Strategies for navigating the 401(k) jungle

Every paycheck, tens of millions of Americans diligently save a chunk of their income via 401(k) retirement investment plans.

Yet for many people, much about their 401(k) is a giant mystery. How can you judge whether your plan is a good one — or a dud? And how do you know whether you’re investing correctly?

With a record $4.8 trillion now in 401(k)s and similar plans, such as 403(b) plans for public employees, the stakes have never been higher. Recognizing this, new federal rules took effect July 1 that will force employers to reveal more about the often-hidden fees of the programs. Those expenses can eat up a sizable chunk of your savings over time.

The fee disclosures will provide a great opportunity for investors to take a broader look at their 401(k) plans. Particularly if you haven’t paid much attention to changes in your plan in recent years, you may find more features that can raise the odds of success — or at least lower the odds of something cataclysmic happening to your nest egg.

Here’s a road map for evaluating your 401(k) or 403(b) plan, how to make the most of what you’re offered, and what to expect as more companies add new features to their plans:

Do you know your investment options?

Many investors have been frozen in place since the stock market crash of 2008 and the subsequent partial recovery. If it has been years since you last looked at what your 401(k) plan offers, you might be surprised at your choices. Your employer might have added new investments and substituted others, hopefully with the aim of providing a better opportunity to build a diversified portfolio.

Conventional mutual funds remain the main type of investment in 401(k)-type plans, along with money market (cash) accounts and, in the case of publicly traded firms, company stock. The average plan offered 19 separate investment choices in 2011, according to a Vanguard Group survey. That was up from 16 in 2002.

Yet most people use only a few options — 3.2, on average, according to Vanguard. That isn’t necessarily a bad thing. For younger workers in particular, a few may be all they need for basic diversification starting out: say, a blue-chip U.S. stock fund, a small-company U.S. stock fund, a foreign-stock fund, and a bond or other income-oriented fund.

“Once you have three or four options in major asset classes, you’ve pretty much got it covered,” said Michael Yoshikami, head of financial-planning firm Destination Wealth Management in Walnut Creek, Calif.

But older employees who have amassed substantial savings are more likely to want additional diversification options. That can lead to frustration, because popular niche investments still are relatively rare in 401(k) plans.

For example, it baffles some financial advisors that commercial real estate funds aren’t offered by more plans. The latest survey of 401(k) plans by the Plan Sponsor Council of America found that in 2010 28% offered real estate funds, which typically invest in shares of real estate investment trusts.

Gold and other such “sector” mutual funds are even scarcer. Fewer than 20% of plans offer them. And only a very small sliver of plans include exchange-traded funds on their menus.

Perhaps surprisingly, 401(k) plan options often are more extensive at smaller companies than at big firms, said Michael Alfred, co-founder of BrightScope Inc., a San Diego company that rates about 50,000 401(k) plans.

“But a lot of that has nothing to do with what’s best for investors,” Alfred said. More likely is that smaller firms’ investment rosters reflect the success fund companies have had in marketing many mediocre options to small-company executives. Some small-company plans have as many as 50 investment options, Alfred said. “I think that’s definitely overkill.”

Should you go the simplified route of a “target-date” fund?

Target funds can eliminate for many investors their most vexing challenge: deciding how to diversify assets and how to change that mix over time.

Target-date funds (sometimes called life-cycle funds) invest based on a specific retirement date. Say you expect to retire in 2040. A fund with that date most likely would hold the majority of current assets in stocks, aiming for long-term growth. But each year, the percentage in stocks would decline while the percentage in typically more conservative, less volatile investments such as bonds would rise.

Target-date funds have exploded in popularity with 401(k) plans over the last few years. Eighty-two percent of plans now offer the funds, up from 58% in 2007, according to Vanguard. And 47% of plan investors use a target-date fund, up from just 18% in 2007.

The jump in participants’ use of the funds in part reflects that many companies make a target-date fund the so-called default option for investors: If you don’t want to choose specific investments, your savings are channeled into the target-date fund closest to your assumed retirement year.

One benefit of target-date funds’ rise is that they lessen the risk investors will wittingly or unwittingly keep all of their money in just one type of asset, such as stocks.

“Fewer participants now are holding extremes” of asset allocations compared with five years ago, said Jean Young, a retirement-plan specialist at Vanguard.

But experts advise investors to do at least some basic research on their target-date fund. Specifically, what percentage of the fund currently is in stocks? That allocation can differ significantly among fund companies using the same target date.

If the target-date fund for your presumed retirement year currently has a larger percentage of assets in stocks than you’re comfortable with, one solution is to go with a fund with a closer target date, which most likely would have a smaller share in stocks and more in bonds.

Target funds’ asset-allocation percentages can easily be found on your 401(k) plan’s website. That at least gives you a starting point for understanding what’s in these funds.

Another simplified option for leaving asset allocation decisions to a professional money manager is to invest in a “balanced” fund, which always maintains a mix of stocks and bonds. But note that unlike target-date funds, balanced funds aren’t managed to become more conservative over time. A balanced fund’s asset mix depends solely on how the manager views the relative appeal of stocks and bonds.

Is your employer encouraging you to save as much as possible?

In the last few years more companies have adopted two features aimed at boosting employees’ 401(k) savings rates. One is automatic enrollment, meaning a certain percentage of your pay automatically goes to the 401(k) unless you opt out; the second is automatic escalation, meaning your contribution increases each year until it reaches a set limit.

The basic idea is overcoming inertia — people’s tendency to put off making investment decisions that they find too daunting.

More than half of mid-sized and large 401(k) plans use automatic enrollment, Vanguard says.

Life Technologies Corp., a Carlsbad maker of biotechnology systems, is typical. Employees are automatically enrolled at an initial contribution rate of 3% of pay. The rate then increases 1 percentage point yearly until it reaches 6%, said Carole Mendoza, the company’s director of benefits.

Though employees can choose to opt out of the escalating contribution, the vast majority don’t. “Ninety-three percent have stuck with it,” Mendoza said.

Because most employers match some portion of employees’ contributions to their 401(k) plans, automatic enrollment and automatic escalation can help ensure that employees are getting the maximum amount of employer help in building their nest eggs. The standard match is 50 cents for every $1 of employee contributions, up to 6% of pay.

Under BrightScope’s 401(k)-plan rating system, “The fastest way to get a high score is for the company to put in more money,” Alfred said. “The best plans are the most generous.”

But 401(k) generosity can be difficult for struggling smaller companies in this economy. That may be one reason that automatic enrollment is far less common at smaller firms than at larger ones: Fewer than 12% of plans with up to 49 worker-participants used automatic enrollment, according to the Plan Sponsor Council of America’s latest survey.

If your 401(k) plan doesn’t offer automatic escalation, the onus is on you to make the decision to boost savings. One strategy is to raise your contribution at the same time you receive a pay increase. That would ensure you’re putting more into your plan while still getting some increase in take-home pay.

Of course, in the real world that’s no snap for workers who often need every dime of income just to make ends meet. But if your company offers matching contributions, and you fail to contribute, you are giving up free money. That’s a lesson that parents and grandparents often need to drill into the thinking of young people.

If your employer allows it, should you choose to invest your 401(k) assets outside the plan’s options?

Some companies have a brokerage “window” as part of their 401(k) lineup. That window can allow employees to invest in nearly any asset rather than limit themselves to what’s in the plan.

Brokerage windows are relatively rare: About a fifth of companies offer them, according to the Plan Sponsor Council and Vanguard data. One reason they’re uncommon is that many companies fear employees could end up destroying their savings by investing in high-risk assets or by trading excessively.

But some companies that offer the window say that only a tiny number of employees use it, and that those users aren’t novice investors.

“We find the people who [invest] through the brokerage window pretty much know what they’re doing,” said G. Joyce Rowland, senior vice president of human resources at Sempra Energy, the parent of Southern California Gas Co. Of about 17,000 Sempra employees, just 158 use the brokerage option, she said.

The benefit of the brokerage window is that your investment options can be unlimited. That should appeal to older investors who have accumulated significant savings and want to diversify beyond the mutual fund menu of a 401(k).

Laila Pence, a financial advisor at Pence Wealth Management in Newport Beach, said the brokerage window is useful for older investors who choose to emphasize income-producing investments such as high-dividend individual stocks and high-yield “junk” bonds. “One thing that reduces risk is [assets] that pay cash flow,” she said. But few stock mutual funds stress dividend income, and junk bond funds typically aren’t available in 401(k) plans, she noted.

Even if a company doesn’t offer a brokerage window, its older employees may have another way to get broader asset diversification: If you’re at least 591/2 and still working, you may be able to do a so-called in-service withdrawal that rolls part of your 401(k) assets into an IRA that you can then invest on your own.

Note, however, that there may be tax-related reasons to put off an in-service withdrawal. Before taking the plunge it’s best to get input from a financial advisor.

Does your employer offer some kind of investment guidance?

Eventually, most people could use help with their investments. The majority of companies now make financial-advisory services available to their 401(k) plan investors.

The Plan Sponsor Council’s latest survey showed that 59% of 401(k) plans offered some kind of advice program. The most common type of service provided is via online programs that help with basic issues such as asset allocation.

Smaller companies are much better about giving employees access to one-on-one counseling with a financial advisor. More than 77% of plans with fewer than 49 worker-participants offer one-on-one counseling, compared with just 27% of plans with more than 5,000 workers, the council survey showed.

Despite the prevalence of company-sponsored advisory programs, relatively few workers have taken advantage of them. Across plans of all sizes, just 22% of participants sought advice in 2010, the Plan Sponsor Council said.

Since the 2008 crash, “People have actually backed off — they’ve become more passive,” said David Wray, president of the Plan Sponsor Council. Vanguard’s survey found that just 11% of 401(k) plan participants traded at all in their accounts last year, the lowest percentage since the company began its regular surveys in 1999.

But an aging workforce and rising 401(k) balances are likely to mean an increasing need for advice.

The 401(k) is no panacea, but with the housing market overall still depressed and banks paying virtually nothing on savings, the plans are many people’s only hope for building wealth.

“It’s the one asset they must grow,” Pence said.

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