Investing

Don't make this common mistake when starting up your 401(k)

Twenty/20

Making sense of the options in your 401(k) can seem daunting at first. That causes many people to make investment decisions that are influenced by something very simple — the order in which they're presented.

In 401(k) and other workplace retirement plans, funds are typically listed alphabetically. This creates a significant cognitive bias, a mental trap that can affect your decisions.

The earlier a fund shows up in your list of options, the more likely you are to include it among your investments. And you might invest more of your money in it, too, according to a recent research paper in the Financial Review. "Funds listed at the beginning of plan menus receive significantly greater allocations compared to funds listed towards the end of plan menus," the authors concluded.

Making wise investment decisions is an important part of setting up your 401(k). While it doesn't take long to sign up and decide how much money to contribute, don't skimp on the time you spend deciding how to invest that money.

Why you should take advantage of a 401(k)

Workplace retirement plans are a common benefit: Nearly 7 in 10, or 67%, of employees had access to one in 2018, according to figures from the Employee Benefit Research Institute. But only 79% of employees with a workplace plan took advantage of it.

Many Americans will depend on savings accumulated in a 401(k) or other workplace plan to fund a comfortable retirement. That's why it's so important to start investing as early as possible. And 401(k)s have other advantages: They offer a valuable tax break and many employers match a portion of contributions, which means they give you what amounts to free money that can supercharge your savings.

Here's how to get started.

1. Sign up

You might even be able to skip this step, since some companies automatically enroll new employees into a 401(k) with a default contribution — either a dollar amount or a small percentage of the employee's salary.

Whether your company automatically enrolls you or not, it's still important to get details about the plan and when you can start contributing. Your first stop to get that info is the human resources department. "Go to HR and find out who the plan sponsor is," David Reyes, a financial advisor and founder of Reyes Financial Architecture, told Grow earlier this year. That information can help you set up an account with that plan sponsor, if you're not already enrolled, or log in to tackle the next steps.

Some employers require you to work at the company for a specified period before you can start contributing to a 401(k). About 4 in 10 companies impose a wait of three months or more, according to data from the Plan Sponsor Council of America.

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2. Decide how much to contribute

One reason experts like 401(k) plans so much is because they make it easy to start investing. "They take the guesswork out of when to invest because money comes out of your paycheck automatically," Christine Benz, director of personal finance at Morningstar, told Grow earlier this year. "Turns out, that's a really great way to invest."

Still, you need to decide how much money to contribute each pay period. Experts typically advise you aim to put away 10% to 15% of your salary for retirement each year, but even if you're juggling a lot of other expenses, some is better than none. "Put $50 or $100 in there just so you're used to saving and seeing a statement that has investments in there," Reyes recommends.

As you earn more money, aim to increase your contributions. You can make an annual 401(k) contribution of up to $19,000 a year, plus an extra $6,000 if you're 50 or older, as of 2019. Those amounts increase to $19,500 and $6,500 for 2020.

It's especially important to contribute to a 401(k) if your employer offers a match. There are a variety of formulas for matching contributions, but the average reached a record high of 4.7% this year.

That means, if you make $50,000 and contribute at least that amount, your company will contribute $2,350 as well.

3. Pick your investments and review fees

There will be a few investment options to select from within your 401(k) plan, typically index funds, like the following:

  • Stock funds. Your options here may include companies of different sizes (small-, mid-, and large-cap stocks) or from different geographic regions (U.S. and international).
  • Bond funds. Options might range from funds representing a large portion of the bond market to specific regions.
  • Target-date retirement funds. These are made up of a mix of investments that changes over time, depending on when you plan to retire.
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When selecting investments, also known as determining your asset allocation, you have two options: The do-it-yourself route, in which you select individual investments from that list of funds, or the hands-off approach of allocating all your funds into one already-mixed target-date fund. Regardless, the goal is to have a variety of assets to balance out potential risks, or what's known as diversification.

Funds are grouped by asset type, so be sure to avoid that aforementioned alphabetical bias and compare similar options before making a decisions.

If you take the DIY approach, you'll need to decide what portion of your portfolio is invested in bonds versus stocks. The Baltimore-based money managers at T. Rowe Price suggest these goals:

  • 20s and 30s: 90% to 100% in stocks (because of your long investment timeline), with up to 10% remaining in bonds.
  • 40s: 80% to 100% in stocks, with up to 20% remaining in bonds.
  • 50s: 60% to 80% in stocks, 20% to 30% in bonds, and up to 10% in cash.
  • 60s: 50% to 65% in stocks, 25% to 35% in bonds, and 5% to 15% in cash.

Target-date funds are popular because they alleviate the stress of figuring out asset allocation yourself. "Sometimes, not overthinking it is the best strategy," Benz says. "You can really muddy the waters by trying to be too tactical."

Sometimes, not overthinking it is the best strategy. You can really muddy the waters by trying to be too tactical.
Christine Benz
director of personal finance at Morningstar

As you pick investments, pay attention to fees for individual funds and the overall account. The lower, the better. All other things equal, an investor paying annual fees of 1.3% will reach retirement with about $100,000 less than one paying fees of just 0.25%, according to the Center for American Progress.

If you see a lot of offerings in your plan with fees greater than 1%, Benz recommends contributing just enough money to get your employer's match — and then shopping around for alternative ways to invest the rest, like an IRA.

Remember to check in periodically

Many 401(k) providers offer options to help workers automate the retirement-planning process, including automatically increasing contributions each year or re-balancing your portfolio to get back to your desired asset allocation. It's important to take charge of your retirement planning, and even small changes — like a 1% increase in your savings rate — can really add up over time.

So remember to do some checking in on a regular basis.

While you should review your account statements each quarter, resist the urge to make changes to your plan based on what the market is doing.

Any major changes, like tweaking your asset allocation, should only happen annually. So long as you are decades from retirement, Reyes says, don't feel like you need to react to every news event: "It's important to remember these are long-term investments."

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