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| The Basics | 5 years later, many 401(k)s are still at risk
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The market-bubble burst in March 2000 taught us the value of diversification. But many 401(k) plans still don't offer choices investors need to protect themselves.
By Liz Pulliam Weston
For most 401(k) participants, the popping of the stock-market bubble in March 2000 was like being trapped in a falling elevator.
Chances were good that:- You didn't have enough investment choices to adequately protect yourself.
- You weren't taking proper advantage of the options you had.
- Your company provided little if any guidance on the best ways to endure a prolonged downturn.
A lot has changed in five years. The risks of inadequate diversification have become all too clear. Technology stocks are still well below their peak, the Standard & Poor's 500 has gone nowhere and far too many workers have lost their nest eggs to overindulgence in company stock.
But chances are still pretty good that:- You don't have enough investment choices to protect yourself.
- You aren't taking proper advantage of the options you have.
- Your company is providing little if any guidance on the best ways to endure a prolonged downturn.
Lack of diversification costs huge
A study of 401(k) plans released last month found that 62% failed to offer enough plan choices for workers to build adequately diversified portfolios.
The cost of inadequate diversification is huge. Workers who had enough choices, and who used them properly, averaged annual returns of 10.7% over a 20-year period, according to the study, which was conducted by professors at New York and Fordham university business schools. That compares to the 7.5% averaged by the workers with inadequate plans.
Over 30 years, the worker with higher returns who contributed $10,000 a year would build a nest egg of nearly $1.9 million. The worker with lower returns would amass just over $1 million -- an $845,000 difference.
Workers who maintain investments outside their 401(k)s have at least some chance to protect themselves. They can use their IRAs or other accounts to try to balance out the deficiencies of their workplace retirement plans, loading up on foreign funds, for example, if that's not an option offered in their 401(k)s.
But 401(k)s are the only financial asset of a majority of workers -- six out of 10 -- according to research by the Investment Company Institute. So an inadequate plan could condemn them to an inferior retirement.
The authors of the 401(k) adequacy study, Martin Gruber and Edwin Elton of New York University's Leonard N. Stern School of Business, and Christopher Blake of Fordham University's Graduate School of Business, believe a good 401(k) would offer the following eight options:- Large-company growth stocks
- Large-company value stocks
- Small- and medium-company growth stocks
- Small- and medium-company value stocks
- International stocks
- High-quality domestic bonds
- High-yield domestic bonds
- International bonds
The researchers found that large-company 401(k) plans were far more likely to offer enough choices to build a diversified portfolio than their small-company peers. Indeed, research by Hewitt Associates found that the majority of large companies surveyed offered almost all of these investment choices -- the exceptions being international and high-yield bonds.
Workers not utilizing all choices
But the presence of these options doesn't ensure their proper use. Hewitt's latest asset-allocation study, conducted in 2003, found the vast majority of worker savings in just a few categories: low-return money market and stable market funds, large-company stock funds and, heaven forbid, company stock. (The good news is that the percentage of worker money allocated to their own company's stock in plans that offered that option shrank from 41% in 1999 to 30% today -- but at 30%, it's still well over the maximum 10% that financial planners recommend.)
| Large-company 401(k) plan options | | % of plans offering option | Investment option | Assets allocated* | | 52% | Money market | 13% | | 63% | Stable value | 23% | | 19% | Short-term bond | 6% | | 40% | Bond index | 5% | | 49% | Intermediate/long-term bond | 6% | | 5% | Treasury inflation-protected securities | 2% | | 13% | High-yield bond | 2% | | 67% | Balanced | 11% | | 55% | Asset allocation/lifestyle | 10% | | 88% | Large-cap equity | 17% | | 65% | Medium-cap equity | 5% | | 79% | Small-cap equity | 3% | | 70% | Equity index | 11% | | 78% | International equity | 2% | | 34% | Global equity | 4% | | 15% | Emerging markets | 1% | | 7% | Real estate investment trusts | 1% | | 14% | Self-directed brokerage | 2% | | 8% | Sector | 1% | | 49% | Employer stock | 30% | | 16% | Other** | 8% |
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*Assets allocated when plan offers the option
**Includes plans with choices such as international bond funds or a "mutual fund window," offering a wide array of mutual fund choices.
Source: Hewitt Associates
The study authors didn't include a number of other investment options that can help workers diversify, such as real-estate investment trusts, emerging-markets funds and precious metals.
These investments are generally considered to have a low correlation with the overall stock market. In fact, real-estate investment trusts gained more than 20% over the past five years, compared to a 1% loss by the S&P 500 (with all dividends reinvested).
Such alternatives are found in very few plans, however. Just 7% of large-company plans offered REITs, for example, and they attracted only 1% of workers' funds. Only 8% offered any kind of sector fund, which would include precious metals and other commodities, along with other specialty stock funds concentrating on health care, telecommunications or technology. These, too, attracted just 1% of workers' money in total.
'One-stop allocation' to the rescue?
And the trend toward offering more choices to workers seems to have stalled. The average number of choices offered in large-company plans grew from 12 in 2001 to 14 in 2003, according to Hewitt Associates. Subsequent research shows employers don't appear to be interested in adding new options, worrying that more investment choices have led to more confusion and paralysis among workers.
Concern about this confusion, though, is leading to one possible solution for workers faced with inadequate choices. Employers are increasingly interested in offering "one-stop" asset allocation or lifestyle funds that promise to do all the heavy lifting for investors (see "7 hot 401(k) trends").The best of these funds offer wide diversification with exposure to small-, mid- and large-cap stocks, international stocks and enough -- but not too much -- exposure to bonds and other fixed-income investments. Professional managers pick the investments and maintain the proper allocations so that investors don't have to fiddle with their funds.
If your plan offers an asset allocation or lifestyle option, you might investigate its composition to see how well the eight recommended asset classes are represented.
3 steps to DIY diversification
If you don't have that option, and your plan has too few choices to construct an adequately diversified portfolio, consider the following steps:- Use the best of what you've got. Even an inadequate 401(k) is usually better than none at all, and not using your plan is a serious mistake (see "7 most common 401(k) blunders").
- Ask for better choices. Plan providers often present employers with their most popular fund choices, which tend to be large-company stock funds, fixed-income options and whatever is performing well lately. But you're not interested in a popularity contest; you want enough money when you retire. So petition for a more well-rounded selection, and get your coworkers to act as well.
- Fund an IRA. You don't want to pass up your company's match, but once you've contributed enough to get the maximum matching funds, you might consider adding a few bucks to a traditional or Roth IRA. If you open the account at a brokerage, you'll have wide access to funds that can help you supplement your 401(k).
Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.
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