $34.89 at the end of 2004! (This assumes that you harvest losses to offset income during times when the market is providing losses.) Taxes would have wiped out the vast majority of your gain. What’s more, the actual capital gain tax rate over those years was variable, but generally much higher than the 28 percent assumed in this example. Keep in mind that you’re also taxed on nominal gains, meaning that during inflationary times the bite of the tax man is unusually large.
Clearly, it’s vital to maximize your tax-free investments. This means that if you have a 401(k) plan, you should make the largest contribution to it possible, or set up an IRA or Keogh account. Yet investors are hardly rushing into these tax-advantaged accounts: According to BusinessWeek’s June 6, 2005, issue, “only about half of American workers participate in 401(k) and other employer-based retirement savings plans.” Worse, the magazine adds that “fewer than 10% of eligible workers contribute the allowable maximum to 401(k) plans; more than half fail to diversify, especially beyond their employers’ stock; few rebalance portfolios in response to age or market returns; and almost half withdraw from 401(k) plans when they change jobs.”
Getting Started
Let’s look at how you can invest in your 401(k) plan. More than 95 percent of U.S. companies with over five thousand employees currently offer a 401(k) plan to their employees, and smaller companies are adding them in droves. The catchy name, 401(k), comes from the section of the Internal Revenue Code that defines the plans. Offering special tax advantages, 401(k)s were established by the federal government in 1981 to encourage people to prepare for retirement. Essentially, 401(k)s are defined contribution plans.
IRS regulations define what you can contribute to your 401(k), but say nothing about how much it will be worth when you retire. That sum is up to you, and will be determined by the investment choices you make. With 401(k) plans, you make a defined contribution from your salary. The government regulates the amount that you can contribute—in 2006, the maximum contribution amount will be $15,000 as provided by the Economic Growth and Tax Relief Reconciliation Act of 2001. After 2006, these contribution limits will be increased in $500 increments to factor in the effects of inflation. It’s important to remember your company’s plan may have additional limits.
401(k) Retirement Plans Have Many Benefits
What makes 401(k) plans great is that your contributions are in pretax dollars. If you make $100,000 a year and contribute 10 percent to your 401 (k) plan, that $10,000 contribution is treated as deferred compensation, and not subject to taxes other than Social Security. As a result, when tax time comes, you’ll only be taxed on an income of $90,000, your salary less your 401(k) contribution. Every dollar you put into your 401(k) is deducted from your income taxes for that year. If you’re in the 28 percent tax bracket, it’s like earning 28 percent on every dollar you put in your 401(k). That’s a huge initial return on investment!
Another 401(k) benefit is that all the money you put in your 401(k) plan compounds on a tax-deferred basis. Never forget that taxes and inflation are the enemies of investment success. Granted, you’ll have to pay taxes on your 401(k) savings when you start taking it out of your account—presumably when you retire. In some instances, if your planning is poor or you’ve done too well with your investments, the tax hit could be considerable. But that’s a nice problem to have. Clearly, the power of compounding your money without the tax man taking his cut is overwhelming. I highly recommend IRA contributions for the same reason—even though they’re not always tax deductible, they too compound on a tax-deferred basis, which enhances your returns considerably.
There’s yet another reason to take advantage of your 401(k) plan. In many cases, your employer will match a portion of your 401(k) contribution, typically fifty cents for every dollar you contribute. To use our example above, your $10,000 contribution would be matched by a $5,000 contribution from your employer. That’s like getting an instant 50 percent return on your investment! If you work for a company that matches a portion of your 401(k) contribution, you’d be foolish to pass it up.
Finally, 401(k) plans are today’s retirement plan of choice because they’re portable and follow you from job to job. All your contributions are yours alone, and, after your contributions become vested—typically after a certain number of years with your company—all of the money your employer contributed is yours as well. All together, 401(k) plans are a great way to maximize your after-tax wealth.
The Basics
Now let’s learn about your 401(k) and look at the best ways to invest the money you put in it. The government allows your employer to restrict who gets to participate in their 401(k) plan, but the restrictions are usually not onerous. The most important eligibility standards are simple: your employer can prohibit you from joining until you’ve been with the company for a year or until you are twenty-one. Your employer may not offer a 401(k) plan to all employees. If you work for a big company, for example, only certain employees or certain divisions may be eligible. While there are fewer restrictions today than in the past, they can still be a problem. If you don’t have a 401(k) plan available to you or your company offers another type of pension plan, it’s important to learn as much as you can about what your company is offering.
Your Company’s 401(k) Plan
The first thing to do is get the specifics on your company’s plan. Don’t be surprised if your personnel manager or human resources manager gives you a blank stare when you ask about it, as it’s not unusual for 401(k)s to be delegated to a plan administrator. Depending on the size of your company, the plan administrator is either someone within the human resources department or a person from an outside firm that specializes in plan administration.
Who Does What?
The plan sponsor is your employer, or the company offering the plan. They define the structure of the plan, what investments are available, how you can invest your money, and finally, whether they are going to match a portion of the money you contribute. The trustee of the 401(k) plan is either an individual or committee that has overall responsibility for the plan. They report to the plan sponsor. The plan administrator is the person or outside company that provides you all the information you’ll need to get your 401(k) started. The investment managers are usually outside firms that offer mutual funds or money management services. They are the ones who actually buy and sell securities, bonds, or Treasury bills on your behalf. Finally, the record keeper is just that. It is usually an outside firm that keeps track of all the paperwork, contributions, investments, and other information having to do with the plan and its participants.
When you inquire about your firm’s 401(k), you’ll usually receive a summary plan description that tells you what your company’s plan provides and how it operates. It will outline your investment choices, from investing in outside mutual funds to purchasing company stock. It explains such things as when you can start participating, how to contact the plan administrator, and how to make contributions. Hardly thrilling reading—but the summary plan description will give you the nuts and bolts description of your company’s 401(k) plan. The summary annual report summarizes the financial reports that the plan files with the Department of Labor.
The individual benefit statement is more interesting. That’s the document that describes how much money you’ve accrued and what percentages of your benefits are vested. It’s essentially a summary detailing how much money you have in your retirement account. The material modifications document is a summary of any changes in your company’s plan. If they change the plan by adding or dropping a mutual fund or making a new asset class available to you, you will learn about it in this report.
Where to Invest Your 401(k)
Okay, let’s say you’re contributing the most that you can to your 401(k), and you’re taking full advantage of every matching benefit that your employer offers—now what do you do? While we will cover overall portfolio allocations fully in the next chapter, we’ll also look at some specific examples here. For all the examples I’ll outline shortly, I will assume that you are forty-five years old and already have $81,000 in your 401(k). (I use these figures because the global consulting firm Hewitt Associates found this was the average-sized 401(k) account for people in their forties. Hewitt arrived at this average after studying roughly 2.5 million workers eligible to participate in the retirement plans offered by large companies.) In my calculations I will also assume that you can contribute $10,000 of your pretax income to your plan. When feasible I always advise maximizing your 401(k) contributions, but here I will take the middle road and assume the more modest $10,000 contribution.
T-bills and Bonds Offer Little
An investment in T-bills and bonds will earn very modest returns over the long term. I recommend them only to reduce your overall portfolio’s volatility or when you need a reliable income after you’ve retired. As we saw in chapter 6, T-bills or money market funds are likely to do little more than keep pace with inflation, limiting your portfolio’s terminal value to roughly the same amount—in real dollars—to what you’ve contributed to your 401(k) plan over the years. Clearly, this is not the way to maximize your total returns.
Let’s look at the sad reality of investing your 401(k) in bonds or T-bills. Using the current yield on the twenty-year Treasury Inflation Protected bond of 1.79 percent as a proxy, a forty-five-year-old making annual contributions of $10,000 and earning the real return of 1.79 percent per year would have just $353,459 in his or her 401(k) at age sixty-five. That sum doesn’t even get you close to a comfortable retirement, particularly if you’re hoping to live off the proceeds from your portfolio. Investing your entire 401(k) in bonds would force you to either continue working past the age of sixty-five or begin consuming your portfolio’s principal to support yourself.
T-bill returns are even worse. If you managed to earn the average real return from T-bills seen over all rolling twenty-year periods of 0.13 percent, your portfolio would be worth just $285,622 when you hit age sixty-five. Ouch!
Equity Allocations
Clearly, your prospects are quite bleak if you try to build your retirement nest egg with fixed income. As we saw in chapter 6, over the next several decades we’re moving from a period of risk-free returns to one of return-free risks in the fixed income markets.
To take advantage of the trends I expect to unfold over the next twenty years, you’ll want to find index funds, ETFs, or mutual funds available in your 401(k) plan that invest in small stocks, value stocks, and growth stocks where the fund employs a “growth at a reasonable price” philosophy.
Many 401(k) plans have added index funds and exchange traded funds to their menus. If your plan has, they should be the first place to look when allocating your portfolio. When planning for your retirement, you have three basic choices—aggressive, moderate, and conservative. While I’ll give you an overall portfolio allocation process in the next chapter, you may want to use your 401(k) even more aggressively, because you aren’t taxed on your portfolio’s gains. Remember to balance out your 401(k) strategy with other investments outside of the plan. If you want to be aggressive, you’ll want to invest the majority of your portfolio in indexes like the Russell 2000, the Russell 2000 Value, and the Russell 1000 Value. For the large-cap growth portion of your portfolio, remember that I do not recommend using an index, since those are typically composed of stocks with high price-to-book ratios. A moderate equity allocation for your 401(k) would be approximately 50 percent of the portfolio in a large-cap value index like the Russell 1000 Value Index, 35 percent in the Russell 2000 Index (which invests in small-cap core companies), and the remaining 15 percent in a large-cap growth mutual fund using a growth-at-a-reasonable-price methodology. Finally, a conservative mix would put approximately 50 percent in large-cap value, 25 percent in small-cap, and 25 percent in a large-cap growth mutual fund using a growth-at-a-reasonable-price methodology.
Instead of using an ETF or index fund for your large-cap growth allocation, you’ll need to wade through the Morningstar data covering the large-cap growth mutual funds offered by your plan. (I know, you would probably rather get a root canal, but this is your future we’re talking about!) As we saw in the mutual fund section, this is accomplished most easily by visiting Morningstar’s Web site at www.morningstar.com. Look at the characteristics of each of your plan’s large-cap growth funds and select the one that has the lowest PE and price-to-sales ratios and where the manager’s style reflects a “growth at a reasonable price” philosophy. As we did in chapter 9, start with the Risk Measures section of the Web site. Look for large-cap growth funds with relatively low standard deviations and high Sharpe ratios. Next, go to the portfolio section and throw out any funds with very high price-to-book, price-to-sales, or PE ratios. Finally, focus on the large-cap growth funds that have low valuations but also show high earnings growth and strong price momentum. You should end up with funds that possess characteristics similar to the best growth strategies I uncovered in my research for What Works on Wall Street, and a sound investment strategy for the large-cap growth portion of your portfolio.
What About My Company’s Stock?
There’s a one word answer to that question: Enron.
More than eleven thousand Enron employees had an average of 58 percent of their 401(k) money invested in the company’s stock. Their sad fate was widely reported in the news, and is an important lesson for all of us.
More generally, in plans that match employee contributions with company stock, participants hold an average of 40 percent of their assets in company stock, according to the Profit Sharing/401(k) Council of America in Chicago. Many 401(k) plans let you invest in your company’s stock. I strongly discourage you from making a large investment in a single stock, however secure you think it is or however proud you may be of the company you work for. Typically, people feel it’s the loyal thing to do and will put too much of their 401(k) savings in their company’s stock. Indeed, in many 401(k) accounts, the company’s stock accounts for 50 percent of the equity allocation! This is a huge mistake. You never want to take the exponential risk that is associated with investing in a single stock. And if you think that Enron was an anomaly because the management committed outright fraud, think of how an IBM employee who diligently invested all her money in IBM stock must have felt as she watched its price drop 50 percent in the early 1990s!
There are only two reasons you might want to invest a small percentage of your 401(k) in your company’s stock. First, if the company is selling it to you at a reduced price, or second, if the stock meets the criteria of a successful time-tested strategy. Take a look at your company stock’s underlying factors. Is it a market-leading company with a high dividend yield? If so, it would fit into one of the large-cap value strategies we analyzed in chapter 8. And remember, even if your company’s stock does fit into a successful time-tested strategy, you should never invest more than a small percentage of your portfolio in a single stock.
It’s Time to Get Going
If you have a 401(k) plan available to you and haven’t yet put any money into it, start doing so right now. If you’re forty-five years old and don’t want to work until you’re eighty, you’ve got to begin to maximize your contributions to your 401(k) immediately. Get your 401(k) set up today and start taking advantage of the tax savings it offers you. Get involved as well. If your plan has rotten investment choices, lobby your company or plan administrator to add better ones. Finally, decide on a portfolio allocation you can stick with through thick and thin. If you’re risk-tolerant and aggressive, you’ll want to have 40 percent in small-cap funds and indexes, 40 percent in large-cap value funds or large-cap funds of stocks paying high dividends, and 20 percent in large-cap growth funds like those outlined in this chapter.
Chapter Ten Highlights