Contents
An Overview of Retirement Plans
Retirement Plan Terminology
401(k) Retirement Plans
403(b) Retirement Plans
457(b) Retirement Plans
Traditional IRAs
Roth IRAs
SEP IRA and SIMPLE IRA Plans
Rollover IRAs
How to Manage Your Retirement Plan
How to Consolidate Different Retirement Plans
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How to Manage Your Retirement Plan
Once you have one or more retirement plans established, you need to decide how to invest the money that you contribute to them throughout the year. To choose the right investments for your retirement plan, you need to:
- Determine your asset allocation
- Select specific investments based on that allocation
How to Determine Your Asset Allocation
Asset allocation is the process of diversifying your assets across a variety of investment types to reduce risk and maximize return. The asset allocation that suits you best depends primarily on your age—in particular, the number of years left until you plan to retire. That said, a few general rules of thumb apply:
- The younger you are: The more time you have until retirement, the more risk you can tolerate. Tolerating risk in this case means being able to invest comfortably in aggressive investments—those that tend to rise and fall dramatically in value but that have the greatest potential for gains over the long term. Examples of these types of investments include small-cap stocks and emerging market international stocks. Here the term cap refers to the size, or market capitalization, of the company. Smaller companies have smaller market caps (market values) than larger companies.
- The older you are: The closer you are to retirement, the less risk you can tolerate. Older participants should favor more moderate or conservative investments, such as bonds, CDs, and money market funds.
Asset allocation is not just about minimizing risk but also about maximizing return. It’s been shown time and again that diversifying your money across various investments that react differently to economic and market changes can lift your overall portfolio performance over the long term.
Sample Asset Allocations
Below are suggested asset allocations for conservative, moderate, and aggressive retirement investors. Often, the easiest way to allocate your retirement plan funds is by using index mutual funds or index ETFs (exchange-traded funds). These investments contain a basket of stocks or bonds of one particular type, such as small-cap stocks, large-cap stocks, international stocks, or bonds. One particularly conservative option is a money market fund—
a mutual fund that invests in short-term debt instruments that, though not FDIC-insured like a bank account, are very safe. (For more information on asset allocation, see the Quamut guide to Investing Basics.)
Conservative Asset Allocation
Moderate Asset Allocation
Aggressive Asset Allocation
Rebalancing Your Investments
Asset allocation has a major impact on long-term investment performance, so it’s crucial to maintain the optimal allocation for your age. Because different types of investments tend to grow at different rates, you must rebalance your retirement assets (and any other investment accounts you own) at least once a year. Rebalancing means selling assets that have grown in value and then using those proceeds to add to your slower-growing assets in order to bring your asset allocation back in line with the ideal allocation for your age group. If you don’t rebalance, your asset allocation can drift significantly out of line over time.
How to Select Investments
Once you’ve determined your asset allocation, you’re ready to select investments to fill each slice of the pie. Most retirement participants use mutual funds to build a portfolio in line with their target asset allocation.
Picking Mutual Funds for Your Retirement Account
A mutual fund is a large investment portfolio managed by a professional manager. Most mutual funds own stocks or bonds, though some funds own a blend of both. All mutual funds can be divided into two types:
- Actively managed funds: Funds in which managers make their own picks for their portfolio and actively buy and sell securities
- Passively managed funds (index funds): Funds that attempt to mimic the performance of an established broad-market index (such as the S&P 500, which includes 500 of the largest U.S. companies)
Actively Managed Funds vs. Index Funds
Actively managed funds have higher expense ratios than index funds. An expense ratio is a fee that funds assess to cover their costs. High expenses make a significant difference in returns over time. Though you might expect actively managed funds to justify their higher expense ratios with superior returns, in reality, roughly two-thirds of actively managed funds fail to beat their relevant indexes. For these reasons, index funds are often the better choice for most investors.
Tips on Comparing and Selecting Specific Mutual Funds
- Performance: Ignore the previous year’s performance and focus instead on the fund’s performance over the past 5–10 years at least. Keep in mind, however, that past performance is no guarantee of future results.
- Expenses: Avoid index funds with expense ratios over 1.0% (or 1.5% for actively managed funds).
- Manager: Focus on funds with managers who have led the fund for at least the past five years.
Never invest simply on a hunch or based on a tip. Instead, work with a financial advisor (if you can afford one) and/or research mutual funds yourself by consulting a respected source, such as Morningstar (www.morningstar.com).
Stocks, Bonds, and Other Investments
Though IRAs and other retirement accounts allow you to invest in individual stocks and bonds, doing so is generally much riskier than sticking with mutual funds, so it’s not the best choice for most investors. (For more, see the Quamut guides to Stock Investing and Mutual Fund Investing.)
Below are a few guidelines to heed regarding retirement- account investment options beyond mutual funds.
- Consider ETFs: ETFs (exchange-traded funds) are similar to mutual funds, but they trade like individual stocks. They track many of the same indexes as index mutual funds but often have lower expense ratios.
- Avoid annuities: Annuities are tax-deferred savings plans offered by insurance companies. Since retirement accounts provide tax-deferred growth, there’s little benefit to owning an annuity within a retirement plan account, especially since annuities often charge high annual fees.
- Be wary of your company’s stock: If your company offers you special incentives to invest in your company’s stock as part of your retirement plan, be prudent. Invest in your company’s stock only after scrutinizing it as you would any other investment, and never overweight your asset allocation with too much of your company’s stock—or with any other single investment, for that matter.
Should You Use an Investment Advisor?
If you’re a knowledgeable investing enthusiast who enjoys managing your own money, you may do well managing your retirement accounts yourself. But if you know little about
investing and have no interest in learning much more about it, then it’s probably worth the time and money required to hire an investment advisor. These advisors charge commissions, an hourly rate, or an annual fee based on the assets they manage. (For advice on how to find and select an investment advisor, see the Quamut guide to Investing Basics.)
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