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© 2012 Morningstar, Inc. All rights reserved.

How to Make the Most of Your 401(k)

(or 403(b)/457)

× Christine Benz, Director of Personal Finance

× Adam Zoll, Assistant Site Editor

Money Smart Week, April 7

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Why a 401(k) (or a 403(b)/457)?

× Payroll deduction is an easy and convenient way to save for

retirement

× Your employer may provide matching funds that help your retirement

savings grow faster

× Earnings in the account grow tax-free or tax-deferred

× You get a tax break when you contribute to the plan (with a

Traditional account) or when you take money out (with a Roth

account) once you reach age 59½

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4 Key Questions to Ask

× How Good Is My Plan?

× Are My Savings on Track?

× How Should I Allocate My 401(k), 403(b), or 457 assets?

× What Do I Do With the Assets When I Leave My Job?

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Question 1: How Good Is My Plan?

Things to consider:

× Fund lineup

× Fund expenses

× Plan expenses

× Company match

× Roth 401(k) option

× Availability of additional help

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Fund lineup

× At a minimum it should include:

× U.S. large-cap stock fund

× U.S. small-cap stock fund

× Foreign-stock fund

× Bond fund

× Index funds: often your cheapest option

× Target-date funds: good for set-it-and-forget-it investors

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Fund expenses

× Charged by the company that runs the fund

× Appear on your plan disclosure statement and expressed as a % of

assets and as a dollar amount per $1,000 invested

× Actively managed (non-index) funds should charge no more than 1%;

index funds no more than 0.25%

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Plan expenses

× Charged by the plan provider to cover record-keeping, customer

service, administrative costs, etc.

× These may be spelled out on your plan documentation, or you may

need to ask the plan administrator

× Find out about fees charged for services such as using the plan's

brokerage window or taking out a loan

× Smaller-company plans tend to cost more for participants than larger-

company plans

× Median 401(k) fees per participant (including fund and plan expenses;

Source: ICI, 2011):

× Plans with <100 participants: 1.29%

× Plans with >10,000 participants: 0.43%

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Company match

× Money the company contributes to the plan on your behalf

× Typical setup: Employer contributes 50 cents for each dollar you put

in, up to 6% of pay

× Find out the vesting schedule—when the matching money becomes

yours

× Even in a poor plan, it often pays to contribute at least enough to get

the match

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Roth 401(k) option

× Allows participants to invest post-tax money today in order to enjoy

tax-free withdrawals in retirement

× Best used by those who expect their income tax rates to be higher in

retirement than they are today

× May be combined with a Traditional 401(k) for tax diversification

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Additional plan features

× Find out if the plan offers free investment advice

× Ask about plan rules for hardship withdrawals—to cover medical or

college costs, or to purchase a home, for example

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If your plan is bad

× Talk to the company benefits department about where it falls short—

they may not be aware of the problems

× Consider saving enough for the company match, then maxing out an

IRA, then adding to the plan

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Question 2: Are My Savings on Track?

Things to consider:

× The role your 401(k) plays in your retirement plan

× How much you will need in retirement

× Road-testing your savings plan

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The role your 401(k) plays in your retirement plan

Other retirement-savings vehicles may include:

× IRA

× Social Security

× Your home (downsizing, reverse mortgage, etc.)

× Other savings

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How much you'll need in retirement

× Lots of moving parts: number of years until you retire, how much

you've saved so far, your savings rate now and in the future, whether

you will work in retirement, whether you have a spouse who also is

saving, and when you will take Social Security

× Common (but imperfect) rule of thumb: save 15% of pay, including

the company match and any IRA contributions

× Better still: Use online retirement calculators to see where you stand;

the more detailed, the better; try at least three different ones

× Consider talking to a fee-only financial advisor if needed

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Road-testing your savings plan

× As you get closer to retirement, use the 4% rule to see where you

stand

× Example: You've saved $500,000. Could you live on 4% of

that amount ($20,000) plus Social Security your first year?

× If you don't have enough saved, ramp up saving and/or consider

working longer

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Question 3: How Should I Allocate My 401(k), 403(b), or 457

Assets?

× Three key ways to allocate your 401(k) or other company retirement

plan

× Method 1: Buy a target-date fund and call it a day

× Method 2: Take advantage of “advice engine” provided by

your plan

× Method 3: Allocate your own assets

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Method 1: Buy a target-date fund and call it a day

× How it works:

× Target-date funds are designed to be “set it and forget it”

× Pick the fund that matches your anticipated retirement date,

and the target-date fund takes it from the there: sets and

updates stock/bond mix and selects underlying investments

× Morningstar’s favorite target-date series: T. Rowe Price,

Vanguard

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Method 1: Buy a target-date fund and call it a day

Pros

×You don’t need deep investing knowledge

×Enables you to take advantage of professional asset-allocation advice

×Limited upkeep requirements; may help you combat bad behavior

Cons

×Eggs in one basket: Most target-date funds feature funds from a

single firm, and few firms do everything well

×Target-date funds aren’t universally good; some are costly or draw

from subpar lineups

×Preset stock/bond mix may or may not suit your situation

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Method 2: Take advantage of ‘advice engine’ offered by your

plan

× How it works:

× You answer a series of questions about your financial

situation and other assets

× Advice engine suggests a recommended allocation using

funds available in your plan

× Some plans even take the next step and implement those

recommendations for you

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Method 2: Take advantage of ‘advice engine’ offered by your

plan

Pros

×You don’t need deep investing knowledge

×Usually free of charge

×Enables you to take advantage of professional asset-allocation advice

×Limited upkeep requirements; may help you combat bad behavior

Cons

×Not available at many employers

×Recommended stock/bond mix may or may not suit your situation

×Recommendations may not be 100% objective

×Portfolio may suffer from “de-worsification”—too many options

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Method 3: Allocate your own assets

× How it works:

× You determine the stock/bond/cash mix that best suits your

situation and preferences

× You research and choose individual investments

× You handle ongoing maintenance

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Method 3: Allocate your own assets

Pros

× Allows you to customize your choices and make updates when you

see fit

× Allows you to produce a portfolio that conforms to your philosophy

(e.g., all index funds)

Cons

× You may not have the time or knowledge to build and maintain the

portfolio

× Free rein/limited guardrails can lead to behavioral traps like

performance-chasing, excessive loss aversion

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How to allocate your own assets

Step 1: Arrive at a suitable stock/bond mix

Factor in your age

×Under 40, or even 50? Most of your portfolio belongs in stocks

×Over 50? Start taking risk off the table

Good sources of asset-allocation guidance include:

×Target-date funds (Vanguard, T. Rowe Price’s series are M* favorites)

×Morningstar Lifetime Allocation Indexes:

http://corporate.morningstar.com/us/documents/Indexes/AssetAllocatio

nsSummary.pdf

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Sample asset allocation for someone just starting out

× Investment mix of retirement assets for accumulators should skew

heavily (or entirely) toward stocks, be diversified globally

U.S. Stocks: 54%

Non-U.S. Stocks: 35%

U.S. Bonds: 6%

Non-U.S. Bonds: 1%

Treasury Inflation-Protected Securities:0%Commodities: 4%

Source: Morningstar’s Lifetime Allocation Indexes, Moderate Index for Retirement in 2055

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Sample asset allocation for 40-somethings

× For people in their 30s and 40s, equity allocations remain high, but

bonds grow a bit; portfolio begins to be slightly less global

U.S. Stocks: 57%

Non-U.S. Stocks: 30%

U.S. Bonds: 7%

Non-U.S. Bonds: 1%

Treasury Inflation-Protected Securities:0%

Source: Morningstar’s Lifetime Allocation Indexes, Moderate Index for Retirement in 2040

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Sample asset allocation for 50-somethings

× Bond stake increases at the expense of stocks; foreign weightings

continue to decline

× Inflation protection plays a greater role

U.S. Stocks: 47%

Non-U.S. Stocks: 19%

U.S. Bonds: 21%

Non-U.S. Bonds: 3%

Treasury Inflation-Protected Securities:3%

Source: Morningstar’s Lifetime Allocation Indexes, Moderate Index for Retirement in 2025

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Risk continues to diminish at age 60 and beyond, but stocks

take up a big share of the portfolio

× Positions in safe securities—cash and bonds—drift up

× Inflation protection also increases to help protect purchasing power

Source: Morningstar’s Lifetime Allocation Indexes, Moderate Index for Retirement in 2015

U.S. Stocks: 31%

Non-U.S. Stocks: 10%

U.S. Bonds: 34%

Non-U.S. Bonds: 5%

Treasury Inflation-Protected Securities:12%

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How to allocate your own assets

Off-the-shelf asset-allocation guidance is a start, but take into account:

×Human capital: volatility of work earnings

×Other assets, such as a pension

×Spouse’s asset-allocation choices

×How much you have saved (less = somewhat higher equity

weighting)

×Your risk capacity

×How long you expect to be retired (longer = higher equity weighting)

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Step 2: Populate your portfolio with high-quality core funds in

line with your asset-allocation preferences

Core Noncore

Large-company stocks and funds Company stock

Broad-market index funds Sector funds

Intermediate-term bond funds Small-company stocks/funds

Broad foreign-stock funds Emerging-markets funds

Balanced funds Region-specific funds

Target-date funds

TIP: 80%-100% of most portfolios should consist of core investments.

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How to identify great core funds

× Cheap out. Look for:

× U.S.-stock fund expense ratios less than 1.00%

× International-stock fund expense ratios less than 1.25%

× Bond-fund expense ratios less than 0.75%

× Simplify: Index funds can be a solid choice

× Evaluate quality of firm: Morningstar Stewardship Grades

× Look for long manager tenure: At least 5 years, preferably 25

× Consider past returns over a number of market environments (though

remember the limitations!)

× Read analyst reports for a qualitative overview

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Question 4: What Should I Do With the Assets When I Leave My

Job?

× Four key options

× Option 1: Take the money and run

× Option 2: Let it be

× Option 3: Roll it into an IRA

× Option 4: Roll it into a new employer’s plan (only an option if

you’re not retiring)

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Option 1: Take the money and run

Pros

×Access to a lump sum all at once—can use to pay off debt, etc.

Cons

×Ugly tax treatment: Money taxed as ordinary income plus incurs a

10% penalty if you’re under age 59½

×Your money will no longer benefit from tax-deferred compounding (or

tax-free compounding, if you’re in a Roth option)

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Option 2: Let it be

Pros

×Plan may be low-cost and top-flight

×Plan may feature options unavailable outside of 401(k)s, such as

stable-value funds

×If you’re over age 55 and have left your employer, can tap money

without a penalty (must be 59½ to tap an IRA)

×401(k) plans may have extra legal protections unavailable in an IRA

Cons

×Company may not allow it

×You may be paying an extra layer of expenses that you could avoid by

rolling over into an IRA

×Difficult to monitor many different accounts

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Option 3: Roll it into a new employer’s plan

Pros

×Can make sense if new plan is gold-plated: ultralow fees plus strong

investment lineup

×If using advice from provider, can get more holistic view of various

accounts

Cons

×Won’t be an option if you’re retiring

×May pay extra administrative costs that aren’t present in an IRA

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Option 4: Roll it into an IRA

Pros

×Can avoid extra layer of fees that may accompany 401(k) plans

×More choices: Can take advantage of “open architecture” and buy

almost anything

×Less oversight: Can roll multiple 401(k)s from multiple former

employers into a single IRA

Cons

×You may miss out on 401(k)-only choices, such as stable-value and

institutional funds

×May miss out on some legal protections available with 401(k) wrapper

×Lack of guardrails makes it easier to get into trouble

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5 Key Takeaways

× Pay attention to costs

× Always get the match

× Keep it simple

× Be holistic about your retirement plan

× Get help if you need it

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