Investment losses in a 401(k )are directly related to the level of risk you are taking inside the plan. However, they are not the only source of risk. Here are a few common sources of losses in a 401(k) both related to investments and not utilizing all benefits of the plan.
Never changing preselected investments: Many people today choose only the percent of their paycheck that goes into the plan. They are hired with a company, are automatically enrolled in the 401(k), they are auto assigned a portfolio based on the age and target retirement date, and "Congratulations" they are contributing consistently to a plan. I spoke to a prospective client last week, as she handed me her 401(k) statement, she said, "I do not know anything about this plan." It was completely set up by her employer. “Did you choose your investments?” I asked. "No." (It's 100% in a Target Date 2035 fund.) "Did you choose your contribution rate?" "I don’t think so." (It's 3%.) The company matches up to 6%, not only is she losing out on free money given to the employee through matching her contributions, but the investments may also not be in line with her overall goals. If the company had not set up her plan it is likely that she would not have a cent in her 401(k), however, understanding the plan and avoiding a few costly mistakes will help her build a larger retirement faster.
Only considering return: Many employees take investing into their own hands and design their own portfolio within the 401(k). Most of the focus is on the return they are looking to receive with very little attention being paid to the level of risk they are taking. Say they start out with ten investments in their 401(k) chosen from the menu of investments available from the custodian. After the first quarter they look at their plan and see that one or two of the investments underperform the other eight. They sell them. The next quarter, they look at their investments, and again they sell the bottom two. The problem with this common inviting process is that in times of prosperity they are ditching the safer, less volatile investments and gradually adding risk to the portfolio. This is fine until we see volatility in the market, or we have a major drawdown like we saw in March 2020. The safer investments would have buoyed the portfolio and kept it from taking all the loss of the market. If the person is 20 years old and wants to take all the risk available, this is a fine investing style. As we get closer to retirement our desire is to have less risk in the portfolio. This style can lead to a risk level higher than anticipated and greater losses when the market corrects.
Too Much Company Stock: We see it with some of the bigger company 401(k) plans. Sometimes the company match goes only to company stock until it vests. The company may also allow for a direct investment program where they will give you incentives to buy company stock inside your plan. These perks can be a great way to utilize all of your company benefits. However, you should always look at your overall plan and decide what percentage of company stock you would like to have. A general rule is to never have over 5% of any one stock inside a retirement plan for someone approaching retirement. I do have clients who work for certain government defense contractors who have substantially more than 5% in their 401(k). I have seen the percentage be 100%! Not only do you have market risk, but you now have company specific risk as well. It was common in the late 90’s for employees of Enron to have all their retirement plan in Enron stock. This did very well until it ended very badly in 2001. Owning company stock as a portion of your total retirement plan can be a valuable and profitable part of your portfolio if it aligns with your overall risk.
Not Maxing out the Plan: I hear the phrase often; "I am maxing out my 401(k)." The next question is always, "Are you maxing it out or are you maxing out the match?" Nine times out of ten, the company matches up to a certain percentage and the employee is contributing up the match, but maxing out the plan may mean contributing significantly more. Let’s say you are making 100k / year and the company matches up to 4%. You are only contributing $4000 to the plan. The annual limit in 2021 is $19,500. You can contribute $15,500 more into the plan. Remember the $4000 match does not count towards this limit. Each year you are missing out on the opportunity to put more money to work inside your plan.
Leaving the Company before you vest: Many companies today make you stay at the firm for three, five, even seven years before you get all your company benefits. This does not affect the money you put in but could drastically affect the amount you take with you if you leave the firm. The reason is the firm can discount the amount of money they put in through a vesting schedule. Not staying for the full term could cost you money and could be a reason to stay with the firm.
This is not an exhaustive list of all risks in a plan; however, they are the most common I see working with clients on a daily basis.
by Jonathan Lawton CFP®
Managing Partner, OpenAir Advisers LLC.
If you have questions about these or any other topics you can reach the author at Jon@openairadvisers.com
Advisory services offered by OpenAir Financial, LLC, a registered investment advisor in the state of Texas. Insurance products and services are offered through OpenAir Advisory, LLC, an affiliated company.