The True Story of My 401(k)

In the last post, I covered in general the math behind retirement planning and investing. But theory only gets us so far. Today, I wanted to share the reality of retirement planning and investing by telling you the story of my own 401(k) plan.

I hope that this story will help you realize that unless if you are a professional money manager, you are probably going to make some stupid mistakes as you learn to manage your own money. I will highlight some of the areas where I went wrong and hope to spare you repeating the same mistakes yourself.

Year One – Enrollment

As I scanned the endless number of forms in the employment packet, I was particularly looking for the enrollment form for the 401(k) plan.  While my husband has always been a diligent retirement saver, this was the first time I was going to start contributing to my own retirement plan. It was a relatively quick form where I believe I put in my contact information and the percentage of money I wanted to contribute from each paycheck. Done. There was no pamphlet, orientation or video about the 401(k) plan, just that one form. With each paycheck, I noted that the correct percentage of money was being withheld and felt good that I was doing the right thing.

The only thing I overlooked is that I was supposed to log on to the website for the 401(k) plan and designate how I wanted my contributions invested. Since I did not designate any particular investing strategy, by default, my money was put in the most conservative option, the cash reserves account. If you have spent even 5 minutes reading about investing strategies, you would know that cash reserves is the completely wrong choice for a young person. Cash reserves is most appropriate for people very close to retirement or perhaps in retirement already who cannot tolerate loss of any amount of their savings. For a young person, this is the wrong strategy because the very low returns on this type of account, coupled with inflation mean that you are typically losing money rather than growing your nest egg.  For the first year of my 401(k) investing, I earned a miserable 0.03% return.

On the bright side, however, I recall that the stock market was not doing so hot during this particular time so I might have avoided losing money by accidentally putting my money in cash. I also received the benefits of the employer match and a reduced tax bill. Also, I realize that I have to count the fact that I even signed up for the plan and saved money as progress. This simple step is one that far too many people overlook.  Today, many companies are trying to “help” people take this step by automatically enrolling them in the 401(k) plan, whether they fill out the election form or not. You have to opt out of the 401(k) plan rather than remembering to opt in.

Year Two – Learning

In my second year of 401(k) investing, I finally figured out that I needed to select my investment choices. As I logged on to the website, there was just one simple page that said basically, “Here are the investment choices, just fill in the percent you want in each.”

Sounds easy, right? But there was no guidance about what these funds were or what the recommended allocation would be for someone my age.  Knowing nothing about the funds and not wanting to spend the time to learn about them, I ended up using the “scatter approach,” sprinkling a little bit of money in every single fund.

Unfortunately, the choices I ended up with were hardly appropriate.  My overall portfolio had the following allocations: 30% cash, 28% bonds, 42% stock. Again, this is more appropriate for a person in retirement already and hardly suited for long-term capital growth.

To avoid the scatter problem I (and presumably many people) encountered, today, many employers offer targeted retirement funds based on your age where all you do is select when you are retiring and the fund mix is supposed to automatically adjust from being more aggressively weighted in stocks while you are young and become more conservative as you age.

In that second year, 55% of my money was earning -0.12% – 0%, which, as you can imagine is a pretty big drag on achieving any sort of reasonable return. Fortunately, the money I had in stocks was earning some money, ranging from 12% – 21%. After two years of investing, I had made approximately 8.4% on my money (or about 4.2% per year averaged out).

Year Three – Pseudo Sophistication

While I was hardly doing well in my 401(k) strategy at this point, at least I was determined to figure out what I needed to do better.  A friend mentioned to me that the way he chose mutual funds was by looking at the Morningstar rating for each fund. If the funds were rated less than a 4 or 5, he avoided them. He also did some reading in the prospectus for each fund. This sounded pretty good and it was nice to have an objective test about which funds were “good” and “bad.”

So I looked up each fund on Morningstar.com.  I made a spreadsheet and noted which funds were rated low.  I also tried reading a few prospectuses, but even with my business and legal knowledge, I couldn’t figure out whether they were good investments. For example, I read this disclosure in a prospectus for  an S&P 500 index fund:

“[The Fund] will invest, under normal circumstances, at least 80% of its assets in securities or other financial instruments that are components of or have economic characteristics similar to the securities included in the applicable index . . .

Fund management may also purchase stocks not included in the S&P 500 when it believes that it would be a cost efficient way of approximating the S&P 500’s performance to do so. If Fund management uses these techniques, the Fund may not track the S&P 500 as closely as it would if it were fully replicating the S&P 500.”

Reading this with the eyes of a lawyer, there was a lot of uncomfortable wiggle room here. It sounded to me as though this fund could be investing in the stocks of the S&P 500 index or it might be investing in something completely different so long as the returns of whatever it was investing in were similar to that of the performance of the S&P 500. This was hardly comforting. As an individual investor, how would I ever really know what my money was being invested in?

There was a 401(k) seminar held at my place of employment where a representative of the investment bank holding our 401(k) assets was there to answer questions. After the presentation, I went to ask the representative some questions. He gave me a personal investment plan, recommending 90% stocks and 10% bonds for my age category. He even gave some guidance on what type of stocks (small-cap, mid-cap, international, etc.) and specific funds within the plan to invest in.

I also made a spreadsheet of the various management fees charged by each fund, since I had heard that I wanted funds with low fees. I somehow combined all of my “knowledge” of the ratings, fees and prospectuses to make some quick decisions. I logged onto the 401(k) website and dumped all the low-rated funds. I also finally pulled my money out of the cash account and significantly reduced my bond holdings, putting the majority of my money in stocks.

I probably could have done OK at this point if I would have followed exactly what the 401(k) representative had advised. However, feeling I might know better due to my “research,” I changed some of the stock and fund recommendations. Sadly, I ended up cashing out of some funds that were doing pretty well and putting money into funds that weren’t so great on the blind faith of the Morningstar rating. I put money into a lot of new funds dealing with sexy topics like “global technology fund,” “worldwide health” and a real estate investment trust. On the plus side, I was finally in a mix of 93% stocks and 7% bonds, more appropriate for my age group.

After three years of investing, my total return since I started investing (i.e. dollars invested, mine and my employer match, compared to total portfolio value) was 14% or about 4.5% per year.

Year Four – Sitting Tight

Perhaps confident in the intense effort of year 3, I just sat tight with my investment choices in year 4 and kept my contributions up.  In year 4 my total return since I started investing was 16% (4% per year).

Year Five – Embracing Index Funds

In Year 5, I again went on a quest for knowledge about how to better invest my money in the 401(k) plan. This time, I sought advice from The Motley Fool website. Here was their advice:

If you are more than 10 years away from retirement, you’d probably fare best by putting most of the money that you defer into an equity index fund. A so-called target retirement fund is also a good choice.

–“401(k) Step 1: The Birds ‘n’ Bees of Your 401(k),” The Motley Fool

Instead of my scatter approach into several different types of stock funds, I consolidated to put half of my contributions into the S&P 500 index fund offered by my 401(k) plan and scattered the rest in various other stock funds. Sounds pretty good, right?

Unfortunately, again, following general investing advice without thinking it through yourself didn’t serve me well. In the case of my particular 401(k) plan, the S&P 500 index fund was only earning about 4% that year. So I had actually moved money out of funds earning double digit returns to put my money in the index fund. Not very smart. However, I was also moving money out of some funds that were losing money so perhaps overall I did just OK.

In year five, my overall rate of return was 24% or about 4.8% per year.

Years Six and Seven – The Lost Years

Going through the history of my 401(k) plan has been a very enlightening experience. One lesson I learned was that you have to be diligent in keeping your own records. At some point I switched to receiving electronic statements rather than paper ones but I must have become lax about downloading the quarterly statements to my home computer. I have no idea how my plan was doing during these years.  I have some records in Quicken I could try to parse but nothing in an easily-accessible format. I don’t think these were particularly good years for the stock market, however, so I suspect I was earning no more than 4% per year and perhaps less.

At the end of year seven, my employer decided to transfer the 401(k) plan to a different investment bank for management. The stock market was doing horribly so when the first plan cashed out my portfolio I ended up losing 17% of the total money I had invested from the beginning of the plan (or about -2.7% per year).

Year Eight – A Switch in Providers

Year eight began with a switch to a new 401(k) provider. My investment elections were largely the same although now all of the funds had different names. By the end of the year, my investments had recovered some of their value. My overall rate of return since starting the plan was 18% (or 2.2% per year).

Year Nine – Holding

In year nine, I didn’t touch the 401(k) and just let it sit. To my great good luck, the latter half of this year is when the stock market started to recover a significant amount of value. By the end of the year, my overall rate of return since starting the plan was 35% (or almost 4% per year).

Year Ten – Ready for a Change

So that brings us to the present. As you can see, at 4% returns per year, I am not going to make my retirement millions very quickly.  After inflation of almost 2%, I am really only earning about 2% per year. Pitiful.

There is almost no data I can find about what the average investment return is on a 401(k) plan. Most of the data is either of the generic variety, such as: “on average, stocks earn __% per year” or the slightly deceptive “plan participants actively contributing to their plans last year increased their balances by ___%.”

The data on average investment returns is conspicuously absent. Is it that horrible? Or is it just too complicated to calculate for thousands and millions of plan participants? So perhaps my 4% is average, perhaps it is low and perhaps it is above average.

In any event, 4% is not enough to make my own retirement goals. I would really like to see my plan earning at least a consistent 8% annual return averaged out over time. Of course, there will always be good years and bad years when you are as heavily invested in stocks as I am but there are a couple of reasons why I think I could achieve 8%. First, I know that at least the first 2 years of my returns were far too low based on poor investment decisions and I can only hope that over time I will continue to learn more and make better decisions. Secondly, when I analyzed various investments in my plan, there are always a good handful that are far exceeding 8% each year. If I could just learn how to get a little more money into the higher performing funds at the right time, I think 8% should not be too difficult.

So, what to do now? A few options:

1) Stay put and do nothing. We have had a lot of terrible years in the stock market recently and it may be that with more time and more positive years to correct for the negative years my desired 8% will materialize by itself.
2) Convert my 401(k) to an IRA. This would allow me to escape the limited investment choices of my 401(k) plan but I would have to learn more about how to pick quality investments myself.
3) Fiddle around with the investment mix in my current 401(k). Basedon my past experience trying to do this, I have limited confidence this will make any difference at all.
4) See if there is an age targeted fund option in my 401(k) I could switch into. Note that targeted funds are not the cure-all and have their critics too. Many say these funds are ineffective because they are based on boilerplate investment ratios that may or may not make sense given particular market conditions.
5) Radical: Cash out the 401(k), pay taxes and invest the proceeds in something else, like real estate. Does anyone do this? Someone just wrote in to MarketWatch to ask that very question here.
6) Pay for professional advice.

I really am not sure what is the “right” answer or whether there are other options I need to consider. I need to give it more thought. It just goes to show how complicated it is managing your own money. I am at least fortunate that I have some background and skills to be able to ask some good questions and conduct research.

So far, the only solid advice I can give anyone about organizing their 401(k) is:

1) Always keep a record of how much money you have put into your plan. That is probably the most important number you can track. Count both your money and your employer match as your “basis.” Don’t get too caught in the weeds tracking individual stock purchases and returns. If you only have time to do a very quick analysis of how you are doing, you just calculate your return based on how much money you put into the plan over all time and what the current value of your plan is today. Note that this information seems hard to find on most 401(k) statements. The statements usually tell you how much you contributed over a certain period of time (like a quarter or a year) but not over all time. You need to track that number yourself.

2) Don’t rely exclusively on the returns stated in 401(k) statements. There are lots of ways to calculate rates of return. For the individual, all you really care about is how much money you put in and how much you are worth now. This applies to individual fund purchases as well as the overall balance. For example, in my own analysis, the highest return I received on any fund  ever based on a simple look at dollars in and dollars out was about 26%. The 401(k) statement was far more generous indicating the fund’s return was at least double that amount. This is not to say the 401(k) statement was wrong, just that it wasn’t calculating the return in the way that I expected it to be shown.

3) Don’t rely blindly on any investing rules of thumb. As you can see from my experience, blindly believing third party ratings or generalized investment mix advice has not been entirely successful. Successful investors likely take these rules of thumb as a guide and then tweak them based on their knowledge of particular market conditions. For example, a really good investor might say, “90/10 is generally the right investment mix but given the ____ condition in the market right now, that formula should be adjusted to ____ to take advantage of ____ opportunity.” Or maybe, “The ___ fund in your 401(k) plan is performing so well right now and will for the forseeable future that this is where you should be parking most of your money right now.” Gaining better knowledge of how to read the market and think like an investor is high on my to do list now.

Readers, do you have any successful investing tips to share? What is your own 401(k) story? Please share in the comments.