Even though most 401(k) plans are organized terribly, with high fees and a poor selection of mutual funds, and even though most 401(k) plans are quite inflexible—in most cases, you can adjust the distribution of your assets among the investment options your 401(k) administrator offers only once a month, or once a quarter—the extra profits you would make from deferring your taxes alone would be enough reason to invest heavily in your 401(k) plan. In the vast majority of cases, there’s another great reason to contribute to your 401(k): the employer match. Typically, for every dollar you contribute to your 401(k), your employer will match some part of that contribution up to a certain point. For example, your employer might match 50 percent of your contributions: the company puts in 50 cents for every dollar you put in, up to 10 percent of your income, so once you contribute 10 percent of your income to your 401(k) in any given year, the boss stops giving you free money. You should always take your employer for every last dollar it’s willing to put into your 401(k).
There’s one hitch here: most employers will gradually vest their contributions over time. In plain English, that means you become entitled to the employer match in full only if you stay with the company for some period of time. There are two ways your employer is likely to vest its contribution to your 401(k) over time. It might give you 20 percent per year, so that after five years working for the company, all company contributions will be fully yours, even if you leave. The other common way employers vest their contributions is harder on you: they’ll vest 20 percent after three years, and add 20 percent every year until they finish at year 7. This is a drawback, especially in an age when people increasingly move from company to company looking for work. But not every company vests its contributions over time, and even if you leave after a year or two, getting 20 percent to 40 percent of your employer’s contribution is still a lot better than getting nothing.
If you contribute enough to get the full employer match every year, you’ve taken a huge step toward building long-term wealth. Unfortunately, that wealth is locked up inside a 401(k) plan, and aside from the two points I just mentioned, there’s nothing nice to say about most of these. What’s so bad about a 401(k)? Let’s start with the legitimate rules. This is a retirement account: end of story. If you contribute to your 401(k), there are very few circumstances in which you’ll see that money again before you turn 59½. Those special circumstances are called hardship withdrawals, and they’re difficult to get. First, your employer isn’t required by law to permit hardship withdrawals, so if your employer doesn’t include rules regarding hardship withdrawals in the Summary Plan Document for its workers’ 401(k) plans, you’re out of luck. If the company you work for does permit hardship withdrawals, you still have to pay a 10 percent penalty excise tax, in addition to the income tax you’d pay on any distribution from your 401(k). You can get a hardship withdrawal to buy a primary home, to prevent a lender from foreclosing on your home or evicting you, to cover the cost of college tuition for yourself or a dependent within the next twelve months, or to pay medical expenses that will not be reimbursed for you or your dependents. But before you can even take a hardship withdrawal, you’ll have to prove to your employer that you genuinely need the money and cannot get it anywhere else. And again, this all depends on whether your employer even permits hardship withdrawals. You can also withdraw money from your 401(k) before you turn 59½ in some other circumstances, but they aren’t circumstances you want to be in: if you become totally disabled; if you go into debt for medical expenses over 7.5 percent of your adjusted gross income; if you are required by court order to hand over the money to a divorced spouse, a child, or other dependent; if you are laid off in the same year you turn 55; or if you lose your job and set up a regular, approximately uniform payment schedule for distributions from your 401(k) over the course of your life expectancy.
Forget trying to get your money out early; it’s too costly. Let’s talk about the fees instead. In a typical 401(k) plan, you’ll likely be offered anywhere from six to twenty different funds, or even more, that you’re allowed to invest in as part of your plan. Plus, you’ll be able to purchase stock in your employer if it’s a publicly traded company. But before you even determine where to place your capital, you’re already paying a fee based on the amount of money you’re contributing. Most people don’t notice these administrative fees, because when you receive your monthly or quarterly account summaries, that fee is simply subtracted from your actual return before it’s reported. So these fees are not included as separate items in your account summary. It’s possible that your employer takes care of these costs for you, but you won’t know unless you check, so ask your human resources or personnel department for a quick breakdown of how your 401(k) is administered and who’s footing the bill. Just ask for the 401(k) prospectus. These are truly hidden fees and you don’t want to let them slip past you.
In my view, one of the worst aspects of a typical 401(k) is the poor selection of approved mutual funds. This is what you’d expect given how a 401(k) is set up. The offerings in your 401(k) have been chosen either by the company in charge of administering the 401(k) or by the human resources department at your company, which, though adept at hiring and firing people, usually isn’t well trained in asset management. If an asset management company runs your 401(k), the odds are good that your plan will let you choose from many funds that belong to the company that’s administering your retirement plan, whether they’re good or not. Many insurance companies have also gotten into this game. If you learn only one thing from this book, learn that insurance companies are not to be trusted. It’s not unlikely that an insurance company is in charge of your 401(k), especially if you work for a small company or if you have a 403(b) plan, which is what teachers, professors, and nonprofit employees usually have. The insurance companies often package their 401(k) as an annuity and charge you much higher fees, as well as include their own high-fee annuity offerings that no one should buy. You can always ask about the type of 401(k) plan a prospective employer offers when you interview for a job, and you can compare your potential employers based on the types of plans they offer, but it’s not likely you’ll have much luck finding a good 401(k). You might be able to find yourself the least bad plan. That said, it’s absolutely essential that you examine the 401(k) prospectus when you look over the compensation any potential employer offers you. It doesn’t take that much in fees to cost you tens or hundreds of thousands of dollars come retirement, so you need to assess this as you’d assess any other benefit. Once you get a job, you can always try to agitate for a better 401(k). You can go to human resources and push for better offerings or a better plan administrator. There’s no reason why everyone shouldn’t do this. Agitation from employees and from politicians has steadily made 401(k) plans better and better, and I believe that on average it will continue to do so into the future. But for now, 401(k) plans are mostly disappointing (and completely necessary, 100 percent mandatory unless you have very low income and aren’t planning on staying with your current employer for long), aside from the fact that 401(k) contributions are tax-deferred and your employer likely matches some part of your contribution.
Investing in your 401(k) is one of the smartest, best things you can do to build lasting wealth for yourself and your family. But investing in a 401(k) badly is one of the worst possible things you can do to your chances of ever becoming rich, or even achieving modest prosperity. And the way the system is set up, it’s very easy to do a bad job of running your 401(k). Letting workers manage their own retirement funds is great, but we forget that we live in a country that makes no effort to teach anyone practical financial lessons, and few companies that offer 401(k) plans try to teach their employees anything about investing for fear that they’ll be sued if their employees lose money taking even the blandest advice. So how can you take advantage of this terrific—tax-blessed, as I sometimes call it—retirement plan without falling victim to the many perils of 401(k) investing? I’ve got you covered. Here a
re the five most common mistakes people make in their 401(k) plans that ruin their future, and how you can avoid them:
The Five Most Common 401(k) Mistakes
1. The most popular 401(k) investment is your employer’s stock. Don’t ever buy any.
2. The second-most popular 401(k) investment is different versions of the stable-value fund. Avoid these unless you’re close to retirement.
3. Most 401(k) investors assume that the mix of funds offered in their 401(k) plan is representative of the mix of actual investments in the market and a good proxy for diversification. Don’t be confused by your 401(k)’s offerings. Stick to my bedrock principles and you’ll be fine.
4. When people leave their jobs, for whatever reason, most choose to cash out their 401(k) plan or leave their plan alone and pay higher fees to maintain the old 401(k) with their old employer. Both of these decisions are bad. When you leave your job, be sure to roll over your 401(k) into an IRA.
5. Increasingly, workers are falling victim to automatic enrollment in 401(k) plans, which come with a terrible set of default investments. Don’t let this happen to you. Pay attention to where your money’s going, and allocate your assets yourself.
1. Don’t ever buy your employer’s stock. This has been said many times before, and apparently to no effect, as people continue to invest more money in their employer’s stock than in any other type of 401(k) investment. There are very few situations where you want to own stock in the company that writes your paychecks. Remember, diversification is the single most important principle of investing, and you need to put your income on the table when you look at your investments. Let’s say you work at CVS Caremark, making $60,000 a year. Should you also own CVS stock? I think it’s a great stock; in fact I recommend it later in this book as a great long-term investment. But no, you shouldn’t own even a single share of CVS as long as you work there. Your fate is already tied to the performance of CVS even if you don’t invest a penny in its stock. As the professionals would say, you’re already levered to CVS. If something really terrible happens to the company and it needs to take drastic measures to cut costs, you’re already in trouble just because you’re on the payroll. Let’s say you get laid off. In this case your income is already plunging from $60,000 to $0 a year. The last thing you need is to have your retirement funds tied up in CVS stock. If you were contributing $10,000 a year to your 401(k) and plowing all of it into CVS stock, then both your salary and your portfolio would take a hit. What happens to you if the same trouble that cost you your job also takes 50 percent off the value of the stock? All those $10,000 contributions will get sliced in half too.
A huge part of the reason we invest is that we need to augment our paycheck, which just doesn’t provide enough money for all the finer things in life. If you get fired, you want to be able to rely on your investments, and you can’t do that if you’re invested in your employer’s stock. Think of the sad hypothetical CVS employee in my example. What if this guy is just a year away from retirement? All of a sudden, not only is he out $60,000 of income that he was expecting to earn in his last year on the job, but he’s also just had his whole retirement fund cut in half. There’s no way he can retire now.
This is beyond the realm of possibility for a massive, well-established company like CVS, right? Maybe it feels that way now. Think of those poor Enron employees. They’re Exhibit A for why you absolutely cannot invest your 401(k) money in your employer’s stock. They worked for a massive, well-established, well-run company, and the idea that its stock could get cut in half in a day must have seemed preposterous to them. But that is just what happened when the first news of the fraud broke, before we even knew the full extent of the malfeasance. I’m sure those who invested 401(k) funds in Enron’s stock never thought it would go all the way to zero, which it did, thoroughly wiping out all of their retirement savings. You rely on your employer for your income; don’t also rely on your employer to fund your retirement. As an investor, your job is to spread the risk around, not to concentrate it all in one place, which is exactly what you’re doing when you buy shares of the company you work for with your 401(k) contributions.
I don’t care for any of this “Know what you own, own what you know” nonsense either. Peter Lynch, the brilliant investor who originally said that, didn’t mean that you should buy stock only in companies that you’re personally familiar with, either because you work for them or because you use their products. He meant that you should be familiar with your stocks, and that therefore you should buy only what you can comprehend and have some level of experience with. The advice does not mean you should buy stock in whatever company you know best, which in most cases would be your employer’s stock. As I’ve just explained, that’s a recipe for disaster. Familiarity is no reason to invest in anything, especially not with crucial retirement capital. Familiarity might give you a useful perspective on whether a given company is worth owning, but by itself, it means nothing.
I’m sure some of you will say, “Cramer, what about those workers at Apple and Google who made fortunes because they were compensated in stock, stock that subsequently quintupled in value over a brief two-year period? Don’t they disprove what you’re saying about buying your employer’s stock?” Not at all. We’re looking at two totally different situations. Especially at big tech firms like Apple and Google, higher-ups are often paid largely in stock options (in this case, call options). A call option gives you the right, but not the obligation, to buy a stock at a certain price, called the strike price, within a certain period of time. When we’re talking about executive compensation, these options are normally “struck” at the stock’s closing price on the day they’re issued, which is incidentally why so many executives got busted for backdating options—they were basically paying themselves with options and claiming that they were issued on days when the stock was particularly cheap. This has nothing in common with retirement investing, and even less in common with investing in a 401(k). The people who made fortunes from being paid in the stocks of particularly successful companies were taking enormous risks, and for every stock option millionaire, there are a dozen stock option failures, guys who were paid in options while working at failed start-up companies and who ended up with options worth nothing and no wages. People who are paid in options are pursuing a high-risk strategy, way too risky for the money you’re going to use to retire. Many executives get paid with stock options because it’s a great way to pay executives for performance. If their stocks go higher, they make fortunes; if the stocks tank, their options are worthless. But these executives usually are already making enormous six-to seven-to eight-figure base salaries, and I guarantee you they’re not relying on stock options to fund a comfortable retirement. They’re hoping that their stock options will allow them to throw lavish, decadent parties for themselves and their rich friends. You’re probably not in that position.
I’ll say this one more time: it doesn’t matter how great your employer is as a company, or how great its stock is. Under no circumstances are you allowed to invest any part of the money in your 401(k) in your employer’s stock. This is the single most common way people wipe out their retirement savings, and honestly, you know better than that. When people who worked at Enron or WorldCom made this mistake and then called in to my old radio show during the segment where I would tell workers what I’d do if my 401(k) was as devastated as theirs, at first I felt pity for them, because it’s awful to lose your retirement savings. But then, almost always, I would harden my heart because these people committed the most basic, elementary investing mistake, one that is sure to hurt you over the long term. In the end, I still pitied these guys because they didn’t know better. No one had ever told them what I’m telling you. But now you don’t have that excuse, so sell your company stock. Some employers provide their matching 401(k) contribution in their own stock. If so, take the first opportunity you have to sell that stock and move your funds to a better investment—in this case, any other investment is b
etter than owning shares of your employer, especially in your retirement account.
Honestly, I regard buying your company’s stock in your 401(k) as the single most dangerous investment you could ever make. I would rather buy Treasurys, U.S. government bonds. These are the ultimate unambitious investments, with spectacularly low yields and even less risk than shares of my employer for my 401(k). That’s how serious I am about this.
Jim Cramer's Stay Mad for Life Page 8
