Mellody's Math: Making Over Your 401(k) Plan

Workers lucky enough to avoid getting laid off this year may face a different problem: some companies are suspending or decreasing matching contributions to 401(k) plans.

General Motors, Delphi Automotive Systems and U.S. News & World Report have all cut back on matching contributions to 401(k) plans as part of cost-saving measures. Though these type of cutbacks have not been widespread, analysts are warning that more firms could also chop 401(k) contributions if the nation slips into a severe recession.

You could be next. Employees should take steps to protect their retirement funds. One important step: Invest the maximum amount allowed into your 401(k).

To safeguard your long-term financial goals, first make sure to max out your 401(k) contributions. If you are not currently maxing out your contribution, try your best, because now is a better time than ever, as you need to compensate for the (possible) cuts in your employer match.

See Mellody's 401(k)Survival Checklist

Amid the stock market turmoil of the last 18 months, many people saw their 401(k) plans take a beating. Yet only about 80 percent of 401(k) participants have changed their asset allocation since they started the plan. To explain how to do a 401(k) makeover, I took a look at where one couple went wrong to explain how they could fix the problem.

One Couple's 401(k) Problem

When Cheryl and Alex Peterson met, they each had about $60,000 in credit card debt, but they decided to buckle down and start saving diligently. Now out of debt, the couple, both 33-year-old Boeing employees, bought a house this fall. But their 401(k) plans have been hurting ever since the market soured.

Both of their 401(k) plans were heavily weighted in the most aggressive areas of the stock market. They had invested 60 percent of their money in a science and technology fund, which saw a 74.7 percent decline in one-year returns through Sept. 30, 2001.

The remaining balance of their 401(k) plans were in large-company growth stocks, which were the hottest area of the market — up until March 2000. As is often the case when the markets decline, the best performers have the furthest to fall, and that is what happened.

The Petersons had invested 20 percent of their 401(k) funds in the S&P Index Fund, which saw a 26.7 percent decline in one-year returns, and 20 percent in a growth fund, which saw a 34.5 percent drop in one-year returns. Overall, the Petersons' portfolio had slipped 57 percent over a one-year period.

The problem is that even though Alex and Cheryl are in three different funds, they aren't really diversified, because all of the funds invest in large-cap growth stocks, and five of the top 10 holdings overlap between funds.

Mellody's Solution

Because the Petersons are young and have many years to go before retirement, they should stay 100 percent invested in equities.

Since they have lost significant money in their current allocation, they should leave their current assets where they are, and not make the common mistake of selling out at the bottom.

But they need to change their allocation to a more diversified lineup of funds. Boeing, for instance, has a lot of terrific 401(k) plan options and the company still matches contributions even though the airline industry has had a tough time.

I recommend the following allocation for the Petersons:

Value Fund: 40 percent

Small Companies Fund: 30 percent

Growth Fund: 15 percent

S&P 500 Index Fund: 15 percent

Science & Tech: 0 percent

Retiring as Millionaires

If the Petersons had their portfolio set up this way last year, they would have been down only 12 percent as compared to 57 percent. Plus, that 12 percent loss would be substantially better than how the overall market has done. The S&P 500, the broad market indicator, was down 26 percent for the last year.

The Petersons currently have $31,000 in their 401(k), and would ideally like to retire at age 55, meaning they have 22 years left to save and invest.

To be able to retire at 55, they should maximize their 401(k) contributions every single year. Currently, they can only contribute $10,500 each, but over the next few years, that number will increase under a new tax law that ultimately sets the maximum annual contribution to $15,000 per person by 2006.

If the Petersons make the maximum contribution and achieve a 10 percent return on their entire 401(k) portfolio, they will have $2,523,005 in their 401(k) plan by the time they retire at age 55. That does not factor in their IRA investments and social security, or retirement money that will likely come from Alex Peterson's military work.

But working until age 65 would be even more fruitful for the couple. If they keep working until that age, they will nearly triple their retirement money to $7,343,431.