The best moves for your 401(k)

Whether you're just beginning to save, starting a new plan or simply dissatisfied with your progress, these 5 easy moves will help you get on track.

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By Tim Middleton

Imagine if your first job out of college were to create a comprehensive investment portfolio guaranteed to provide financial security for an entire family for 25 years of retirement. And one more thing: You have to supply the money.

Congratulations: That's the exact job you actually have.

It's called your 401(k) plan, and if you screw it up, you and your loved ones will be living out of trash bins when you're too stooped to greet customers at Wal-Mart anymore.

The biggest 401(k) mistakes

Fortunately, it's harder to get out of bed in the morning than it is to create, monitor and guide a successful retirement portfolio.

How to plan your 401K

Frankly, finance professors can't do it any better than you. I know; I've interviewed four Nobel economic laureates in my career, and each time I've asked them how they have set up their personal retirement plans. All four said the same thing: Vanguard index funds.

Vanguard because it's a not-for-profit company and is therefore the cheapest to hire. Index funds because they reliably track benchmarks with proven records of success. Even if you don't have Vanguard as your plan provider, you can buy index funds from the provider you do have. And any plan allows you to do the other two things that will deliver the highest total returns: start early and contribute the maximum. (For a look at Vanguard's best funds, click here.)

Here are five moves anybody can make to construct a powerhouse 401(k). Over any significant period -- 15 years or more -- these steps have never failed to generate returns two or more times higher than such noninvestment alternatives as savings accounts or stable-value plans. Any American family that contributes faithfully and invests prudently can expect to amass a kitty of $1 million, in today's dollars.

Calculator: How much can you save?

Join, you dummy

Even though a pension reform act from 2006 makes it possible for companies to enroll employees automatically, it also allows employees to opt out. Only 81% of qualified employees actually belong to their plans, according to the Profit Sharing/401(k) Council.

The two excuses most people use to avoid participating are that they can't afford it or that their plan isn't very good. My response: You're living beyond your means, and you're wrong.

You need to be smart enough to pay yourself first -- and that's what retirement savings are, a payment toward your personal future -- or no self-help article

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will ever help you. On the other point, I've examined literally hundreds of 401(k) and 403(b) plans, and nearly all offer enough decent investment options to make them worthwhile.

Capture the company match

This is absolutely free money, and anyone who isn't getting the most that his or her employer offers is a fool. IRS-approved plans such as 401(k)s are extremely powerful even if you don't get an incentive from the boss in the form of a match; the tax deduction effectively adds a quarter or more from Uncle Sam for every 75 cents you set aside. A company match is usually more powerful still.

One of the most common matches is 50% of up to 6% of your annual gross pay. So if you earn $50,000 and contribute at least $3,000, the match pitches in an additional $1,500. Even if you have a math phobia, you can appreciate that this is a 50% return on your investment, guaranteed and fast.

Maximize your contribution

Most plans allow you to contribute as much as 15% of your gross pay, to a maximum of $15,500 ($20,500 for people 50 and older, adding what's called a catch-up contribution.). But the average contribution is only 7%, according to the 401(k) council. The more you contribute, the less you pay in income tax, and then all those dollars the government has effectively added to the pot compound along with the other money.

Assume you're in the 25% tax bracket. You contribute $4,000. Your out-of-pocket cost is $3,000. The other $1,000 comes from the tax deduction -- it's Uncle Sam's money.

Now assume you could count on getting an annual average return of 8% over your lifetime -- and you can. That $1,000 tax-saving contribution will grow to $2,000 in 10 years, more than $4,000 in 20 years and $20,000 in 40 in years, the time between age 25 and 65. You'll pay tax on that when you withdraw it; if the rate is 25%, you'll forfeit $5,000. But you'll still have $15,000.

Minimize your risk

This doesn't mean putting your money into low-yielding options like stable value. It means balancing investment classes against each other in a way that reduces the overall risk of the total package. My suggested complete 401(k) package, outlined below, balances risks exactly this way. It has a standard deviation of 11.75. That's about 18% above the stock market. Sounds risky, eh? But consider: You'll also have Social Security benefits. Assume they're worth $20,000 per year in today's dollars.

That's equal to a 5% annual return on a $400,000 bond portfolio. This is not a phantom, even if you can't list it among your actual assets.

Assume you've got that million in your account; this effectively brings you to $1.4 million. The standard deviation on that portfolio is 8.01 -- 20% less than the stock market.

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Build it, and fortune will come. Here is that suggested portfolio:

The Perfect 401(k)

 
Holding% of assets

Vanguard 500 Index (VFINX)

35

Vanguard Small Cap Index (NAESX)

25

Vanguard Europe Pacific (VEA, news, msgs)

20

Vanguard Emerging Markets Index (VEIEX)

10

Vanguard REIT Index (VGSIX)

10

Easy as pie: 60% in domestic equities, including a big portion of small-capitalization stocks; 30% in foreign developed and emerging markets stocks; and 10% in commercial real estate.

The foreign exposure will bring slightly lower returns than the domestic stocks, but the positions are somewhat diversified. The real-estate fund has about only a 30% correlation with stocks. Generally, it follows its own way and has built-in inflation protection as rents rise.

According to Morningstar, this combination has delivered annualized returns over the past decade of 7.2%. Considering that that period includes two bear markets -- most 10-year spans include only one -- this is not representative of what you can actually expect. Very likely the return will be in double digits. But it would certainly be at least 8%.

Rebalance every year

Over time, domestic small-cap and foreign emerging-markets funds will grow beyond their boundaries, because they are the hottest performers. By the same token, in tough times they'll underperform, because they're the riskiest. So every year or so, readjust your contributions to increase the flow to funds that have fallen below this initial percentage and away from those that have grown too large.

Because you're putting fresh money into laggards, you will always be buying relatively low. Ultimately, stock profits depend on your entry point. The less you pay upfront, the more you'll make in the end.

There you have it. Unless the next 40 years are utterly unlike the past 100 in terms of the expected returns of financial assets, and assuming your contributions between you and the boss are at least 10%, you will absolutely retire relatively rich.

If, on the other hand, you put your retirement saving off for 20 years, you won't have to save twice as much:

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You'll have to save three or four times as much, because you will have lost all that compound interest.

So get going.

At the time of publication, Tim Middleton didn't own any securities mentioned in this article.

Produced by Elizabeth Daza/Graphics by Joe Farro

Published Oct 1, 2008