Smart 401(k) Investing—Investing in Your 401(k)
Beyond Mutual Funds
A variable annuity is a hybrid insurance company product, combining a number of funds that resemble mutual funds with insurance protection that guarantees, at a minimum, that your beneficiary will get your principal back if you die before beginning to collect benefits.
Your 401(k) plan may offer variable annuities as well as mutual funds as investment choices. Or, if your plan provider is an insurance company, the plan itself may be a variable annuity.
With a variable annuity, you allocate your contributions among the subaccounts that the annuity offers. Each subaccount has an investment objective and makes investments to meet that objective. Your earnings depend on the investment performance of the subaccounts you choose and the formula the company uses to credit any gains or losses to your account balance.
Variable annuities have some advocates, who point to the insurance protection as a safeguard against losing money. But critics object to the cost of this insurance protection, which makes variable annuities more expensive to own than mutual funds making similar investments. The critics also point out that many variable annuities carry higher management fees than mutual funds do, further raising the expense and reducing your return.
If your 401(k) plan offers a brokerage account, sometimes called a brokerage window, you can invest in stocks, bonds, mutual funds or other investments the brokerage firm handling the account offers. You give buy and sell orders just as you do with a regular, taxable account.
Advocates of this approach think that having the greatest possible choice is the way to allow experienced investors the opportunity to realize the largest possible return on their retirement savings. And because the entire account is tax-deferred, if you sell a stock or bond you’ve purchased through a 401(k) brokerage account for more than you paid, you owe no capital gains tax on the profit—though you will owe income tax when you withdraw from your traditional tax-deferred 401(k) account.
Others worry that having unlimited choice may be confusing or intimidating, and that employees may not have enough information to make wise choices. However, in most cases, plans offer a menu of funds from which you can choose as well as the brokerage window.
In addition, critics argue that investing through a brokerage window might encourage participants to buy and sell frequently, trying to beat the market. This practice, known as day trading or market timing, is at odds with the long-term goals of a retirement savings plan.
The Cost of Flexibility
A 401(k) brokerage account has an annual fee—anywhere from $25 to $175—depending on the brokerage firm the plan uses. There may also be transaction costs and commissions on each trade you make through the account. You may also pay higher fees on mutual funds you buy through the account than on funds that are part of a plan menu.
|When you invest in your company's stock, you may get: |
Should you invest your 401(k) plan contributions in stock issued by the company you work for? That question generates intensive debate, in part because recent events demonstrate the risk of depending too heavily on any single company for your financial security. But your employer may offer incentives that are hard to refuse.
If you work for a publicly traded corporation, your 401(k) investment menu may include company stock or a fund that buys only your company’s stock.
You may find that your employer encourages you to make this choice. For example, you may be able to buy the stock for less than the current market price. You may be able to contribute a higher percentage of your salary if you’re buying the stock. Or your employer may match a higher percentage of your contribution if it goes into the stock.
Your employer may also choose to make any matching contributions in stock rather than in cash. In that case, your account is credited with shares of stock or shares in a company stock fund no matter how you invest your personal contributions. There are financial advantages for your employer in making matching contributions in stock, in part because the company doesn’t have to lay out cash—though all of its matching contributions are tax deductible.
Offering company stock as an investment choice gives employees the incentive of partial ownership in order to strengthen their commitment to the company. It also provides a way to let employees share in the profits if the company prospers.
But if employees have the bulk of their 401(k) money in company stock, their long-term financial security is at much greater risk than if they had built a diversified portfolio.
Learning from History?
The fall of Enron Corporation focused attention on the potentially devastating effect of owning too much company stock. Overall, 57.73 percent of employees’ 401(k) assets were invested in Enron stock as it fell 98.8 percent in value during 2001. But employees at many companies still have even larger percentages of their 401(k) assets in company stock than Enron employees did.
Pros and Cons of Company Stock
|Only 11 percent of plans offer company stock, but 59 percent of participants offered company stock invest in it (How America Saves 2011).|
If company stock is one of your 401(k) plan choices, you’ll be faced with two important decisions: Should you invest? How much of your portfolio should you commit?
There may be good reasons to choose the stock, in addition to any potential financial incentives your employer offers. If you work for a strong company in a strong market sector, you could realize a substantial gain from owning the stock. But there are potentially serious problems.
You can’t ignore the fact that you already depend on your employer for your current income, so you’d be tying your financial security even more tightly to a single source. In the worst possible circumstance you could be out of a job, and that portion of your 401(k) portfolio committed to company stock could be totally worthless. Experts disagree on how much company stock in a 401(k) account is too much, but many prefer a maximum of 10 percent to 15 percent.
You may have less flexibility to change the allocation of your plan assets if some of your money is invested in company stock. But a 2006 federal law requires companies to let employees sell company stock they received as an employer match after holding it for three years. That could result in losses if the share price dropped before the time limit expired. However, some companies may permit you to sell shares received in a match immediately. For additional information, see our Investor Alert, Putting Too Much Stock in Your Company—A 401(k) Problem.