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Your 401(k) Isn't as Bad as You Think

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Employer-sponsored 401(k) retirement plans have a bad rap. You get only a limited number of choices to invest in, and those choices often aren't very good.

Some new research confirms that badly structured 401(k) plans are to blame for some of the losses that workers suffer. Yet although the vast majority of plans have investment options that are good enough for workers to create strong retirement portfolios anyway, most workers aren't up to the challenge.

Who's to blame?
A recent study by the Wharton School of Business and the Vanguard Group took a look at 401(k) plans at 1,000 different companies that together employed nearly 1 million participants. The study, sponsored by the National Bureau of Economic Research, looked at the period from 1998 to 2004, which covered more or less an entire market cycle, including the end of the 1990s bull market, the tech bust, and the beginning of the subsequent rebound in stocks.

The study compared the actual returns that participants earned against theoretical returns for investment portfolios of similar risk that weren't limited to investments that the plans offered. It found that after 35 years, 401(k) savers earn about 23% less than they should have.

But while many people tend to blame the limited investment options that 401(k) plans offer for their bad performance, the study found that 94% of plans had enough choices to let investors create efficient portfolios. Instead of blaming the plans, therefore, the researchers concluded that workers themselves weren't doing the best they could with the choices they were given.

Making the same old mistakes
Among the ways that workers failed to earn the best returns were the following:

  • Lack of diversification. Most participants don't use all of the fund options they're given. In particular, workers tend to invest too little in bond funds, gravitating toward either stock funds on the aggressive end of the investment spectrum or money market or stable value funds on the conservative end.
  • Too much company stock. Workers seem drawn to buying company stock in their 401(k) accounts, perhaps because it's comfortable investing in a business you already know well. Workers at many companies, including Chesapeake Energy (NYSE: CHK  ) , ExxonMobil (NYSE: XOM  ) , and Coca-Cola (NYSE: KO  ) , invest on average half or more of their account balances in company stock. Often times it doesn't make sense to invest yourself both financially and occupationally where you work -- no matter how much confidence you have in the company.

The research only confirms what many have already noticed about how most investors make less than perfect choices. Yet studies like these make a really big assumption about 401(k) participants: that they don't have any substantial assets outside their 401(k) accounts. And although that assumption makes the economic analysis a lot easier, it also risks drawing the wrong conclusions about workers' portfolios.

Crazy-looking choices that might just be rational
Once you remember that a 401(k) account might be just a piece of a worker's overall investment portfolio, what constitutes optimal behavior changes. For instance, you'd typically think that someone who invests 100% of his 401(k) in company stock was taking on an unacceptable amount of risk. Yet if that 401(k) makes up only 5% of that worker's total net worth, then putting all of his 401(k) contributions in company stock becomes a lot safer.

Similarly, choices that seem insufficiently aggressive may in fact be appropriate in combination with other investments outside the 401(k) account. For example, using a 401(k) solely to hold a fund with high-dividend paying stocks like Philip Morris International (NYSE: PM  ) and Kraft Foods (NYSE: KFT  ) might seem like the wrong way for someone to invest who has a long time horizon. Yet if they hold high-growth prospects like Agrium (NYSE: AGU  ) and Netease.com (Nasdaq: NTES  ) in their regular taxable accounts, then their overall portfolio would have the right level of risk for a younger worker.

Moreover, doing so could give them a lower overall tax bill, because any gains would be eligible for the 15% maximum capital gains rate rather than ordinary tax rates up to 35% on 401(k) withdrawals.

Don't judge too quickly
So as you put together your overall investing plan, remember that while your 401(k) account is an important part of the plan, it's not meant to be your only account. If you're smart about what investments you put where, you can prove the researchers wrong and build your overall wealth the best way you can.

The economy looks better, but we're not out of the woods yet. Amanda Kish explains why unemployment is worse than you think.

Fool contributor Dan Caplinger loves his 401(k) and hopes you do, too. He owns shares of Philip Morris International and Chesapeake Energy. Netease.com is a Motley Fool Rule Breakers recommendation. Chesapeake Energy and Coca-Cola are Motley Fool Inside Value picks. Coca-Cola is a Motley Fool Income Investor recommendation. Philip Morris International is a Motley Fool Global Gains pick. The Fool owns shares of Chesapeake Energy. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is the best you can get.


Read/Post Comments (3) | Recommend This Article (2)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 22, 2009, at 4:18 PM, sernow wrote:

    Not to split hairs here, but you need to fully think through this statement:

    "For example, using a 401(k) solely to hold a fund with high-dividend paying stocks like Philip Morris International (NYSE: PM) and Kraft Foods (NYSE: KFT) might seem like the wrong way for someone to invest who has a long time horizon. Yet if they hold high-growth prospects like Agrium (NYSE: AGU) and Netease.com (Nasdaq: NTES) in their regular taxable accounts, then their overall portfolio would have the right level of risk for a younger worker.

    Moreover, doing so could give them a lower overall tax bill, because any gains would be eligible for the 15% maximum capital gains rate rather than ordinary tax rates up to 35% on 401(k) withdrawals."

    It's true that it's likely more tax efficient to have capital gains held in taxable versus tax-deferred accounts. The same is true with high paying dividend stocks that pay qualified dividends. These dividends are taxed (using your above scenario) at 15% if held in a taxable account, but eventually taxed at ordinary income if held in a tax deferred account. Ideally these holdings should be in a Roth IRA and possibly a Roth 401K.

  • Report this Comment On September 22, 2009, at 8:48 PM, TMFGalagan wrote:

    Sernow -

    Thanks for your comment. The difference is that with the dividend stocks, you're paying that taxes immediately year after year as you receive dividends. The loss of tax deferral offsets the lower rate somewhat. In contrast, you can defer capital gains tax even in a taxable account as long as you hold onto your shares.

    Your point is well-taken -- if you have a Roth option available, that could be best. Still, if I wanted to have a portfolio that combined dividend payers and non-dividend payers and had to allocate them between a traditional 401(k) and a taxable account, I'd put the non-dividend payers in the taxable account to take greater advantage of the tax deferral.

    best,

    dan (TMF Galagan)

  • Report this Comment On September 23, 2009, at 11:16 AM, gulph wrote:

    Could you please post a link to the Wharton School/Vanguard study? Thanks.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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