Asset Allocating 401(k) Tax-Qualified Retirement Plans.

Captive retirement plans where working employees (participants) contribute their own money via payroll deductions (and then the company may match it) come in several different versions: 401(k), 403(b), 457, etc. We're just going to say 401(k) here.

A captive retirement plan is one where the investor can't roll it over into an IRA. This is because they're still an active employee, making contributions.

Investment choices of a 401(k) plan are called different things (investments, funds, options, choices, selections, etc.), but they are all just open-ended mutual funds.

Advice on how to get the most out of 401(k) Plans

How a 401(k) plan is managed while the investor is captive to it is critical. Even though it could mean the difference between steak and Alpo after a decade of retirement, 401(k)s are still the most neglected part of retirement planning.

This page has the information needed to understand what's going on, and what you can do to get the most from your money - while in captivity and afterwards.

Even if one hires a financial advisor for their other investments, 401(k) investment management is usually overlooked. Investment managers just don't like to spend resources giving advice on them. This is because it's a lot of work, it's hard to get the data needed, they probably don't have the software tools needed, they don't know what to do, and then they're rarely paid for it. This is because they can't use their firm's custodian to hold and control the assets; which means they can't make commissions on trading, nor can they charge fees as a percentage of assets. The only time they're paid is when the investor writes a check that directly compensates them. So they usually ignore it, even when it's the client's largest asset.

This page is about optimizing investment performance while being captive to a retirement plan. We build custom investment portfolios out of captive retirement plans that weed out poorly-performing fund options, increase diversification, lower risk, increase returns, and eventually maximize retirement income.

These investment strategies are the same as those described on the Model Portfolios page. The difference is they're funded with just the plan's limited investment choices.

Why good management is needed: The pitfalls of 401(k) plans

The biggest problem with captive retirement plans is insufficient investment choices, which means lack of asset class choices. Asset classes are how investments are categorized between the different sectors and sizes of stocks, different issuers of bonds, real estate, tangibles, and the various flavors of international investments. This limited selection leads to lack of diversification, which results in higher risk and poor investment performance.

Participants are usually not knowledgeable about asset allocation techniques, which guide how to divvy money up between the investment options. This results in having too much exposure to only one type of equity market, usually Large-Cap Growth stocks. This will result in losing a lot of money when the stock market goes down.

The next problem is poor performance of the investment choices. This is true both from a naive point of view (not seeing much growth even when the markets are going up), and from a technical point of view (when investment vehicles underperform their proper benchmark index). Participants usually lack the expertise needed to determine if a fund is performing well or not.

The combination of these two problems result in losses seldom being recovered when markets go back up.

If there are trading costs involved in moving money around between the options within a plan, some people will avoid these costs, even when they're losing many times as much by doing nothing.

Some plans have high annual fees that employers pass on to employees. Most all of their fees are hidden, secret, and are not even disclosed to employers. Some guess that most plans have fees as high as 5% annually.

Some plans have restrictions on when money can be moved around among the investment options (e.g., only on the first day of the quarter). Then when a trade is made, it could take over a week for the money to actually be moved. This helps in permanently locking in losses.

The combination of these problems leads to having much less money in your 401(k) when you retire, which leads to having much less money to spend.

The single most important free tip on managing your 401(k) is to avoid all flavors of Target Funds. This is just the latest sales gimmick used for collecting retirement assets these days.

If an investment option has a year in its name, has a certain goal in a future time period, or the word target in it's name, then it's a target fund.

The short version is that target funds automatically invest in less stocks and more bonds as the target year approaches. This sounds logical, but the bottom line is that they rarely perform well. The reason they look like they perform well, is because in order to analyze them properly, a complex benchmarking process has to be used. So only people like us can do that well. Every one we've looked at so far has had miserable results. Since target funds are new, very few have reached their target yet. The long version about why these should never be held, is in the do-it-yourself investment management eBook. Investing in target funds will probably shave 10% to 30% off of your retirement income over your lifetime.

Escaping 401(k) captivity

Once you terminate employment, you can easily escape 401(k) captivity.

Transferring a 401(k) plan into a rollover IRA solves all of these problems. You then have access to a large universe of much better-performing investment vehicles, with plenty of asset classes to choose from.

You'll usually also have access to tools which allow you to determine which investments are better than others, and perform basic asset allocation strategies.

Last but not least, you can go online and move money between investments whenever you want to, from anywhere, for a minimal fee, and these trades are usually executed within a day or so.

Being able to "self-direct" your IRA results in having total control over your investment portfolio. If you self-direct well, then you'll be way better off when it comes time to get a retirement paycheck from your investments. You can easily do this just by telling your custodian how and when to send money.

You can reconstruct your portfolio to provide retirement income (or you can hire us to help). The point is that you probably won't even be able to do this at all if you stay in a captive plan.

This is because most 401(k)s only provide life insurance company methods of realizing retirement income. These are usually called things like "life income," "life options," "life certain," "joint and survivorship," annuities or annuitizing. These are all ways of getting you to give all of your money to a life insurance company. They then buy an annuity, which is the investment vehicle that pays the retirement income. You then have little to no control over anything anymore. Even if you get the latest high-tech variable annuity, then you're back to paying enormous fees and being stuck in another captive plan with lousy investment options.

Taking any form of an annuity payout is just handing a quarter to a third of your income over to the insurance company, and getting little to nothing in return. NEVER EVER do that no matter how much pressure a salesperson is putting on you! Always take options like, Lump sum, transfer, or IRA rollover. The bottom line if you're retiring and you want to get income from a 401(k) plan is to keep telling them, "I want to transfer it into a rollover IRA."

Selling you an annuity is what pays by far the most commissions to the salesperson/401(k) provider/Life insurance company. These huge commissions and enormous annual fees come right out of your retirement paycheck, and provide little to no value to you. What you're doing is taking a lot of money away from them, that they just assumed they would have. So they're going to pretend you can't do that, or they don't understand, or try to trick you into some form of annuitizing. Never sign any of their forms! Once you've signed up for an annuity, you are stuck with it for life.

First pick a custodian you like, and get their IRA rollover transfer forms. Have them all filled out, and then contact your 401(k) about rolling everything over to a self-directed IRA. Better yet, just let your new custodian do all of the paperwork for you, as some will. The people at your old 401(k) will be unhappy with you, but you'll never have to deal with them again after the transfer, so it doesn't matter.

All about opening a discount brokerage account as your IRA rollover custodian is discussed here

Once you've escaped captivity, and opened up a discount brokerage account, then this page is the best place to start learning how to manage your own investments. The real beef is in our investment management eBook, or we can manage it for you.

Why 401(k) plans are in the shape they're in

Corporate human resource benefit managers in charge of setting up and managing these plans for employees are referred to here as HR people.

HR people are constantly hounded by salespeople from investment firms wanting to show them the wonderful benefits of their 401(k) plans. For example, Fidelity will pound away at them with the benefit of low investment management fees. Others will use performance, low administration costs, better service, a larger list of investment choices, or whatever they perceive their strengths to be. So some choose plans based on sales pitches.

Most HR people are not educated in investment management, so they don't know much more than what these salespeople tell them. Some think that having five investment choices is just fine. So HR people may not even know how bad their plan is. It may take being enlightened by a concerned participant to wake them up (just send them to this page).

Sometimes HR people are very much up on the subject, and may recommend good plans. But corporate finance people that just want to get the plan that costs the company the least money may shoot it down. So retirement plans are usually chosen by the bottom line cost to the corporation, over what's best for participants.

HR people also live in a world of fear. If they give their participants investment advice about which fund options to invest in over others, and it doesn't work out, they can be sued for either pretending to be a fiduciary when they're not, or being a fiduciary and then giving bad investment advice. So they just don't do that. This is why they seem to be useless when participants ask for help. It's not their fault; the "system" is set up to make this not part of their job. It's YOUR JOB to take responsibility for your future. All you can do is become informed and then take action.

Next, HR people are so overwhelmed with day-to-day HR work, that they have no interest in selecting a better 401(k) provider. Switching plans is an expensive and time-consuming nightmare. So forget it, they're not going to change 401(k) plans because a few enlightened participants are complaining. If half of the participants constantly rode them, then they'd listen, but this rarely happens. So the chances of getting them to upgrade a bad 401(k) plan are not good. Start a petition and see what happens.

The vast majority of 401(k) plans are pathetic. If yours is, then the amount of money you'll have at retirement could be anywhere from one half, to one quarter as much, compared to what you could have received in a well-managed self-directed IRA. The math in our money eBook shows how getting just 2% less rate of return results in having about half as much retirement income. Just getting out of TIAA's limited fixed-income (bond) payout structure could make a huge difference in your retirement.

Given all of this, you must realize that the plan you currently have is the plan you're going to be stuck with as long as you are captive.

You must take control of the situation to realize decent investment performance and adequate retirement income. The bottom line: It's the performance of the actual investment choices inside the retirement plan, and how much one holds of each, that will eventually determine how much your retirement paycheck will be.

So if you're an individual participant, or a financial consultant that advises individual participants on how to manage their 401(k)s, all you can do is manage what you're stuck with the best you can.

For most "normal people," there's no way to tell which options to choose other than asking a friend or guessing, each providing about the same value. So your choice is to spend many hours researching it, hire a professional, or just resign to having a small retirement paycheck.

The step-by-step process of 401(k) investment management

How to optimize and self-direct your 401(k) plan while still being captive used to be a freebie, but it was deleted and added to the money eBook.

You'll get five html files that show how to allocate 401(k) plan money between the five risk tolerance categories when you buy the eBook or the Model Portfolios.

How to tell if you're 401(k) is not doing well

The math below assumes that your 401(k) statement doesn't calculate all of this automatically for you.

In the example below, all you're doing is calculating the rate of return you received over the last three years, and then comparing it to the markets.

First, determine how much you have in stocks and bonds in percentages. Everything you invest in is either cash, bonds, or stocks.

Add up all of the money you have in stock funds. Then add up all of the money you have in bond funds. Total them. Now divide the total by the amount held in both stocks and bonds. This gives you the percentages needed to do the math.

Example: You currently have the following in your 401(k) plan:

Growth Fund:            $35,000
Value Fund:              $15,000
Technology Fund:    $5,000
Income Fund:           $25,000
Bond Fund:               $10,000
Stable Value Fund: $10,000
                       Total: $100,000

The first three are stock mutual funds. Divide the amount held in the Growth Fund, 35,000 by 100,000, and the answer is 0.35, or 35%. Add the next two funds, and you'll see that you have 55% of your money in stocks.

The second two are bond funds, and so you have 35% of your money in bonds.

The Stable Value Fund is 10% of your money. It's in cash and not invested.

Pick a time frame that your 401(k) shows historical investment performance for, and that you've had your money in the plan. This example uses the last three years. The longer the time horizon, the better.

Find the last three year's rates of returns for everything. Let's assume these returns over the last three years:

Growth Fund            (35% of your money): 9% average annual rate of return
Value Fund              (15% of your money): 8%
Technology Fund    (5% of your money):    5%
Income Fund           (25% of your money): 4%
Bond Fund               (10% of your money): 6%
Stable Value Fund (10% of your money): 3%

Find the average blended rate of return like this:

35% x 9% = 0.35 x 0.09 = 0.032 or 3.2%
15% x 8% = 0.15 x 0.08 = 0.012 or 1.2%
5% x 5% = 0.05 x 0.05 = 0.0025 or 0.25%
25% x 4% = 0.25 x 0.04 = 0.010 or 1.0%
10% x 6% = 0.10 x 0.06 = 0.006 or 0.6%
10% x 3% = 0.10 x 0.03 = 0.003 or 0.3%

Add them together:   0.032
                                    0.012
                                    0.0025
                                    0.010
                                    0.006
                                  +0.003
                                 = 0.066 or 6.6%

This blended rate is a 6.6% average annual rate of return over the last three years. This means every year, all of your money grew at around 6.6%.

Next, o n this page, you will see a table of historical investment returns. Look at the returns for the stock (S&P500) and bond markets (Lehman Brother's Aggregate Bond Index). These are known as market indexes. Use the same rate of return for cash/money market as what's shown on your 401(k) statement. If there's nothing there, then use 3% for both.

It's important to make sure that the month ending dates are the same on your statement as shown on our web page.

Now do the same math as above with the index rate of return numbers, using the same percentage of stocks (55%), bonds (35%), and cash (10%) you hold. These returns for the last three years are not the actual numbers, as they vary monthly.

Stocks (S&P500) returned 10%
Bonds (Lehman Aggregate) returned 7%
Cash (T-Bills) returned 3%

S&P500: 55% x 10% = 0.55 x 0.10 = 0.055 or 5.5%
Bonds: 35% x 7% = 0.35 x 0.07 = 0.025 or 2.5%
Cash: 10% x 3% = 0.10 x 0.03 = 0.003 or 0.3%

Add them together:   0.055
                                    0.025
                                  +0.003
                                 = 0.083 or 8.3%

Your 401(k) averaged 6.6% and the markets averaged 8.3%.

This means that you realized an annual return of 1.7% less than if you would have just invested the same amounts in S&P500 and Bond Index funds over the last three years. In terms of money, you would have had over 4% more money ($121,136 vs. $127,024) over the last three years. This difference magnifies greatly as time goes on.

If your rate of return is less than the market indexes, then you either have a bad 401(k) plan, or you chose your options poorly. In most cases, both are true at the same time. If you continue like this for over ten years, then the amount of your retirement paycheck from your 401(k) will be about half as much as it should be. This is why all of this is so important.

Your investment options should have had a higher rate of return than the market indexes. But as you now know, most 401(k) plans don't even have funding options that perform better than the markets.

This is mostly because of the incompetence of the people that put the plans together, or because using the better performing options would result in them making less money, or because their company is limited to using only the poorly-performing options that their company manages (for example, a Fidelity 401(k) only offers Fidelity mutual funds. We're not picking on Fidelity, as this is usually one of the better 401(k) providers).

We offer three 401(k) management services

1) For individual participants: If you send us a list of investment options, we can tell you what to buy and sell, and how new money should go into each option. You don't even need to tell us how much money you have.

It generally takes half an hour to screen the funds and half an hour to make the appropriate investor model. So for around $100, you can get professional investment advice on how to invest more wisely in your 401(k). Then you just make your own investment trades.

2) For professional advisors, HR People, and 401(k) Administrators: You can either buy and modify our existing asset allocation models yourself, or you can have us do the work.

You (or we) just evaluate the investment options, and then use them to determine which asset classes are available to invest in. Then funds are chosen to represent the asset classes, they are weighted, and custom investment models are created (usually with three to five risk tolerance categories).

Then after having participants complete an Investment Fact Finder to determine their risk tolerance, you can use the model portfolios to provide several valuable services (for clients, prospects, employees, or seminar attendees). So if they scored Moderate risk tolerance, then you just give them the Moderate Model, which shows which investments to hold and how much. It also shows the returns over several time frames.

They want simple recommendations that tell them exactly what to do, and this is exactly what you'll be giving them. Doing a good job at this can be very profitable because it opens the door to managing participants' personal assets, the IRA rollover when captivity ends, getting easy referrals, or the corporation letting you perform seminars for their employees.

It usually takes an hour to screen the funds and an hour to make the three to five portfolio models. So the total cost would be around $200. A good financial planner should be able to charge a couple of clients this much.

If you're in the market for a new 401(k) plan, or want to replace an existing plan, then we can also look over the options and make a recommendation about one which is better and why.

3) For both investors and professionals: We will evaluate each investment option in detail for $9 each.

For example, if your 401(k) plan has three Fidelity funds with the name "Growth" as the investment objective, which one do you invest in? Are they all really growth, or is a mutual fund family that cares more about marketing than truth deceiving you? What kind of growth is it? What size growth is it? You could invest in all three, but if one is good and the other two are dogs, you're going to get results that are two-thirds dog.

For $27, we could have evaluated all three options, and you would probably have made your $27 back in a month by avoiding the dogs.

Please note that these investment strategies can also be applied to variable annuities, life insurance policies, single mutual fund families, and other plans where one is captive to a limited number of investment choices

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