It May Be Time for a 401(k) Plan Tuneup

When he received his monthly 401(k) statement in the mail a few days ago, Richard Walter admits, “I winced.”

The 42-year-old, a controller for California Optical Leather in San Leandro, Calif., found out that even the top-performing stock mutual funds in his company-sponsored 401(k) retirement plan can lose money.

Yet unlike some 401(k) investors who rushed to sell their stocks as the market has stumbled in recent weeks, Walter sat tight.

Did he do the right thing?

The question of whether--and how--to shift assets in 401(k) accounts has suddenly become a much hotter topic with many Americans, with major stock indexes down 9% to 20% from their peaks and increasing talk that the market could be poised for a bigger decline.

While most Americans know the importance of participating in these tax-deferred retirement plans, few know how to manage their 401(k)s effectively, financial planners say.

Because these accounts often represent the bulk of participants’ savings, the stakes are high. If the ideal U.S. investment environment of recent years is about to give way to rougher times on Wall Street, the effect on 401(k) nest eggs could be dramatic.

Where should you start? A basic review of how your 401(k) money is invested, and your account choices, makes good sense right now, experts say. Get your latest statement and pull out the company information packet that details your options.

Too many investors probably can identify with Dianne Franks, a 42-year-old Pasadena resident. Though she knows enough not to react to short-term movements in the stock market she knows little about her 401(k) plan.

“I think that most of my money is in mutual funds,” says Franks, a contract administrator for an environmental firm. “I think they’re in stocks.” But, she admits, some of her money could be in safer but slower-growing investments.

“All I know is that when I make a payment, they send me a pie-shaped thing and it says ‘mutual funds,’ ”

Franks says.

This is typical, says Dan Maul, president of Retirement Planning Associates in Kirkland, Wash. “I don’t think the majority of people can tell you the names of the funds they’ve invested their 401(k) money in,” Maul says. “I doubt they could tell you what percentage of their 401(k) money is in stocks and what percent is in bonds.”

Surveys have shown that the bulk of 401(k) money is, in fact, invested in stocks or stock funds.

A 1996 study of 23,000 401(k) plans nationwide found that 42.4% of investors’ money was in diversified stock funds and another 19.5% was in shares of the companies the investors work for.

Less popular were more conservative investment options, including money market funds, often called “cash” accounts, which pay returns pegged to short-term interest rates, and guaranteed investment contracts, or GICs, which are similar to bank certificates of deposit, paying a set interest rate.

What’s the right mix for you? That depends on your circumstances and needs. To start, experts suggest this exercise:

* Step 1. Determine your short-term, intermediate-term and long-term financial needs.

Think of short-term needs as those that must be met within two years, intermediate-term needs as those that must be met in two to seven years, and long-term needs as those that won’t arise for at least another seven years or more.

* Step 2. To meet those needs, divide your nest egg--that is, all of your savings and investments, both inside and outside your retirement accounts--into three theoretical buckets.

Your short-term bucket could be used for a variety of things. For instance, if your child is headed for college next year, you may need to take money out of this bucket to pay his or her tuition. This short-term bucket may also represent an emergency fund.

Your intermediate-term bucket exists to cover planned expenses in two to seven years. Example: If you expect to buy a house in the next five years, you’ll need to set aside money for a down payment.

Finally, your long-term bucket represents money you will tap in retirement.

* Step 3. Determine how your 401(k) money should be divided among these theoretical buckets.

This will go a long way toward helping you decide whether to invest all or most of your 401(k) money in stocks, in a combination of stocks, bonds and short-term accounts, or perhaps just in short-term accounts.

If you’re a decade or longer away from retirement and you have other funds set aside to meet short- and intermediate-term needs, your 401(k) account probably belongs exclusively in your long-term bucket. (Remember, there’s a penalty for withdrawing money before age 59 1/2.)

On the other hand, if you are five years or less from retirement and may need some of that money, at least part of your 401(k) money may technically be in your short- and intermediate-term buckets--funds you’ll need to tap sooner than later.

With a basic idea of your short-, intermediate- and long-term financial needs in hand, you’re ready to review your 401(k) investment allocation.

But “before you do anything with your 401(k) plan, make sure that the alternative investments in your plan allow you to reallocate wisely,” warns financial planner Jim Shambo of Colorado Springs, Colo.

Because 401(k) plans can differ significantly in terms of how many investment options there are, how often you can switch investments, how much your employer contributes and so on, “the quality of the plan’s investment choices should dictate your moves,” Shambo says.

That said, generic advice is best given in the context of your time horizon:

LONG-TERM INVESTORS

At age 42, Richard Walter figures he has 15 to 20 years before retirement--and several years beyond that before he will need his 401(k) money.

“I don’t know if this is a case of being unsophisticated or too sophisticated,” Walter says. “But I consider this my long-term money. So I know to leave it alone”--even though the money is fully invested in stocks and even though Walter realizes that, in the short run, the stock market could plunge.

As a rule of thumb, the more time you have to invest, the more aggressive you should be with your 401(k) money.

That’s why Scott Lummer, chief investment officer for the 401(k) Forum in San Francisco, an investment advisory service, believes 401(k) money in a long-term bucket should be heavily weighted toward stocks.

You’ve probably heard the statistics: Since 1926, U.S. stocks have delivered gains of about 11% a year on average--even though since 1953 alone, the market has slumped 15% or more over extended periods 14 times.

Bear markets come and go, but the stock market has moved higher over the long run because it ultimately tracks economic growth.

That’s why Nancy Acton, a technical writer who lives in Saratoga, Calif., has 100% of her 401(k) account invested in stock funds.

“I’m only 26,” she says. “I have a long time horizon.”

Others may feel more comfortable with an 80%-20% split between stocks and bonds, or even 75%-25%.

Bonds, GICs and other income-oriented accounts are less likely than stocks to decline sharply in value in the short term, but they don’t offer stocks’ long-term growth potential.

Even so, investors thinking of increasing their stock allocation in their 401(k)s now--perhaps to take advantage of falling stock prices--should do so slowly, cautions Jack Brod, a principal in Vanguard Group’s personal financial services unit.

“When you’re moving from a conservative strategy to a higher-risk one, it’s best to do so gradually,” Brod says. His suggestion: Rather than shift existing money out of safer accounts and into stock funds in your 401(k) plan, change your contribution mix so that new money you invest goes more toward stocks.

INTERMEDIATE-TERM INVESTORS

Many investors who are close to retirement fall into this group. So do some younger investors who simply don’t have savings outside their 401(k) accounts.

For these folks, a more conservative blend of stocks, bonds and cash may be appropriate to stress capital preservation as well as appreciation.

And though planners don’t recommend taking out loans against 401(k) money, the reality is that some young investors may need to do so in the next five years or so.

How to structure a more conservative 401(k) mix?

The typical 401(k) plan, according to a 1997 survey by consulting firm William M. Mercer, offers participants a choice of more than eight investments--usually in the form of mutual funds or mutual-fund-like vehicles.

Typically, this will include one or two funds that invest in U.S. stocks, a foreign stock fund, a balanced fund that invests in a mix of stocks and bonds, a bond fund, a guaranteed investment contract and a money market fund.

Some companies also give investors the option of investing in company stock.

Intermediate-term investors may want to consider having only 60% of their 401(k) money in stock funds, with the rest in more stable alternatives.

A simple way to do this is through a balanced fund, which, thanks to the interest-paying bonds in the portfolio, is unlikely to decline as sharply as a pure stock fund if the market overall tumbles 20%, 30% or more.

The most stable investments, however, tend to be GICs and money market funds.

At the end of 1997, nearly 80% of all plans offered a balanced fund, about two-thirds offered a bond fund, and about 60% offered either a GIC or a money market mutual fund option.

Before you select an investment, make sure you know exactly what you’re getting into, financial planners say.

A 1997 survey by the John Hancock Mutual Life Insurance Co., for instance, found that nearly half of all Americans think bond funds cannot lose money. This is false: Bonds’ value declines if market interest rates rise.

The same survey discovered that nearly half of all Americans thought money market funds could invest in stocks and bonds. This too is false.

SHORT-TERM INVESTORS

People who are two years or less from retirement or who will need 401(k) money to meet basic expenses should think of protecting some of the gains their portfolios have already enjoyed, financial planners say.

In this case, moving some assets out of stock funds and into a nearly risk-free money market fund, GIC or short-term bond fund may be advisable.

Still, even in retirement, you will need some growth investments. So your asset allocation mix still should include stocks. But a reasonable mix in a 401(k) account might be 40% or so in stocks and the rest in more stable, interest-paying investments, experts say.

The greater the sum you’ll need to withdraw in the near future, the lower the stock allocation should be.

Need more help? Any of the major mutual fund companies--Fidelity Investments, Vanguard, T. Rowe Price Investment Services, etc.--offer free guides on asset allocation and retirement issues. Or your company may provide such help in its 401(k) plan literature.

It may be that your allocation is just fine the way it is. But if it isn’t, this is as good a time as any to find that out.

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Where the Money Is

Participants in 401(k) plans had nearly 62% of their plan assets in the stock market as of 1996, a figure that has most likely risen since then, experts say. More stable, income-oriented assets, such as GICs (guaranteed investment contracts, which resemble money market funds or bank CDs), bond funds and balanced funds accounted for the rest of plan assets. How 401(k) assets were allocated, according to a survey of 23,000 plans by the Employee Benefit Research Institute:

401(k) Asset Allocation

Stock funds: 42.4%

Company stock: 19.5%

GICs: 16.7%

Balanced funds: 9.3%

Money market funds: 6.0%

Bond funds: 4.0%

Other: 1.6%

Note: Total does not add up to 100% because of rounding.

Source: Employee Benefit Research Institute