Millions of Americans are going to receive their quarterly statements for their retirement investments starting this week -- a daunting fact given the market roller coaster ride all of us have been on the past couple of months. Aside from not opening your statement, here is what you need to know to put your mind at ease about your hard-earned retirement dollars.
What is a 401(k), or defined contribution plan, and how does it work?
A defined contribution plan, the catchall category for a 401(k), 457 or 403(b) plan is an employee-sponsored retirement savings vehicle that allows you to put away pretax dollars for your retirement. Typically, employees are given a number of investment options to choose from and can elect how they would like to invest their money. Employees also usually determine how much money they would like to defer from each paycheck. Their contributions and earnings then grow tax free until the assets are withdrawn, at which point they are taxed as ordinary income. A 401(k) is a terrific vehicle to save for retirement not only because of the tax savings but because of the fact that almost 80 percent of employers will match a portion of your contribution.
My biggest worry -- and one that actually keeps me up at night -- is not the choppy market but the fact that people are not taking advantage of 401(k) plans. Almost 25 percent of all employees who have access to employer-sponsored retirement plans do not participate. It is pretty simple -- if you do not put the money away now, there will not be enough for you to live on later. And if your employer offers a match, not contributing is like leaving free money on the table.
How has the recent stock market decline affected most people's 401(k) accounts?
Generally speaking, a typical investor with a broad range of mutual funds is down about 9.5 percent. Interestingly, although it seems like all the bad economic news is coming from here in the United States, international markets are actually worse off. Stocks have fallen more than 15 percent in Europe and are down more than 20 percent in India and 30 percent in China. The message here -- there are few safe places to hide in this really trying market.
There is an important lesson to be learned for 401(k) investors in wake of the fall of Bear Stearns.
The rapid decline of Bear Stearns was a reminder that investors should not put all their eggs in one basket. Bear Stearns employees owned one-third of the company's stock, which fell drastically from $70 to $10 in just three weeks. This was eerily reminiscent of what we saw during the Enron and WorldCom debacle when thousands of employees lost all their retirement savings because they were invested almost entirely in company stock. While Congress has stepped in to limit employee exposure to company stock in their retirement plans, investors are still too concentrated. According to a survey from Hewitt Associates, a leading benefit research firm, nearly two of every five 401(k) plan participants have more than 20 percent of their money tied up in their employer's stock. While the opportunity to own company stock is an important benefit, you need to ensure that the bulk of your wealth and retirement savings are not concentrated there -- diversification is critically important.
What You Should Do
Keep at it. Believe it or not, now is actually the best time to invest in a 401(k). One of the great things about investing in a 401(k) plan is that you contribute money over time and not all at once -- exactly what you should be doing when the stock market is volatile. It is important to remember that bull markets -- one in which stocks are rising -- always follow bear markets -- in which stocks are on the decline. History has shown that after the stock market hits rock bottom in a recession, one year later, stocks on average zoom ahead almost 44 percent!
Do not adjust your 401(k) allocations to favor more conservative investments in an attempt to protect your money. Short-term market fluctuations and downturns are completely normal. While it is important to consistently re-examine the types of investments in your 401(k) and how you are doing, you should never stay on the sidelines or abandon stocks altogether. If you are too conservative, you run the risk of outliving your money. The recommendations I have given before on "GMA" remain the same:
30s and younger: 100 percent stocks
40s: 80 percent stocks and 20 percent bonds
50s: 75 percent stocks and 25 percent bonds
60s: 70 percent stocks and 30 percent bonds
70s and older: 50 percent stocks and 50 percent bonds