"Yeah, the stock market scares me though, so I have it in what they said was the most safe option. I think it is called a money market."
She had her whole 401(k) in cash in a stretch of time when the S&P 500 returned over 50%! Even a moderate, can't go wrong choice, balanced fund returned 14% in 2012 and 21% in 2013! If she had invested her money, her $200/month savings could have grown to over $6,000 instead of being just $4,800. This would have been an amazing return for such a short time.
This just happened to be a time with particularly high returns. Other stretches of time and other investments would produce different returns.
Retirement is the biggest financial decision most people will make. In recent history, employers have typically provided some sort of mechanism for people to have income or assets after they finish their careers. With people living longer and longer these days, employer sponsored retirement plans have become more and more important, although unfortunately, they have become more and more rare too.
WHAT IS A 401(K)?
The 401(k) is a type of plan known as a deferred compensation plan. It is called this because you are deferring income from your current paychecks until later - hopefully until you retire. Essentially it works like this:
- You decide an amount of money that you want withheld from your paycheck. Sometimes you can choose if you want this deferred before you pay taxes on it or after.
- This money is withheld and placed in an account for you.
- Your employer may or may not add a contribution on top. Typically contributions are matching contributions up to some percentage of your pay, but can also include flat contributions or profit sharing contributions.
- The money in the account is invested according to to your instructions.
- Money accumulates as you work.
- When you retire, you have essentially free access to the money.
- Stable Value or Money Market funds. These are basically cash.
- Fixed Income. These are funds with bonds of various types. They may contain US Government Treasury bonds or corporate bonds but the idea is that they will all pay interest to you and a supposedly reliable pace. A much deeper dive for a different day reveals that this is not the case when they are pooled into funds.
- Stocks. These may be divided up into US and International funds. Or maybe divided by size and shape. Stocks are shares of companies. The value fluctuates with the successes and failures of the company. Funds can be either actively managed by someone trying to pick the companies with the best future, or can be a passively managed index fund, just keeping track of a basket of stocks without much interference or cost.
- Balanced Funds. A mix of the other types of funds.
- Target Date funds. These are a special flavor of balanced fund that adjusts as you age. They typically have a retirement year in the name. They start off with aggressive, risky investments in stocks to drive return when you have a long time to grow, and get more conservative moving to bonds and cash as you retire.
- Are you contributing enough? Are you hitting the 16% target? Can you contribute more?
- Have the investments changed in your plan? Plan menus do change, if an old option is not available, search for the next best alternative. If your plan had target date options, it is unlikely that these have changed without keeping you up with the times.
- Do the investments work with your total portfolio? You cannot view your 401(k) in isolation. It is an asset like your other assets and needs to be viewed in that context. Say you have $100,000 in your 401(k) and $100,000 in outside investments and your overall allocation, based on your needs and risk tolerance, is 50% stocks 50% bonds. If both accounts are 50/50, fine, but if your outside investments are all stocks, then your 401(k) should be all bonds.