Are 401(k)s a Bad Idea?

There’s a long-held belief that investing in a 401(k) is the best way to ensure you’ll have an income throughout retirement . Actually, you may not be able to rely on a 401(k) as your primary source of retirement income.

Many 401(k) contributors may be new to investing and look to fund managers for consistent returns over time. But, as we’ve discovered during this economic downturn, mutual funds aren’t a place where you can just plunk down your money and watch it grow.  Plus, the fees you’ll have to pay and the mutual fund choice available to you may limit your returns or even add to your losses.

Placing Blame
“The rub on 401(k) plans is the additional expenses that are affiliated, and depending on the 401(k) that’s offered, the restrictions as far as what funds are offered,” says Timothy MicKey, managing director of Monument Wealth Management.  Additionally, some 401(k) “trustees are not on top of things the way they should be,” he says.  For example, some mutual funds that were once great investment options may be less so when a specific fund manager is no longer in charge, but 401(k) trustees may fail to update mutual fund choices in response to that.  In addition, investors “have to realize that for the last 18 months, diversification did not work.  Almost every sector went down,” MicKey notes. 

“My biggest fear is that people were overly aggressive and waited before they made any allocation changes,” says MicKey. “People who have been hit the hardest went into very conservative products, not understanding that conservative products would be the next shoe to drop,” he adds.

Missing Pieces
“Many people would have no investments if it was not for their 401(k),” says Kathy Williams, an Oklahoma City-based financial planner.

Retirement savings plans via 401(k)s and IRAs were initially meant to play one part in an individual’s retirement income, supplementing pensions and social security benefits which make up a so-called three-legged stool.  However, not all employers offer pensions, and Social Security payouts are facing steep cuts in the next few decades.

“Basically, only government and union employees have pensions now,” says William Driscoll, a Plymouth, Mass.-based certified financial planner.  “Many people don’t have the ability to save adequately, so they need to think in terms of a modified lifestyle, not spending up to their income, but less.”

Real estate, for some, has replaced pensions to hold up income during retirement, as investors bought the biggest homes they could afford and flipped them for a profit during retirement.  But while Driscoll says this strategy might work if you have 10 to 20 years until retirement, in this housing market, “if you want to flip it in three years and come out with six figures, you can’t really count on that.”

“You get the biggest bang for your buck with individual stock issues, but you can’t go in unless you have a diversified portfolio. You’ve got to have at least 20 companies,” MicKey says, which would require investors to do a great deal of research, which they may not have the time or the will to do. 

Diversifying for Safe Savings
A number of investment advisors may be pushing diversified, age-based or target-date mutual funds for those who want to leave asset allocation to a fund manager, but funds that cater to your specific risk tolerance may actually be a better choice.

“I personally don’t like [target date funds] at all,” says MicKey.  There’s nowhere in their planning that they take into consideration the economical cycle.  “I’m much more an advocate of lifestyle funds … based on risk tolerance, which is a much wiser way to go.”

And while CDs may be a secure investment, “CDs serve a purpose for liquidity needs within a certain period, for example, if a client wants to buy a house within three years, go on a vacation or short term goals, not long-term,” says financial planner Williams. “Generally with the taxes that you have to pay on the interest along with low interest rates, they’re not adequate for long term investing strategies.”

Foreign exchange could increasingly play a part in long-term investing, including investing for and during retirement.  “People are more savvy to the fundamentals of major economies of the world,” says Betsy Waters, global director of DBFX, Deutsche Bank's online foreign exchange trading platform( Stock Quote: DB).  Waters notes that most people already have some currency exposure in their retirement portfolios, which may allow them to hedge against other others bets, for example on domestic stocks.

Reconsidering the 401(k)
You may consider a 401(k) a must, however, if your employer matches your contributions, or if you’re lucky, makes contributions whether you do or not.

Since traditional 401(k) contributions are made with pre-tax money, the money you would have spent on taxes is invested.  Your earnings are also compounded over time, which allows earnings to become part of your underlying investment. 

Before you invest or consider moving your money from one fund to another, you’ll need to look at your investment horizon and risk tolerance.  How many years from now do you plan to retire, and how long will you need your money to last?

When you’re looking at individual mutual funds, do your due diligence to make sure the fund is appropriate for your needs by using resources like Ratings Screener.

Younger people “have a wonderful chance to get ahead of the curve.” Says MicKey. “Now is the time to dump as much as they can afford into [a 401(k)].  But if you’re in your 50s or 60s and you’re concerned about your retirement savings, you may want to meet with a financial advisor to talk about changing your strategy.

Related Stories:

How to Roll Over Your 401(k) Into an IRA

Boomers: Should You Put Off Retirement?

The Pros and Cons Behind Annuities



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