The 401(k) Conundrum

A year after my dad died, my mom still has not looked at his 401(k). She recently asked me, "Is a 401(k) a good investment?"

I'm sure my mom is not alone. After all, the former SEC chairman, Arthur Levitt, instituted a variety of mutual fund disclosure reforms because he had trouble reading the prospectuses.

According to a recent study from Wharton professor Olivia Mitchell, the 401(k) market is still fraught with confusion. But with the decline of traditional pensions -- as seen with major changes at companies such as GM (NYSE: GM), IBM (NYSE: IBM), and Ford (NYSE: F) -- it's more crucial than ever that Americans understand their 401(k)s.

The Wharton study covers 2003 and 2004. In all, the study includes 1.2 million participants from 1,500 plans (data provided by The Vanguard Group). Main conclusion: About 80% of workers made no changes to their 401(k)s, and only 10% made one change.

On the face of it, this sounds good. That is, investors are taking a long-term approach. The problem? Investors may not be properly using asset allocation.

Asset allocation involves the strategies of dividing your portfolio across different investments, such as stocks, bonds, cash, and foreign securities. Using sophisticated analysis, a good asset allocation plan can improve return while lowering risk.

Yet, according to the Wharton study, only about half of the workers had exposure to equity funds, and only 20% had foreign investments. In other words, it's likely to take longer to reach retirement goals because of more conservative asset allocation strategies, as foreign exposure has historically offered lower risk (as measured by standard deviation, compared to a portfolio of domestic equities) and the prospect of higher overall returns.

Something else important about asset allocation is rebalancing. This means changing the asset mix over time on the basis of such things as age and portfolio concentration. For example, if foreign investments have done very well, they may represent too much of the overall portfolio. This means selling a portion of these investments and allocating money to other segments.

And, no doubt, the Wharton study recommends that investors seek out educational materials. There's no shortage of resources out there, one of which is the Motley Fool Rule Your Retirement newsletter service.

"One thing that may be useful is the so-called 'life cycle' mutual fund," Mitchell said. "With these funds, money managers are charged with rebalancing over time and also trend the portfolio toward more conservative holdings with age. This reduces the need of the individual worker to focus on the account quarterly or annually, remember his PIN number, and make the difficult decisions."

Fool contributor Tom Taulli does not own shares mentioned in this article.