If you want to retire comfortably, it's crucial that you regularly contribute to your 401(k), 403(b), TSP, or other employer-provided retirement plan if one is available to you. Unfortunately, many employers do a lousy job of helping their employees start investing.
Unless you're already well versed in investing, the abundance of investment options can seem overwhelming -- and prevent you from making good decisions with what may be the biggest investment of your life. But allocating your retirement plan contributions doesn't have to be complicated. In fact, there are just two big factors you need to consider -- and the rest, in a decent employer-sponsored plan, is just details.
Factor 1: When do you need the money?
The more time you have before you need your retirement savings, the more market volatility you can handle.
- If your time to retirement can be measured in decades, your portfolio should heavily favor stocks, which, compared to other asset classes, are relatively volatile but achieve high long-term growth.
- If your time to retirement can be measured in a few years, make sure you have bonds -- a safe but slow-growing asset -- to cover expenses when necessary.
- If you have a countdown clock to your retirement date (or have already retired), there's nothing wrong with having enough cash to cover your short-term expenses.
Even once you reach retirement, you won't need all of your money at once, so it makes sense to keep your money in different investments based on when you need to spend it -- stocks for money that won't need to be spent for several years, bonds for money you'll need in the next few years, and cash for the money you'll spend within the next year or so.
Factor 2: How much do you need?
The less you need to withdraw from your retirement account in retirement, the more aggressive you can afford to be with your investments. Your allocation to bonds and cash should be based on your near-term and medium-term spending needs. You can keep money you won't need in the near future in higher-risk, higher-return assets like stocks, which may take years to realize the solid returns they have historically achieved.
This means that the less you need your retirement account to cover, the bigger your account may be in the end, because you'll be able to keep more of it in stocks. Keeping your costs of living down is critical to keeping the ratio of what you need versus what you have as low as feasible. It also helps if you have other sources of retirement income, like Social Security, a pension, or a job you do for fun and spare cash, which keeps the pressure off of your retirement plan.
Plug those factors into your employer's plan
With those two key factors in mind, it should be much easier to make solid choices within your retirement plan at work, no matter how complicated that plan may seem. No matter how many options you have available, you should be able to break down each of your plan's options into one of five categories:
- Stock funds
- Bond funds
- Cash or money market funds
- Target date plans
- Advanced options
Stock funds are options that own equity stakes in companies. These have the highest long-term potential return rate of any option typically offered in company retirement plans, but they also have no day-to-day guarantees and are frequently subject to high volatility. While your mid- and short-term money belongs elsewhere, the long-term money in your retirement plan likely belongs in stock funds.
You may have just a few stock funds or a dizzying array available to you. There are two key factors you'll want to consider in making your choices: internal costs and diversification. From a cost perspective, the lower the fund's internal costs, the better off you'll be.
From a diversification perspective, a broadly diversified option is often a better choice than one that limits its internal options. The phrase "index fund" is frequently a decent indicator of diversification, but be wary of "sector index funds," which are only diversified within a small slice of the economy.
You may also have to choose from different market capitalizations (such as small cap, mid cap, and large cap) and geographic regions (such as domestic, international, or total world). Feel free to venture out if you'd like, but a low-cost, domestic, large-cap index fund that tracks the S&P 500 is a perfectly acceptable place to get started.
Bond funds hold corporate or government debt. They generally return more than cash but less than stocks. Bonds come with "maturity dates," or dates when they are expected to pay in full and cease to exist. Those maturity dates put a cap on the total potential return for bonds.
Bond funds within retirement plans are often split by short-term, medium-term, and long-term durations, matching bonds of similar maturity dates within each option. Your objective with bond funds is to match the duration of the fund with when you expect to need the money. If you'll need it within a few years, think short-term. If it'll be more than a few years, but less than six to eight, think mid-term.
With interest rates as low as they are right now, though, long-term bond funds may be more dangerous than you'd otherwise think, as their return potential is capped by those low interest rates. Additionally, long-term bonds are most susceptible to losses in current value from higher interest rates. For those reasons, your long-term money is likely better off in one or more of the stock funds in your retirement plan.
Cash or money market funds are useful options for holding money you expect to need in the very near future. They may also be the "default" investment if you decide to put money in your retirement plan but don't specify any other investment choice. If you have money piling up in your cash or money market option, and you don't expect to need that money in the near future, you should look for an alternative option with better long-term prospects.
Target date funds allocate your capital based on your expected retirement date, investing in a manner that shifts from more aggressive to more conservative as that target retirement date gets closer. These plans may make sense if you're just getting started or you want the ultimate "one-stop" investment. But you'll want to watch the fees -- not only the fees the target date fund charges directly, but also the fees charged by the holdings that the target date fund itself holds.
Advanced options may include precious metals, other commodities, real estate, or other asset classes that could be useful for some people at your company. If you're just getting started with your retirement savings, though, you should largely ignore these choices.
Keep it simple -- and get investing
If you want to retire in comfort, getting started early and investing consistently throughout your career is more important than any other factor. So don't let the confusing array of choices in your company's retirement plan keep you from making the simple and straightforward decision to invest in the first place.
- Stocks for your long-term needs
- Bonds for your mid-term needs
- Cash for your near-term expenses
- Keep costs low (both investing costs and the costs your nest egg will ultimately need to cover
In the end, the rest is just details.