Reader Question: What Should I Do With My 401k?
David writes in, “I waste my money on having a personal Financial Advisor w/ Merrill Lynch. He gets 1% of everything invested annually. I cut him a quarterly check and he picks which mutual funds to invest in. The market has been sucking so my mutuals are only up about 4% cumulatively since inception. I don’t know anything about finance so I like using this guy but when I calculate how much 1% annually actually is, it freaks me out how big his fees are.
How can a lazy guy like me who doesn’t know anything about finance still invest intelligently without blowing that 1% annually on advisor fees? The key thing is that I am super lazy and I don’t want to take the time to read up on finances.”
Many smart and talented college graduates enter the workforce these days with little financial knowledge. By the time most people start to think about retirement, they have missed out on some major opportunities.
But before you get caught up in which funds to invest in and what asset allocation you want, make sure to focus on your rate of savings. If you’re making 50k a year but only saving 5%, your rate of savings will have a much larger impact on your retirement accounts than any mutual funds you might invest in. For most investors, your contribution priorities should be as follows:
- 401k contribution up to your company match
- Roth IRA contribution
- Max out 401k
- After-tax investments
Every situation is unique, but these simple guidelines should give you a general idea of what to contribute to. Anyone can manage their retirement accounts with a little research. Looking at David’s situation, we immediately see a major flaw. He is paying 1% of all yearly investments to a financial advisor. Even when his funds lose money, he still has to pay 1%! In addition, the mutual funds picked by David’s financial advisor have built in expense ratio’s that are most likely another 1-2%. This seems ridiculous to me, but many people do it nonetheless because they don’t realize how easy it is to manage your own finances.
The Laziest Investor
Now David states that he doesn’t want to take the time to read up on finances. That is fine! We have a solution for him. Many 401k’s are starting to offer Lifecycle funds which attempt to mimic a desired asset allocation based on the year you plan to retire.
For example, if your 401k is served by Fidelity, you will be able to invest in Fidelity Freedom 2050 Fund(FFHX). The expense ratio is .80% and will often be lower through your 401k(my 401k offers this fund at a reduced ER of .34%). This fund invests in a combination of domestic and international stocks and bonds using a moderate asset allocation strategy for investors expecting to retire around 2050. What this means in layman’s terms is that the fund will hold more stocks when you are younger and will automatically rebalance towards bonds as you get older. This can be a great option for someone like David. His money will be kept in a risk-appropriate allocation until he retires with almost no active management required.
The Aspiring Investor
The aspiring investor should be willing to do some research. There are some great books available like the The Bogleheads’ Guide to Investing, that explain asset allocation(AA) in more detail. A riskier asset allocation will hold more stocks than bonds.
I hold 90% stocks and 10% bonds in my retirement accounts. But for a more moderate AA, a good rule of thumb is to hold your age in bonds. Therefore, if you’re 25 years old, your AA would be 75% stocks and 25% bonds.
If .80% ER sounds like a lot, you’re right. The lifecycle funds require active management and therefore have higher fees than other index type funds. Most 401k’s should offer some type of Total Market Index fund which will passively track all the stocks on the NYSE and NASDAQ in addition to Bond Index funds. The total market funds have lower expense ratio’s than life cycle funds and will always outperform actively managed funds over long periods of time. These funds allow a savvy investor to safely diversify across the entire stock market at minimal cost.
The Advanced Investor
Taking it one step further, the advanced investor will want to expand into international stock allocation as well. Things can get very complicated beyond this point, and I like to keep it simple. I treat all my retirement accounts(401k, Roth IRA) as one big nest egg. From there, I have a 90/10 AA and a 60/40 Domestic/International split. I only invest in 3 types of index funds: Domestic stocks, International stocks, and total bond market. This keeps my portfolio diversified and simple.
The last thing to worry about is taxes. You want to place your least tax efficient funds in your tax deferred or tax free accounts. Here is a good guide on tax efficient fund placement.
You should now be able to decide which type of investor you are and be able to determine how actively engaged you want to be in your 401k. Before you do anything drastic, do a little research, read this blog or feel free to ask me a question.
Have you looked at your 401k since you started working? Do you know what kind of return you’ve been getting?
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