Over more than 30 years as a 401(k) plan consultant, I have worked with some of the most prestigious companies in the world including Apple, AT&T, IBM, John Deere, Northern Trust and Northwestern Mutual.
And, I am always surprised by the simple – but significant – misconceptions many people have about their 401(k) plans.
Here are the most common misconceptions I run across.
1. I only need to contribute up to the maximum company match
Many plan participants believe their employer is sending them a message on how much to contribute. As a result, they only contribute up to the maximum matched contribution percentage.
In most plans that works out to be only 6% in employee contributions. However, many studies indicate that participants need to add at least 15% each year to their 401(k) accounts.
2. It is OK to take a participant loan
I have had many participants tell me, “If this were a bad thing why would the company let me do it?”
Account leakage via defaulted loans is one of the reasons some of us are not able to save enough for retirement. Many people, when they change jobs, elect to default on outstanding 401(k) plan loans because they don’t have the cash lying around to pay the loans back.
In addition, taking a 401(k) loan is a horrible investment strategy. Generally, if you can take a loan from somewhere else, you should do it.
3. Rolling a 401(k) account into an IRA is a good idea
There are many investment advisors working hard to convince everyone this is a good thing to do.
However, higher fees, lack of free investment advice, use of higher-cost investment options, lack of availability of stable value and guaranteed fund investment options, and many other factors make this a bad idea for most of us.
The Department of Labor agrees, as shown in its recent auto portability proposal.
If you can, roll your prior 401(k) account balances, and your IRA accounts, into your existing employer’s 401(k) plan. It is a much more cost-effective option.
4. My 401(k) account is a good way to save for college, a first home, etc.
When 401(k) plans were first rolled out to employees decades ago, human resources staff helped persuade skeptical employees to contribute by saying the plans could be used for saving for many different things. They shouldn’t be.
It is a bad idea to use a 401(k) plan to save for an initial down payment on a home or to finance a home purchase. Similarly, a 401(k) plan is not the best place to save for a child’s education – 529 plans work much better.
In addition, your 401(k) plan is not the best place to save for a new car, boat or that deluxe vacation. If you wish to enjoy any sort of quality of life in retirement, use your 401(k) retirement plan to save only for retirement.
5. I should stop making 401(k) contributions when the stock market goes down
I have had many participants say to me, “Bob, why should I invest my money in the stock market when it is going down. I’m just going to lose money!” When the market is falling or has decreased significantly in value, stocks are on sale. It is the best time to be investing in the market!
Stick with your contribution plan in all types of markets. Stopping and starting contributions is not a good way to accumulate the balance you are going to need to retire.
The biggest challenge participants who stop contributing face is when to resume their contributions. Most wait until the stock market recovers. As a result, they end up buying when the cost of stocks is high — not a good investment strategy.
6. Actively trading my 401(k) account will help me maximize my account balance
Studies have consistently demonstrated that trying to time the market (this includes following newsletters or a trader’s advice) is rarely a winning strategy. Consistently adhering to an asset allocation strategy that is appropriate to your age and ability to bear risk is the best approach.
No one can predict what the market will do in the future. Please don’t believe that you or anyone else can. Don’t try to “trade” your account. Everyone I have known who did this traded their account down to nothing.
7. Indexing is always superior to active management
Although index investing ensures a low-cost portfolio, it doesn’t guarantee superior performance or proper diversification. Access to commodity, real estate and international funds is often sacrificed by many pure indexing strategies. A blend of active and passive investments often proves to be the best investment strategy for most of us.
8. Target date funds are not good investments
Most experts who say that target date funds are not good investments are not comparing them to most participants’ allocations prior to investing in target date funds.
Target date funds offer proper age-based diversification. Many of us, before investing in target date funds, may have invested in only one fund or a few funds that were inappropriate risk-wise for our age. Studies show that the average number of funds used by 401(k) participants is between three and four. That generally is not enough to ensure proper diversification.
9. Money market funds are good investments
These funds have been guaranteed money losers for a number of years because they have not kept pace with inflation.
Unless you are five years or less away from retirement or have difficulty taking on even a small amount of risk, these funds are below-average investments. Try to invest in stable value or guaranteed fund investment options instead.
10. I can contribute less because I will make my investments work harder
Many participants have said to me, “Bob, I don’t have to contribute as much as others because I am going to make my investments do more of the work.” Most participants feel that the majority of their final account balance will come from earnings in their 401(k) account.
However, studies show that the major determinant of how much participants end up with at retirement is how much they contribute rather than how much they earn.
11. A million-dollar 401(k) plan balance is enough to retire on
It should be enough, but for many of us, it won’t be.
A lot of us hope to do things in retirement that we only dream about during our working years. Others will experience unexpected health care costs that can quickly deplete their savings. Quite a few of us will live much longer than we ever thought. As a result, many experts feel that a million-dollar 401(k) plan balance won’t be enough.
Robert C. Lawton has been advising companies on their retirement plans for more than 30 years including Apple, AT&T, Florida Power & Light, General Dynamics, IBM, John Deere, Mazda Motor Corporation, Tribune Company, Northern Trust Company, Northwestern Mutual, Underwriters Labs and many others. He is an award-winning retirement plan investment adviser and President of Lawton Retirement Plan Consultants, LLC a Registered Investment Adviser with nearly a half billion in plan assets under contract.
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