VOICES FROM THE INDUSTRY: Does your 401(k) work as well as most pension plans?

This is definitely not the headline most workers wanted to see on the business section of the newspaper: “Traditional e m p l oy e r- f u n d e d pension plans outperformed worker-funded 401(k) plans during bear market.”

The findings, based on a study conducted by the employee-ben
efit consulting firm of Watson Wyatt Worldwide, bolstered critics’ arguments that 401(k) and similar retirement plans are not up to the task, when compared with defined-benefit pension plans, of preparing Americans for a secure retirement.

Regardless of the merits of the criticism, 401(k)-type plans-in which workers do the bulk of the funding and make the investment decisions-remain a fact of life for most workers. And, fortunately, within the findings of the Watson Wyatt study and from outside experts, there are keys to what workers can do to improve the performance of their 401(k) accounts.

The study found that while both types of plans lost money during the three-year bear market of 2000-2002, 401(k) plans fared worse by an average of 3.86 percent a year compared with professionally managed pension plans.

Although 401(k) plans outperformed pension plans during the three years pre
ceding the bear market, pension plans still averaged better returns than 401(k) accounts over a 12-year period ending in 2002, according to Watson Wyatt: 7.42 percent annually for pension plans vs. 6.86 percent for 401(k)s. That may not seem like a lot of difference, but over decades of investing for retirement, it can add up.

So what can employees managing their own 401(k) or similar retirement account do to bridge the gap?

Diversify

It’s important to maintain a diversified portfolio. When some assets are down, others may be up to help offset losses. For example, while stocks suffered during the bear market, bonds and real estate did well. Please keep in mind that past performance does not guarantee future results and investments involve risk. Diversification does not assure a profit nor protect against loss, however it may give an investor a better relationship between risk and return.

The Watson Wyatt study found that large-company 401(k) plans performed better than plans run by small companies. The study attributed the difference to the fact that plans of larger employers typically offer more investment options, thus allowing for greater diversification.

Many investors don’t take advantage of this, however. According to a 2003 study by Hewitt Associates, 26 percent of plan sponsors felt that the most common investment mistake that 401(k) plan participants
make is not diversifying adequately.

A combination of stocks and bonds in various percentages may help reduce the risk of the overall portfolio. Beyond stocks and bonds you can also allocate between small, medium and large cap companies and value and growth investment styles. This combination, called asset allocation, seeks to capture return opportunities while reducing volatility.

Have an investment strategy

The cornerstone of diversity is an investment strategy that guides how your portfolio is invested. This strategy considers your risk tolerance, time horizon and future income requirements. Having a strategy will help keep you from making decisions based on emotions and fads.

The investment arena is challenging. Like Warren Buffett said, “If past history was all there was to the game, the richest people would be librarians.” But following simple guidelines on a consistent basis provides a strategy for investors who are willing to exercise patience.

Rebalance your assets

One of the key findings of the study was that most workers failed to rebalance their 401(k) accounts. Pension plans, however, following a disciplined investment plan, regularly rebalance their assets in an attempt to reduce risk and maintain their various asset categories, such as stocks, bonds, and cash, in desired ratios. The consequences of not rebalancing periodically
became apparent in the wake of the boom market years of 1995 to 1999. Because workers typically didn’t rebalance, the stock portion of their portfolios grew disproportionably large compared with other types of assets. By 1999, stocks comprised 72 percent of 401(k) account values, according to the Federal Reserve Board, while defined-benefit pension plans held only 59 percent in equities. Thus, when the stock market tumbled in 2000-2002, stockheavy 401(k) accounts suffered.

Easy on the company stock

The Hewitt study noted that the average 401(k) participant who held employer stock devoted 42 percent of his or her account to that stock. Generally speaking, company stock should probably be limited to no more than 10 percent to 15 percent of the portfolio’s value. As Enron and other major corporate bankruptcies illustrated, overweighting company stock can be very risky.

Contribute and make the match

The bear market scared many workers from even making contributions to their 401(k) plan. Yet 401(k) plans will be the main source of income for many retirees. At least contribute enough to maximize any company contribution matches and, ideally, increase contribution amounts every year.