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Insights and Advices on 401k Plan
#1
Most of us who are W2 employees are fairly familiar with 401k plan. US government givespeople tax incentive to save for their retirement, each employee can contribute$18k/year until age 50 when he/her can contribute $24k/year. It is an importantpart for our comprehensive retirement planning. It is your money which is safe even when company you work for filed for bankruptcy. In this article, I like to share some facts and stats about this plan, and insights of top ten Dos and Don’tsfrom an investment professional’s prospective.

Firstly,some facts and stats: among the 156M employees in US, about 1/3, 51Mparticipate in 401k program, with total asset of $3,500 Billion, averaged accountsize of $60k/median $17k, each participant contributing 6% of their salary onaverage. But 28% of employees only have ~$1000 saved, and 56% of those close toretirement got <$25k, rely on Social Security benefit.

[i]Dos:[/i]


1.  Don’t leave free money on the table.
Since a company typically matches 50 cents to the dollars up to 6%, youneed to take advantage of that, at least contribute the amount which company iswilling to match, but preferably much higher, ie 10% of your salary;
 
2.  Starting as early as possible, the magic of compounding.
If starting on age 25, contributing $500/month, assuming annual grow of6%, upon retirement at 67, will have ~$1M. If starting at 35 with the samecondition, will have ~$500k. If delay starting until 45, the amount of savingwould drop drastically to ¼ at ~$250k. Making the goal of comfortable life inretirement, a bit of a challenge. Starting early, let the money inside 401kplan working hard for you.
 
3.  Keeping a long term outlook.
Over a long term prospective, the least resistance for the US equitymarket trend is up. For instance, since 1926, if covered any 20 year period,100% positive; if covered any 10 years period, 97% chance positive; if coveredany 5 years period, 87% chance positive. So never allow day to day marketvariation and volatility affect your LT goals.
 
4.  Proper asset allocation/diversification are key to success.
When I am talking about asset allocation, I am not talking about US stockfunds/foreign stock funds, or large cap/mid cap/small cap funds, they are all in same stock asset class with positive correlation. I am talking about different asset classes such as stocks, bonds, cash, real estate, foreign security,and commodities. Let us focus on the top three of stocks/bonds/RE. Since GreatDepression, over several decades, there are only 2-3 occasions which all thesethree asset classes dropped on the same year. Usually stocks and bonds are negatively correlated, one is going up, while the other one is going down.According to the famous study done by Brinson, Hood and Beebower on 1986 and1991, over a long term horizon, the portfolio return is 94% determined by theasset allocation factors, while remaining 6% impacted by market timing andsecurity selection. By contributing each month, essentially it is DCA (dollarscost averaging) which minimize the timing risk, and using of the MFs (mutualfunds) reduce the individual stock risk, the key factor is the assetallocation, which I will spend the most time talking about.

As a rule of thumb, for young people with 20-30 years until retirement,80:20 ratio for stock funds: bond funds with portfolio growth as main goal;

For middle age workers with 10-15 years work-life left, 65:35 is a goodratio for balance of grow and protection;

For employees who are 5 years away from retirement, flip that ratioaround so 35:65 for stock funds: bond funds with goal of principle preservation.

Also, alternative investments/commodities, if available, 5% is good since they are pretty volatile.
 
5.  Reasonable diversification is good, but don’t over do it.
In principle, account size of $10-50k, use 5-10 funds; $50-100k, pick8-12 funds; for $100k+ account size, 10-15 funds are enough. On average, thereare about 19 funds to select from in employee 401k plan (depends on company401k carriers), and 70% offer Target-dated fund, which is a fairly reasonablefund adjusting to different level of equity exposure as function of ages.
 
6.  Making necessary adjustments over time.
The two key factors for assigning asset allocation are risk tolerance level and time left before retirement. Since our family situation might change over time, ie marriage, have kids, thinking about use retirement money to fund kids college education, our income level, or the expectation for market, could change over times. In addition, the previous asset allocation set will changeas function of market, it is advised to go through your portfolio assetallocation and fund selection, 1-2x per year. Actually time is a form of asset,when we are getting older, we don’t have the luxury of having enough time to gamblefor market to recover should a major down-cycle such as 2008-2009 occurred. If one has the foresight of such big market collapse is imminent, then by all means ok to switch to cash/CD/money market fund. The key thing to remember, is when to return the cash to market. Should not think leaving cash in CD has zero risk, actually it is losing to inflation, so cash also carry inflation risk. Typicallythe 401k carrier (ie Fidelity) will have free consultant on call to provide employee with free advice. Survey showed 64% of those who seek advice showing improvement on performance of their portfolio.
 
7.  Factors to consider when picking up funds.
When selecting the funds, pay attention to its investment objective, risk and fee. Always pick funds performed in top 25% of all funds in same categoryfor 3/5/10 years periods, pick funds with above avg return/below avg risk, pick funds with relatively low expense ratio/fee (info can be found on fundwebsite/Morningstar), generally speaking, <1% is good, and on averaged the 401k expense ratio is 0.63%. If prefer to go for low fee funds, index funds in general offer lower fee than actively managed funds.
 
8.  Risk management and control are critical.
Oftentimes many of us, in the process of seeking ever greater Alpha/ROI(return), we lost sight of the risk control. For that extra 5% potential gain,we are taking on 10-20% more risk, this is not worth it, especially as one gets older. Typically the risk levels are: individual stock>>mutual funds>>bond funds> cash. Some risk indicators to watch out: Beta is ameasure of systematic risk vs. market as whole. Standard Deviation is measureof volatility, higher the numbers the worse the risk and variation. Sharpratio, on the other hand, is measuring the risk-adjusted return, so higher the better. Should you found yourself loss sleep over market action and volatility,it means you are taking on too much risk, and likely need to make adjustment.
 
9.  Pay yourself first, and roll into IRA when leaving.
When you get a pay raise or bonus, always consider paying yourself first by upping your 401k contribution, even by 1% more still helps over the long run. When Roth 401k option which is a post-tax contribution available, is good for young people to take advantage of that since tax rate is relatively low.When leaving company, always remember to roll the 401k to IRA, which can giveyou more individual control and also has more investment selection available.
 
[i]Don’ts:[/i]


1.  Frequently ins and outs of funds might not be the best way to go. Since most of us are not investment professional by trade, and have other day time jobs which doesn’tallow us to constantly monitor of the market action, and often times, humanbehavior and instinct goes against the principle of investing, causing us to buy high and sell low. One stats can spell the big price to pay if were out of market at the wrong time: fully invested in SP500 over last 20 years resultingin gain of 8.19%, missed 10 best days will drop the gain by half to 4.49%, and missed 20 best days will drop further to 2.05%, missed 30 best days will yieldno gain at all.
 
2.  When changing jobs, 68% of us made the costly mistake of cashing out with 10% penalty and paying income tax, only 26% opted to roll into IRA.
 
3.  Don’t make the common mistake which even myself made before: once set (investmentmodel, portfolio asset allocation), all is forgotten. Need to tune up the portfolio at least once per year, like your car, better with 2x/year.
 
4.  Nevertreat your 401k as bank account, only borrow from it in case of emergency, orto pay down high interest debt. Don’t waste it on Try not to taking outdistribution until age 59.5, to avoid the 10% early distribution penalty.
 
5.  Don’t get too emotional to the daily variation of the market, ups or downs. Don’t overly react to the market news, always keep in mind that you are investing forthe long haul, try to think contrarian vs. conventional thinking.
 
6.  Last but certainly not least, don’t make the mistake of chasing the Alpha/ROI and forgot about risk control. Too many people have 401k portfolio dominated by stock funds and lack of diversification in their portfolio, loading up on high risk emerging market funds or his own company stocks. Just think about it, your salary/income/RSU are 100% dependence on your current employment with this company, isn’t this already risky enough as is? Why adding to that by loading up on more company stocks in 401k?
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Insights and Advices on 401k Plan - Rulef - 05-08-2016, 01:45 AM

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