As traditional defined-benefit pensions become increasingly rare, more Americans instead are offered employer-sponsored 401(k)s, defined-contribution plans that require participants to be more proactive and educate themselves. Here are the biggest pitfalls experts say can do the most damage to your nest egg.
Not having one. Let’s get this one out of the way. The experts unanimously agree that the biggest mistake you can make is to not have a 401(k), especially if your employer matches your contributions. Collectively, we’re ridiculously underfunded for retirement
Going with the default contribution level. Some people assume that their plan’s “default” contribution level is sufficient to fund retirement: It’s not. The most common default contribution level is 3% of an employee’s income, but Stephen Utkus, principal and director in the Vanguard Center for Retirement Research says people with a household income of between $50,000 and $100,000 should be saving 12% to 15%, between their contributions and whatever their company matches. People who make more than that should aim to save 15% to 20%, and workers earning below $50,000 should ideally be socking away 9% to 12%.
Abandoning a 401(k) after you switch jobs. With all of the upheaval that comes with switching jobs, it can be easy to forget about rolling over your 401(k). But letting one languish can have serious consequences, says Dana Levit, owner of Paragon Financial Advisors, a fee-only financial planning firm. The funds themselves where your money is parked could change to the point where they no longer fit your investment goals, and if the plan changes hands, your money could get dumped into cash by default, where it won’t even keep up with inflation. So don’t put off a rollover once you’re eligible to join your new company’s plan.
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Withdrawing funds too soon. Cashing out your retirement fund is a horrible idea all around. The money will be taxed at your regular income tax bracket, plus you’ll get hit with a 10% penalty fee. On top of this, you’re spending the money you need to grow — eating your seed corn, so to speak. “If you tap it today, you’re not going to have it tomorrow,” Utkus points out. A slightly better option is borrowing against your 401(k). It’s still risky, financial advisers say, but withdrawing in advance of your allowed draw-down date should be an absolute last resort.
Trying to play “catch up.” People who start saving for retirement late, or who stop contributing for a period of time, are often under the mistaken impression that they can make up for lost time later, says Levit. But the market doesn’t work like that: Not only does doing this deprive you of the returns you’d be getting on that money if you had invested it, but you expose the savings you do have to a lot of risk because what laypeople think of as “catching up,” financial advisors call “chasing returns,” and they warn that it’s a losing proposition. A fund that’s going gangbusters could be something super-risky like an emerging markets or foreign-debt fund that just happened to have a good quarter, Levit says. “I think they can sometimes overestimate how safe the market is.”
Not having a diverse portfolio. In an attempt to keep things simple, people may funnel their contributions into just a couple of stocks or mutual funds. a lack of diversification is bad because it is, by definition, riskier,” says Kent Grealish, an hourly-rate only investment advisor with Quacera LLC. Having a balanced portfolio — that is, one that includes stocks of different kinds and sizes along with bonds — shields you from market volatility.
And even after Enron imploded and took many of its employees’ nest eggs along with it, Grealish says a lot of people ignored the cautionary tale and still hold too much company stock, which magnifies the risk of an insufficiently diverse portfolio. Grealish says if you do hold a lot of company stock, pare that down to a maximum of 5% of your portfolio.
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Being too cautious when you’re young. While some older workers try to grow their nest egg too much, too fast, younger workers often fail to take advantage of the growth potential a more aggressive portfolio allocation gives them, says Beth McHugh, vice president of thought leadership at Fidelity Investments. The rule of thumb is to take your age and subtract it from 110. The remaining number is the percentage that should be in equities, as opposed to safer, more conservative assets. If you’re 25, this means 85% in stocks. At 35, you’re still looking at a mix including 75% stocks.
“Setting and forgetting” a target date fund. Target date funds get a bad rap because they try to apply a one-size-fits-all approach to retirement savings. Investment experts are lukewarm on them but concede that they have their place. Simply defaulting to the target date fund isn’t a bad idea,” Grealish says. “it is just not as good an idea as going through the decision making process and being sure that this actually fits your needs.”
If you know nothing about investing, target date funds are a good place to start out and a better alternative than not saving at all. But although they take much of the guesswork out of investing, you still need to give yours an annual checkup, McHugh says. Even though target date fund allocation is designed to change to more conservative holdings as time goes on, your personal tolerance for risk should still come into play, especially if you’re nearing retirement (by which time you hopefully have picked up a little more knowledge about how investing works.)
Panicking after a bad quarter. Dumping a fund in your 401(k) after it tanks and replacing it with one that’s been doing well might seem smart, but the net result is that you end up selling low and buying high — the exact opposite of sound investing. McHugh says a lot of accountholders yanked their money out of equities and parked it in cash in the wake of the recession. But those investors missed the start of the recovery. Even if they got back into stocks three or six months after the market started turning positive again, they made out worse than those who stayed the course, McHugh says.
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Not paying attention to fees. Starting last year, a new law required plans to spell out more clearly how much 401(k) accountholders pay in fees and expenses. But many of us are still in the dark. One recent study says that only about half of plan participants know how much they’re paying, and about a quarter (mistakenly) think they don’t pay any fees. This head-in-the-sand attitude isn’t smart, since the fees you pay on your 401(k) come straight out of your returns and eat away at your gains. Trade group LIMRA says average fees tend to fall between 1% and 2%, but that range varies tremendously based on the size of the plan. The Government Accountability Office says people in small plans pay an average of 1.33% for “recordkeeping and administrative services,” compared with only 0.15% for large plans.
“If they’re paying more than 1% they should be concerned,” Grealish says. If you’re concerned about fees or want to balance an investment with higher expensees, he suggests looking at index funds. “A good index fund might charge 1/10 of 1%.”