Fixing the 5 biggest 401(k) blunders

By Tim Middleton

The Pension Protection Act of 2006 is supposed to fix the 401(k) system, which is the principal retirement tool for Americans. It's meant to bring more workers into the system and to help direct their investments more intelligently. These are laudable goals, but more rules aren't going to fix the basic problem.

The average American commits five big blunders in planning for retirement, and their cumulative effect can turn potential millionaires into permanent paupers. It doesn't take an act of Congress to correct them. It takes the kind of sensible planning you already do to buy a car or, in Peter Lynch's famous example, a refrigerator. That famed stock picker said investors pay less attention to their portfolios than their appliances.

The five big mistakes are failing to save hard enough; neglecting to maximize returns while controlling risk; relying too heavily on the stock of their employers; fumbling rollovers; and scalping themselves with heedless borrowing from their own nest egg.

Compounded over a lifetime, the smallest mistakes can have life-changing results. Ignoring expenses can clip 10% right off the top. I'll show you one example where a thoughtful choice involving just a few thousand dollars in your 20s can buy you a second home in the sun when your old bones need it most.

Consider this a 12-step program stripped to the bare essentials. Five steps can take you from dreading your financial future to enjoying it.

Get in, max out, catch up

According to Fidelity Investments, the largest operator of corporate 401(k) plans, more than a third of corporate employees don't even join their plans.

The 2006 pension act, signed into law last August, allows employers to automatically enroll you into a plan, forcing you to opt out, rather than in, which is a start. But then there's this issue: Most plan members don't save enough. The average rate is 6.9%, Fidelity says.

That's on what another pension consultant, Hewitt Associates, says is an average salary of $52,120, which works out to be $3,596 annually. But you can contribute up to $15,500. Double this contribution and it is still just half the permitted limit. Contributing enough to get the company match is a no-brainer, but failing to contribute more could be more costly in the end.

Brian Pon, a financial adviser with Financial Connections Group in Berkeley, Calif., says clients come to him for advice because the whole issue of retirement planning overwhelms them with its seeming complexity. "Some kind of analysis paralysis sets in," he says. "Is now the best time to invest? The question really is, 'Is now the best time to save?' and the answer is yes."

Even worse, only about one worker in 10 over the age of 50 takes advantage of the "catch-up" provision that allows them to contribute an additional $5,000.

If you don't think you can afford to max out your company plan, consider opening a Roth IRA in addition to it. Because contributions are not tax-deductible, "the Roth could act as an emergency savings vehicle, since contributions can be withdrawn tax-free and penalty-free at anytime," notes Chad Smith of Financial Symmetry in Raleigh, N.C.

Also, a Roth at a good, inexpensive mutual fund company will probably provide more investment options than a company plan.

Maximize growth, control risk

One-quarter of all plan participants have their entire account in a single investment option, Fidelity says, and it is often a low-yielding stable-value account which provides no opportunity for the growth of capital.

"The overwhelming mistake that I see 401(k) participants make is that they fail to diversify and employ proper asset allocation," says Jeffrey N. Bogue, a financial planner in Wells, Maine.

According to Fidelity, 22% of participants hold only equities, which cost them 30% or more of their nest egg in the bear market of 2000-2002. A well-diversified portfolio includes bonds and other income-oriented investments to help avoid calamities like that.

But 13% of 401(k) participants err in the opposite direction, owning no equities. With average life spans extending well into the 80s, even retirees need to keep at least a third of their assets in equities to keep up with inflation. The Pension Act liberalizes the rules by allowing plan sponsors to recommend model asset allocation. A sturdy rule of thumb is 60% equities and 40% income.

And don't forget as you allocate assets within your 401(k) to take your other investments into account. Working couples often have two plans, and "most have not spent the time to determine how to maximize the asset allocation between their two plans," says Paul Merriman of Merriman Capital Management in Seattle. "The potential return advantage can be as much as 1% a year." Choose from among the lowest-expense options in each plan.

Sell that company stock

Especially at big corporations, participants hold an average of 21.9% of assets in company stock, according to Hewitt Associates. Equity mutual funds spread risk across hundreds of companies; individual stocks are incredibly risky.

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