The below are 6 things wrong with your 401k. A the end, there’s a free tool you can use to fix your 401k in minutes. If you just want to use the tool, scroll to the end.
1. Not Contributing, Putting In Enough Money, Or Setting Up Auto-Contributions
Half of Americans are not contributing to a 401k. If you’re one of them, set up your 401k by talking to your Human Resources department. When you do set it up, know that you can put in $18,500 pre-tax per year and invest it for retirement. This maximum changes every few years by $500 due to inflation, so always check the new limits at the end of the year.
If you’re putting in very small percentages in your 401k, consider upping that contribution by 1 percent a month, until you can go no further. You’ll find it’s not as difficult as you might think. 1 percent too easy for you? Increase by 2 or 3 percent.
It’s also important to set up auto-contributions so that you can pay yourself first. If that money is taken out of your paycheck before you spend it, you won’t be able to miss it and be tempted to spend it on something you don’t really need.
2. Not Taking Advantage of the Company Match
Companies with a good 401k plan will match the amount you contribute to your 401k, up to a certain percent.
For example, if you have a 6 percent match and make $40,000 a year, you can get an extra $2,400 from your company just by contributing money yourself to your 401k. If you contribute $2,400, the company will contribute $2,400 as well, so your effective compensation is higher by thousands of dollars due to the match.
So many people don’t take advantage of this though. Don’t be one of them.
A word of caution though, some companies will do something like only match X percent of each paycheck. So if you contribute 30% of your paycheck at the end of the year because you have enough saved up for expenses, you’ll might only get 6 percent of that paycheck matched. So check with your HR department before you put in more than that to try and max out your 401k earlier in the year.
I explain how the 401k match is basically free money here with a few other thoughts on the subject.
3. Investing In Same Funds With High Expense Ratios (Fees)
401k Providers call the fees on a fund “Expense Ratios”. Due to the fact that your company picks the 401k provider and you can’t just go and pick one, they can basically charge high fees because you can’t switch 401k providers until you leave the company.
Here’s an example of highway robbery via a fund that performs like the SP500. I did the math on how much the average american will lose due to expense fees here and it’s something like $200,000. A fee you think is small will turn a huge loss over time due to compound interest.
Vanguard charges .04% for VTSAX. The Ryder SP500 fund has an expense ratio of 1.57 %. That’s 39 times the cheaper option. If we assume that historically the SP500 returns roughly 7 percent after inflation, we can see how terrible those expense ratios are.
Compound interest is an amazing thing, but high expense ratios are just awful.
Let’s assume we started with $1,000. If you invested in the Ryder fund, you’d end up with $8,290 after 40 years. If you invested in the Vanguard low expense ratio fund, you’d end up with $14,750. You nearly double your money, just by choosing the fund with the lower expense ratio of two funds that are very similar in investable assets. Nearly doubling your money is the difference between $500,000 and $1,000,000. Which one would you rather have just for clicking a button and choosing the lower expense ratio fund?
If you don’t want to go through all the funds your 401k provider has and compare returns with expense ratios, a new free tool offered by Blooom can do that for you here.
4. You Have The Wrong Stock/Bond Ratio Mix
The further you are from retirement, the more you should be invested in stocks. The closer you are in retirement, the more you should be invested in bonds. This is because the further you are from retirement, the more time you have to wait out market downturns. Recessions happen roughly every 7-10 years historically, so if you are a 20 year old, you should be ok to wait out those market downturn if you’re planning on a traditional retirement, as the stock market returns 7 percent after inflation on average historically.
As you get closer to retirement, you don’t really want to risk a market downturn because you won’t have the ability to ride out that recession. Because of the lack of time until then, you should be much more invested in bonds, which give you a fixed rate of return and are much less risky when we talk about volatility.
There are a couple of formulas, but I like this one. The rule used to be that the percentage of stocks you own should be 100 – age, but I think 120 – age is much better. The average life expectancy for an American is 80 years old now, but increases every decade. Research and development increase exponentially, and with the surge of health and wellness knowledge, if you take good care of your body, on average you can expect to live longer than the average.
If you don’t want to recalculate this every time you check your 401k, you can run your portfolio through Blooom and they can spit out the numbers for you easily.
5. Actively Managed Funds Are Not Always Worse
In the financial industry, there is the concept of alpha, which tells you how much a certain fund outperforms its benchmark. A common benchmark would be the SP500.
When I started contributing to my 401k, I decided to choose a plan that produced alpha. A common argument against this is that most funds will not produce alpha in perpetuity due to human bias. It depends on what your risk tolerance is, mine is high. I chose VHCAX (which you can no longer invest in unless you’re grandfathered in). The expense ratio if .37 %, 9x the fees of VTSAX, but it creates 1.5% alpha per year, which means it returns on average 1.5% more than the SP500, it’s benchmark.
Here’s the table for VHCAX’s return:
Here’s the table for VTSAX’s return:
Both of these tables were taken off the Vanguard website. You’ll notice both have been in effect for roughly 2 decades. VTCAX has outperformed VTSAX in excess of the fee by at least a percentage point for all points of comparison. So, it was worth it to me to pay the extra in expense ratio. Now, you shouldn’t just pick a fund without an investment thesis. The short version of why I liked it was because it was actively managed in pharmeceuticals, tech, and oligopolies (airline industry to name one industry) and I believe those sectors outperform others on the long-term.
On average, actively managed funds perform worse than passive investments like the SP500. However, if there’s a fund producing alpha and for decades, for me that’s something I’d take a chance on.
Blooom’s tool allows you to see this — if you’re not comfortable with industries, the market, or are a beginner investor, just use Blooom to find the least riskiest fund with the right allocation.
6. You Never Rebalance Your Portfolio
Once you fix your stock/bond ratio, you need to keep that ratio relatively in balance. The reason this ratio changes is because one portion, either stocks or bonds, will move more than the other. In our case, your stock percentage will increase by much more over the course of your life. This is because stocks have higher after-inflation adjusted returns over the course of time.
Remember that your bond allocation should increase over the course of your life. This means you’ll need to change your ratios (rebalancing) of stocks and bonds every once in a while. Consider rebalancing twice a year or when your allocations are out of balance by 5 percent or more.
One way to get around this is to just invest in a Target Date Fund. This is where your 401k provider automatically rebalances for you, but usually with a hidden cost. In the case of Vanguard, if you invest in just Target Date Funds, you’ll never get what they call “Admiral Shares”, which have expense fees over 50 percent lower. Admiral shares and Investor shares are exactly the same. It’s just that Admiral shares have a lower expense ratio — you can get Admiral shares when you reach a minimum in your account. I explain the difference in Admiral vs Investor shares here and how you can DIY your own portfolio to save those fees here.
Fix Your 401k For Free
All this sound overwhelming? Blooom has created a FREE online tool to help you with some of the above issues. It will tell you:
- If the funds you’re currently invested in have fees that are too high
- If you have the right asset allocation for stocks and bonds
- Are you being too conservative in your allocations? Or are you taking too much risk?
- It’ll tell you how to fix the above problems for free.
- The information they give isn’t super technical (but the analysis and numbers they crunch are!). So you’ll actually understand what they’re saying without a bunch of technical jargon.
What are you guys investing your 401k in? How did you make that decision?
*VTCAX performed in excess since inception, which is a fair comparison given all the other yearly returns. Please note that VTCAX was created halfway through the dotcom bubble.