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How to Make Your 401k Work Like a Pension Plan

They are not the headlines workers want to see splashed across the business section of their newspaper: traditional employer-funded pension plans outperformed worker-funded 401k plans during the 2000-2002 bear market.

The headlines, based on a recent study conducted by the employee benefit consulting firm of Watson Wyatt Worldwide, bolster critics' arguments that 401k and similar retirement plans are not up to the task, compared with defined-benefit pension plans, of preparing Americans for a financially secure retirement.  Regardless of the merits of the criticism, 401k type plans in which workers do the bulk of the funding and make the investment decisions remain a fact of life for workers. And fortunately, within the findings of the Watson Wyatt study and from outside experts, lie keys to what workers can do to improve the performance of their 401k accounts.

The study found that while both types of plans lost money during the three-year bear market, 401k plans fared worse by an average of 3.86 percent a year compared with professionally managed pension plans. Although 401k plans outperformed pension plans during the three years preceding the bear market, pension plans still averaged better returns than 401k accounts over a 12-year period ending in 2002, according to Watson Wyatt:  7.42 percent annually for pension plans versus 6.86 percent for 401k accounts.  That may not seem like a lot of difference, but over decades of investing for retirement, it can add up to tens or even hundreds of thousands of dollars. 

So what can employees managing their own 401k or similar retirement account do to bridge the gap and ensure that their account helps provide adequate income for their retirement? 

Rebalance your assets.  One of the key findings of the study was that most workers failed to rebalance their 401k accounts.  Pension plans, however, following a disciplined investment plan, regularly rebalance their assets to reduce risk and maintain their various asset categories, such as stocks, bonds, and cash, in the desired ratios described in the plan. 

The consequences of not rebalancing periodically became apparent in the wake of the boom market years of 1995-1999.  Because workers typically didn't rebalance, the stock portion of their portfolios grew disproportionately large compared with other types of assets.  By 1999, stocks comprised 72 percent of 401k account values, according to the Federal Reserve Board, while defined-benefit pension plans held only 59 percent in equities.  Thus, when the stock market tumbled in 2000-2002, stock-heavy 401k accounts suffered steeper losses.

Diversify.  As the rebalancing issue illustrates, it's important to maintain a diversified portfolio.  When some assets are down, others may be up to help offset losses.  For example, while stocks suffered during the bear market, bonds and real estate did well.

The Watson Wyatt study found that large company 401k plans performed better than plans run by small companies.  The study attributed the difference to the fact that plans of larger employers typically offer more investment options, thus allowing for greater diversification. 

Many investors don't take advantage of this, however.  According to a 2003 study by Hewitt Associates, while the average 401k plan offered 13 mutual fund choices, participants held only 3.6 funds.  More important, four in ten employees held only one or two asset classes, such as stock or conservative stable-value funds.  They weren't spread out into bonds, or perhaps international funds if they were offered. 

Easy on the company stock.  The Hewitt study noted that the average 401k participant who held employer stock devoted 42 percent of his or her account to that stock, despite recommendations from many financial planners to limit company stock to no more than 10 or 15 percent of the portfolio's value.  As Enron and other major corporate bankruptcies illustrated, overweighting company stock can be very risky. 

Contribute and make the match.  The bear market scared many workers from even making contributions to their 401k plan.  Yet 401k plans will be the main source of income for many retirees.  At least contribute enough to maximize any company contribution matches, and ideally increase contribution amounts every year.  And you can always shift account assets into less risky investment options in the plan.  You don't have to only be in growth stocks, for example.

This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Safe Harbor Financial Planning, a local member of the FPA. 

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