Navigating employer retirement plans

STEP 1:

With so much emphasis in this book on buying a long-term, highly diversified portfolio, it would be reasonable if you figured that this is exactly how you should invest the money in your retirement plan at work.

And you would be wrong.

Yep, it is another example of how complicated it can be to correctly manage your investments. So let me show you how to properly participate in your employer’s retirement plan.

All plans operate basically the same way, so it doesn’t matter where you work. Indeed, the following advice is applicable whether you are:

A private-sector employee funding a 401(k) plan.

A non-profit wage earner contributing to a 403(b) plan.

A federal employee using the Thrift Savings Plan.

A municipal employee participating in a 457 plan, or a self employed person investing via a Sarsep, Simple IRA, SEP-IRA or Solo 401(k).

Pay attention, because the information that follows will help you amass what most Americans would call a fortune.

Ideally, your employer’s plan will offer institutional mutual funds or exchange traded funds. But few do. So be it. Work with the choices available to you as best you can.

STEP 2:

Contribute the maximum that your employer allows. As you have seen, the more money you save, the more you’ll accumulate. But if you feel that you can’t afford to contribute the maximum your employer allows, simply start with a smaller amount and increase it every year until you reach the maximum.

Make only pretax contributions, as there is little advantage to contributing money that you can’t de-duct from your income taxes. (Invest after-tax money in your own investment accounts rather than in your employer’s plan.)

STEP 3:

Place all your contributions in stock mutual funds. If you are at least seven years from using the money in your plan, place all of your contributions (along with your employer’s contributions, if any) exclusively in diversified stock mutual funds.

Note the key phrase in that sentence: “using the money.” Although most people vaguely understand that they should choose their investments with an eye to the future, most incorrectly focus on their retirement date. They think that if they are retiring in a few years, they need to invest more conservatively than those who are planning to work for many more years.

But such thinking is wrong. Your retirement date is irrelevant. Why?

Because you might not need to withdraw money from your plan immediately upon retirement.

Indeed, when our clients retire, they often discover that retirement is not an economic event. Oh, sure, it is one heckuva lifestyle change, but in many cases, that is all it is. Thanks to pensions, Social Security, investment income from non-retirement assets and, sometimes, income from post-retirement work, they don’t need to withdraw money from their retirement plans. And because withdrawals from their retirement plans are taxed, they are happy to leave the money untouched. As a result, they do not touch the money in their retirement plan for many years after they have retired.

Therefore, your investment allocation should be based on the date you will begin to spend some of the money, not the date you’ll retire. This can add years to your investment horizon, which enables you to seek higher returns than you otherwise might attempt. This is crucial, because over a 30-year period, the final five years of your retirement account will produce as much as a third of your account’s total accumulated value (thanks to the wonder of compound interest). This is why, if you are at least seven years away from using the money in your plan, you should be placing all your contributions (along with your em-ployer’s contributions, if any) into diversified stock mutual funds.

Note that I am talking about your current contributions. I am not (yet) discussing your account’s existing balance. Still, this notion might disturb you. After all, you know that the stock market is volatile. I agree — and I am telling you to invest exclusively in the stock market, not in spite of the volatility but because of it.

There are two reasons for this. First, if your investment horizon is 10, 20 or 30 years away, volatility is irrelevant. Remember the crash of ’87? One week before the crash, the Dow Jones Industrial Average was 2,471; one week afterward, it was 1,793 — a decline of 38%. As of May 2007, the Dow exceeded 13,200. So who cares about short-term volatility when you have a long-term investment horizon?

Second, when you are adding money to your account on a regular basis — which is exactly what you’re doing when you participate in a retirement plan at work — volatility is your friend. By investing a preset amount of money at preset intervals (say, $50 with each paycheck), you are engaging in dollar cost averaging — the most successful form of investing ever devised. You can read more about dollar cost averaging in “The Truth About Money” [HarperCollins Publishers Inc., 1996], but suffice it to say here that [dollar cost averaging] automatically arranges for you to accumulate many shares at low prices and relatively fewer shares at higher prices. The math’s efficiency over many decades helps produce long-term profits.

But the most fundamental advice in this book is that you should diversify your investments. Isn’t this new advice contradictory?

Not at all. You see, there are actually two ways to diversify, not just one. The first way, which we have explored in detail, is to invest a current lump sum into a wide variety of asset classes and market sectors.

But the second way involves investing money as you accumulate it (via dollar cost averaging) into a single asset class or market sector. In other words, you can invest by asset class or market sector when you have a large amount to invest, or you can invest by time when you are investing small amounts over long periods.

Both are extremely effective forms of diversification.

That is why we always suggest that our clients place 100% of their retirement plan contributions into stock funds. Often we suggest that 80% be placed into U.S. stock funds (split equally between growth stock funds and value stock funds or between large-cap funds and mid-cap/small-cap funds) and 20% into foreign-stock funds.

This 40-40-20 ratio is merely a suggestion. However, I am adamant that you invest current contributions only in stock mutual funds (even if you use only one fund). Never dollar cost average into bonds — and that includes bond funds, government securities, fixed ac-counts and money market funds. History tells us that over long periods, stocks have always earned more than all of those. I can’t promise that this will occur in coming decades. But still.

One final point: Once you pick your mix of stock funds, stick with it. For years. No matter what. Reject all temptation to switch into other stock funds that might appear to be doing better, or bond funds and money markets that might be experiencing less volatility at one time or another.

Dollar cost averaging demands (demands, mind you) that you own your stock funds throughout periods of poor stock market performance; if you sell or stop contributing while prices are down, you will guarantee that you will enter retirement broke. So stick with your chosen funds as though they are tattooed to you.

Actually, that tattoo metaphor is appropriate. You should pick in-vestments with the expectation that you might own them permanently. Realize that removing them will be painful and expensive — and it can leave scars that will stay with you for life.

So I will say it again: Pick your mix of investments and then stick with them for years. Never switch into other funds simply because they appear to be earning more or losing less. If you follow only one piece of advice from this entire book, this is it.

Diversify your existing account balance. If you are clever, you might have figured out that investing all your contributions in stock funds creates an unintended side effect: After you have been doing this for a number of years, you will have so much money in your stock funds that your next paycheck contribution will be in-significant. As a result, your dollar-cost-averaging strategy will no longer be able to offset the impact of market volatility — the very volatility I earlier told you to ignore.

To solve this problem, you must diversify the existing balance of your retirement account — adding other asset classes and market sectors in accordance with your portfolio model as explained earlier in the book — with particular attention paid to your model if you are planning to tap into your retirement accounts within the next seven years.

Excerpted from “The Lies About Money” by Ric Edelman. Copyright 2007 by Ric Edelman. Reprinted by permission of Free Press, a division of Simon & Schuster Inc. of New York.