Top 5 – 401k blunders

Monday, July 12th, 2010 by Cass Chappell, CFP®


When we meet with a client for the first time, the conversation quickly drifts to their employer’s retirement plan.  The most common of these is the participant-directed Traditional 401(k), a qualified retirement savings plan that allows employees to regularly contribute to the account while deferring current income taxes on the saved money and the earnings until withdrawal. Employees can select from a variety of investment options and direct their own account, and reallocate, as desired.

Many of the blunders described here would also apply to other types of retirement plans (e.g. SIMPLE IRA, 403(b), SEP IRA, etc).

#5.  Chasing “winners”

It is a natural tendency to think that the best performing investments last year will also be the best performing investments in the coming year.  There are several studies that show investment “in-flows” to be at their peak when there has been stellar recent performance.  I guess we don’t want to “miss the boat.”

What many investors fail to realize is that the situation that caused the strong performance may no longer exist.  A great example of this would be government bonds in 2008.  With the “flight to safety” and the lowering of interest rates, Government bonds were among the best performing asset classes in 2008.  These circumstances were not likely to be repeated in 2009…and they did not.

#4.  Too little diversification

Another one of our many counter-productive tendencies as investors is to over-simplify our investment process.  Despite what you may read from the “experts,” putting your retirement savings SOLELY in one major index (such as the S&P 500) is not likely to be the best course of action.

Many investments have performed far better than this index over long periods of time.  The most likely candidates would be those that invest in stocks of smaller companies or even international or emerging markets.
There have been years (think 2008) where investments that tracked the S&P 500 would have been among the worst performing asset classes.  If you were close to retirement (or even IN retirement), a decline of this magnitude could derail an otherwise well thought out retirement plan.  It is easy to see the advantage of diversifying across asset classes and owning some fixed income investments in times like these.

#3.  Too conservative

Retirement accounts are tax deferred.  For that reason, they will be among the last assets an investor should tap into during retirement.  Even if the retirement account is the only sizable personal asset, the portfolio is going to need to last for the remainder of the investor’s life.  William Bengen, in his landmark article in the Journal of Financial Planning, October 1994, demonstrated that being too conservative actually HURTS portfolio performance in retirement. 

In most circumstances, we would recommend an allocation of about 75% to equities and 25% to fixed income.  We would never, ever, recommend going more conservative than 50/50.

Another key:  Participants are likely to be adding to the portfolio with each paycheck.  Dollar cost averaging into a volatile portfolio can produce some fantastic results.

#2.  Contribution percentage is too high


I know.  Seems counter-intuitive.  Let me explain.  If your company matches contributions, it is important that you don’t hit the maximum contribution too early in the year, which for a 401(k) in 2010, with several exceptions, it is $16,500.  I wrote about this in a prior entry, but bottom line – you only receive a match when you are contributing.  The match is based off of your contribution AND your income.  Maxing out too early leaves money on the table…since all income earned after your contributions have stopped goes unmatched.

#1. Contribution percentage too low

For some people, the sound of finger nails on a chalk board makes them cringe.  For me, it’s meeting someone who doesn’t contribute enough to their retirement plan to take full advantage of the employer match.  Except in the MOST EXTRAORDINARY of circumstances, this is the biggest mistake in all of personal financial planning.  Free money is being left on the table.  Stop and think about the math:

  • Employer matches 3%
  • Paycheck is $1000 per week
  • Employee pre-tax contribution would be $30
  • Employer matches $30
  • $60 goes into retirement account
  • Take home pay reduced by about $22 (this is an estimate – since it is pre-tax, deferring $30 will reduce after-tax pay by a smaller amount.  The exact amount would depend on how much you earn.)

Clearly, you can see that I would be a proponent of giving up $22 in cash now to get $60 later.

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