By FPA Member Jerry D. Murphy, CFP®
Last Updated: August 23, 2010
Most employees recognize that contributing to the company retirement plan is essential to building an adequate nest egg for retirement. As important as the contribution is, how the contributions are invested within the plan is also important. This is where the employee takes on the role of “Portfolio Manager,” of their retirement account.
Unlike defined benefit plans (pensions), which are managed by the company on behalf of the employee, defined contribution plans [401(k), TSA, 403(b)] are managed by the employee. The employee, as the portfolio manager, has to determine how the account should be diversified between different asset classes such as stocks, bonds, cash and cash equivalents.
Diversification is a major component utilized in asset allocation. The objective of asset allocation is to achieve the best rate of return consistent with the risk the employee is willing to take. However, the purpose of the strategy is not to deliver above-average, eye-popping returns with increased volatility, but rather to produce more consistent returns with decreased volatility in the portfolio. By decreasing the volatility, this reduces (not eliminates) portfolio risk. Asset allocation is not particularly exciting, but rather a steady-as-you-go approach.
Construction of the employee’s asset allocation model should be carefully thought out. This is a very important step in the growth and maintenance of the retirement assets. Ultimately, the allocation will determine how the retirement assets are invested in equities, bonds and cash.
Portfolio allocation is distinct to the individual investor, as there may be two investors with similar retirement goals, but may have different situations, investment experience or other considerations.
When structuring the asset allocation model, two things should be taken into consideration — investment risk tolerance and investment time horizon.
- Risk tolerance — involves the willingness/unwillingness of investors to endure fluctuations (volatility) in their account balances. When determining risk tolerance, employees should take into account their investment knowledge, inflation effects, investment goals, and investment time frame.
- Time horizon — refers to period of time the investor’s money is expected to be invested before they will need to use it.
Generally speaking, longer investment time horizons allow employees to be more aggressive in their investment approach. Meaning a larger portion of the retirement account could be positioned into equities.
Typically, company retirement plans will offer at least three broad-based asset classes to use in developing the employee’s asset allocation model.
- Cash — This is the safest option in the retirement plan. The objective of the cash account is to pay interest while preserving principal.
- Bonds — are considered debt to the issuer of the bond. The investors of bonds are debt holders. This investment seeks a higher rate of return than cash. Unlike cash, there can be principal fluctuation with bonds. The company retirement plan normally utilizes bond mutual funds that invest in corporate or government bonds. The objective of bond funds is income and potentially some principal appreciation.
- Stocks — are considered equity investments and carry greater risk than both cash and bonds. This risk can result in the loss of principal. In consideration for accepting the risk associated with equities, the investor has the potential to gain higher rates of returns over the long run. The objective of stocks is principal appreciation.
The stock selections within the asset allocation model will probably present the greatest challenge to the employee, due to the number of stock choices. The employee should be reminded that, “not all stocks are equally risky.” Company retirement plans typically offer a variety of stock funds (international, large-cap, small-cap, value, blend, growth). After determining the total percentage of the asset allocation that will be invested in stocks, that portion should be further allocated to the type of stock.
If the employee discovers that developing an asset allocation strategy and managing the retirement account is an overwhelming challenge, there is another alternative: Target date funds. Target date funds are “all-in-one funds.” They basically match the investor’s time horizon by investing in a mixture of different funds. The funds within the target date fund are allocated based upon time period in which the money will ultimately be used. The longer the time horizon, the more aggressive the allocation. The allocation becomes more conservative as the time horizon becomes shorter.
Caveat: Target date funds take a “one-size-fits all approach.” They do not take into consideration each individuals risk tolerance. In addition, some target date funds carry higher expense ratios (those of the underlying funds and another layer of fees for managing the fund).
Do’s and Don’ts of Managing Your Company Retirement Plan
- Don’t abandon your asset allocation model by moving retirement assets to the latest and greatest “hot” investment.
- Don’t try and play “catch-up” by being overly aggressive in the investment strategy to make-up for lost time. This can backfire if the market takes a downturn.
- Don’t panic and potentially overreact to market downfalls by moving to all cash portfolios. All cash portfolio don’t participate in market rallies.
- Do occasionally rebalance the portfolio back to the original asset allocation.
FPA member Jerry D. Murphy, CFP®, is a financial planner with JDM Financial & Investments, Inc. in Bowie, Md.