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Wednesday, February 29, 2012

Kirk Spano: Picking a fund allocation for your 401(k)


By Kirk Spano
Over the past twelve years the average 401(k) return has been just about zero. Is that all the stock market’s fault? Or, are the funds in our 401(k) plans to blame? The answers are yes and yes. Over the past twelve years we know that the stock market has returned just about nothing and the funds inside of your 401(k) are for the most part pretty crummy.

What can you do about that sort of environment and the corresponding investment returns? There are three things I advise: cut risk, add interest and dividend income and make several tactical asset allocation moves per decade.

In advising clients, we have used a simple strategy for 401(k) investing that has worked extremely well for people at least five years away from taking income distributions. We select a default 401(k) setting of about one half of our money in fixed income subaccounts and the other half in stock funds that pay some dividend. The specific funds we select have to do with our choices and where we are in the economic and interest rate cycles.

Why do we take such a conservative default position? There are a number of reasons.

The first reason is that a 401(k) balance is a big part of most people’s retirement savings. It should not be put at high risk as most people cannot overcome losses fast enough given an ever closer retirement. Having 80% to 100% of your funds in equity subaccounts, which is what many do, exposes a 401(k) to almost all of the stock market risk. That is simply too much risk for a core asset.

Next, most mutual funds, called subaccounts in your 401(k), are pretty mediocre. There are few truly outstanding funds in most 401(k) because of how the plans are sold and set-up. While I have seen and set-up plans that have outstanding investment options, most plans I come into contact with are mediocre at best.

Finally, most people only rebalance their 401(k) about once per year. By contrast, the average institutional account, i.e. a pension or endowment, is rebalanced about eight times per year. In order to maintain an active and engaged 401(k) strategy, a person must be active, engaged and skilled. Most people do not fall into that subset of 401(k) owners simply because they are too busy.

There is an exception to the roughly 50/50 fixed income to equity approach. When the stock market has a serious correction, down 30% or more, it makes sense to increase your equity exposure to around 80%. As the market then rebounds to previous highs in later years, gradually move back to the 50/50 blend. In most decades you will only need to trade four or five times. Buy low and sell high can actually work if you have a simple system in place.

If you are younger and looking for an aggressive investment approach, what I have found to be a good place is within a Roth IRA. Roth IRA balances are generally smaller, thus can do less damage to your overall finances if losses occur versus if you suffer big losses in a larger 401(k) account. Also, in a Roth IRA custodied at a brokerage, you will have many investment choices from which to choose. Finally, there are substantial tax and liquidity advantages to a Roth IRA which coincide well with more aggressive investing.

What I have described is an easy and effective way to grow your retirement balances. It will also help you sleep at night knowing you are not taking a high risk approach with what is likely your largest piece of retirement money. For a handful of people, managing a 401(k) can take a more aggressive look, but for most people, a conservative approach makes a lot of sense.

-- Spano is the founder of Bluemound Asset Management, LLC in Elm Grove, as well as a columnist for MarketWatch.com of the Wall Street Journal network and a contributor to other financial publications. Spano is available to consult on financial planning, investment management and retirement planning. Visit http://www.BluemoundAM.com

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Comments: 12

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