Employee Retirement Options, Part 2

Here's a piece courtesy of Marotta Asset Management with some additional retirement thoughts.

Most employees have all their retirement eggs in one basket --their employer's retirement plan. The plans usually offer less than two dozen fund choices to cover all your hopes of maintaining your lifestyle, independence, and dignity in your later years. As discussed in the previous article, the more baskets (and eggs) you have, the better. If most of your retirement assets are with your employer, here's how to make the most of what you've got.

First, there are some mistakes to avoid. Probably the most common mistake made by employees is to allocate an equal amount of money to each of the fund choices. Studies have shown that given ten choices, employees tend to put 10% in each choice. Given five choices they put 20% in each choice. If four of the choices represent one type of asset and the fifth is unique the asset allocation is split 80/20. If the funds happen to be the other way round then the asset allocation is 20/80.

The equal proportions methodology builds very poor portfolios. You can't afford to make these types of mistakes with your future livelihood. The only thing worse than the equal proportions strategy is allocating all of your money to just one fund. You need an investment philosophy that integrates all of your asset holdings. Only then can you evaluate which of your company's fund options are right and determine what percentage to allocate to each.

Many employer sponsored retirement plans are just mediocre. Neither the fund company nor plan provider has much incentive to fill your selections with stellar choices. Plan sponsors have a fiduciary responsibility, but few take that responsibility seriously. Procedures may or may not be in place even to meet minimum guidelines. Still, you should be able to find a few funds worth selecting in order to gain your employer's match.

Your own company or plan provider usually isn't the best place to turn for advice. After all, they are the ones that picked the options in the first place. You should get the outside opinion of a professional financial planner on where to invest.

Another common mistake is to invest in whatever funds have done the best over the past 1, 3, or 5-year period. None of these measures is long enough to produce a balanced asset allocation. Every financial disclaimer states that "past performance is no indication of future returns," and yet, past performance remains the primary selection criteria for many investors. Too many employees pick the asset category that has done the best over the past three years. However, these higher-than-average returns often represent a peak. Going forward, they are the fund choices most likely to under-perform for the next three years.

While three year average returns is a poor way to select a fund, thirty year average returns is a good way to select an asset category for including in your asset allocation. If small cap value is a good asset category to include for the long term, see if your plan includes any small value funds. Then judge them against other outside funds within their asset class and not against other funds within your plan.

You should be looking for funds which are the best funds within their asset class regardless of how well the asset class has done over the short term of just the last few years. Funds that are the best in their category can often be found through index funds that have very low expense ratios.

Remember also that you are looking for a team of funds and not just a few hot shots. Your retirement portfolio consists of more than just your employer's plan. Even if your employer's plan only has a couple of good choices, you can use your other investments to create a balanced asset allocation. While the choices in your employer's plan may be limited, investments in your IRA or taxable account will have an unlimited number of choices from which to craft a balanced allocation.

It is important to start with an over all asset allocation plan and then see what asset classes your employer's plan offers that would integrate well with your investment philosophy. Since your employer's plan usually has the most limited number of choices, pick the best it has to offer that fits with in your over all plan.

Comments

[Arthaey]

Vanguard offers some funds like "Target Retirement 2045". These have a mix of things they invest in, and the proportion changes to become less risky as you approach the fund's "target date". Is this a good enough way of diversifying, even though all my retirement is in a single fund? Or do I need to look into more diverse funds, as well?

[Edmund]

I have all my money for my IRA in Target Retirement 2045. From what I have seen, it's good enough.

Perhaps one needs exposure to REIT. I thought about it, and figured it was a bad time to buy REIT into the middle of a bubble. (Yeah, bad me. I shouldn't market time)

By the time REIT matures some more and their performance is more clear, perhaps Vanguard will add REIT into the retirement fund. Who knows?

[Skott]

I would be surprised if they did. The total stock market index has a proportionate amount of real estate exposure already. I realized this as I was moving my Roth IRA into the 2050 fund and considered having a REIT index also, but I decided against it.

[Luke]

I have about 25% in the 2045 Vanguard retirement fund with an eye on lowering that to 15-20% in 2008. For 20-somethings, the 2045 would be a good option for 401k IF there are awful options. However, I don't believe that these retirement accounts should make up 100% of retirement funds in an account. You are buying the market with 2045 and others, but the broad total market index for a young person should basically be the conservative portion of your account. You should also have small caps, global etc. etc.

I do like the 90/10 split and it is aggressive, however I think now is a great time to go for stocks both here and internationally. And of course IF your portfolio is large enough, you should have a litle something, something in a REIT. Again, I am speaking strictly for the 20-something or even 30-somethings.

Our time horizon is getting longer and longer away. You could purchase $1000 of 2045 in your Roth IRA 5-years ago at 22 and live another 60+ years!

[Lord]

No, cap weighted market indices are usually overweight large cap growth. REITs would make a nice complement to that.