Three Tips to Make Your 401(k) Work for You

It's surprising there aren't many calls in the press to ditch the automobile. After all, think of all the dumb things people do with them. They drive much too quickly and sometimes after drinking lots of alcohol. They even drive while sending text messages, putting on makeup, and reading the newspaper. The consequences can be dire: More than 40,000 Americans die in auto-related deaths each year, with nearly 3 million suffering injuries of some kind. Of course, it would be impractical and silly to outlaw the automobile. They are too intertwined in our lives and are beneficial in many ways. And it would be unfair to blame the automobile for its misuse.

Yet that's exactly what's happened in the case of another vehicle, in this case, the main retirement savings vehicle for most Americans: the 401(k). Last fall, a Timecover story called for the retirement of the 401(k) itself, using the often-catastrophic losses investors suffered in the 2008 crash as the argument against them. But just as cars don't cause accidents, there's nothing inherent in a 401(k) that dooms you to a substandard retirement.

The Time article was trying to make a broader point that the do-it-yourself nature of the 401(k) makes retirement savers much more vulnerable to unpredictable fluctuations in the market, especially versus the company-provided pensions of yore. Although pensions aren't perfectly secure either, it's true that even investors with thoughtfully conceived 401(k) portfolios suffered heavy beatings in 2008. Those nearing or in retirement were dealt an especially tough blow as they faced living off a much-smaller nest egg and because, unlike younger investors, they don't have as much time to recoup their losses. 

Regardless of its shortcomings, though, the 401(k) is probably here to stay. And contrary to the impression provided by the Time article, using one successfully isn't a lost cause. Here are a few tips on how you can make your retirement plan work for you.

Save More
The Time article does make one claim few can dispute: Americans don't save enough for retirement. And, of course, it doesn't help that over the past decade, stocks have gone nowhere, just like most investors' 401(k) balances. Fortunately, there are some good reasons to believe that the next decade for stocks may be better than the last (long periods of subpar returns historically have been followed by long periods of above-average ones), which will give 401(k) accounts a boost. But you can't rely on the market to do all your heavy lifting. If stocks and bonds don't provide the return you need, you'll have to fill in the gap by saving more.

Of course, saving more can be easier said than done, especially now, with so many households strained by high debt, stagnant incomes, and unemployment. If it's not possible to change your savings patterns dramatically right away, start small. You can pledge to increase your savings rate by a percentage point (or more) every year, for instance. If your 401(k) plan has an option that automatically increases your savings rate on an annual basis, take it. The easier you make it to stay disciplined, the more likely you'll achieve your goals.

Morningstar's Retirement Income Calculator, which you can find on the Personal Finance tab on Morningstar.com, can help you determine how much you should be saving. You provide your age, income, and the size of your current nest egg, and the tool will provide you with an approximate savings rate. At the very least, make sure you save enough to secure matching contributions from your employer, if they offer them at all. Not doing so literally leaves free money on the table.

Invest Wisely
If you believe the Time story, you might believe that your 401(k) becomes riskier the longer you save. That is, a bigger account is more exposed to the whims of the market than a smaller one. Yes, it's usually the case that the investors with the biggest accounts are closest to retirement, so it stands to reason they have the most to lose from a big drop in the stock market. That's not an argument against the 401(k), however. It's an argument against having too much invested in stocks, especially when you can least afford to take the risk.

Admittedly, getting asset allocation--the proportion of your portfolio that you allocate to stocks, bonds, and other asset classes--right can be tricky. Morningstar.com Premium Members can use the  Asset Allocator tool to come up with one. Others should consider piggybacking off the research legwork fund companies have done in coming up with their target-retirement funds. These funds are designed to become more conservative (meaning they invest more in bonds and less in stocks) as investors near their retirement dates--exactly what you should be doing on your own.

Start by looking at target-date funds from big shops. (Our favorites are from T. Rowe Price and Vanguard.) Find the fund that corresponds most closely with your retirement date and use it as a guideline for your asset allocation. (Or if you want to opt for a no-fuss, hands-off solution, you can just buy a target-date fund and save yourself the trouble of handing asset allocation.) Also pay attention to the fund's "glide path," the pace at which its asset allocation becomes more bond-heavy. Morningstar.com Premium Members can find information on the top 20 largest target-date fund providers, including T. Rowe Price, Vanguard, and Fidelity, in our new  Research Reports. Otherwise, you can do your homework by taking a look at the different funds' prospectuses.

Because the market fluctuates, your asset allocation will get out of whack over time. A rising stock market will mean that your portfolio will become disproportionately exposed to stocks even if you don't purposefully increase your weighting in them. I'd bet that many investors left their portfolios untouched in the 2003-07 stock market rally, which left them increasingly vulnerable when the crash came in 2008. Likewise, because bonds performed better than stocks in 2008, many investors were left underexposed to stocks. To avoid both extremes, rebalance your portfolio on a regular basis--or at least monitor your asset allocation closely to ensure it's not straying too far from your plan. For more on rebalancing, click here.

Be Flexible
Contrary to what many of us expect, being able to retire at 65 years old isn't a birthright. (In fact, when that retirement age was set back in the 1930s, 65 years was the average person's life expectancy.) The fact is you might have to delay your planned retirement to meet your goals. Working longer not only means you'll save more, but that there will be fewer years during which you'll have to draw upon your retirement assets. An accompanying piece to the Time cover story made this point pretty powerfully. Citing data from T. Rowe Price, it noted that a 62 year old can boost retirement income by 22% by working another three years, and 39% by working another five years.

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