You are not a dummy if you don’t understand your 401(k). As a financial planner, I get a lot of questions around these employer plans. This is unfortunate, because many people will be counting on them for their future retirement income, and understanding the basics is important. I will boil it down to the absolute basics you need to understand. Just remember MEA.
M is for Matching
If your employer provides any kind of matching contribution, that’s great. There are a lot of different calculations they can use, but the key question to answer is “How much do I need to contribute in order to get the full match?”. Try to contribute enough to get the full match. If you can’t right away, many plans offer an automatic escalation feature that will increase your contributions regularly. If your plan does not have that feature, increase your contributions when you receive pay increases to make it less painful.
E is for Expenses
Once you know how much the full match is, and you are planning to contribute, you need to understand the investment choices your plan offers. Each investment choice has what is called an “expense ratio”. This tells you how much of your investment you will pay every year for the privilege of owning it. Higher numbers are worse than lower numbers. You can usually find this number right on the 401(k) website next to the investment option or in the annual disclosures that are required. Don’t pay more expenses than you need to.
A is for Allocation
Now that you have some money and you know how much each option will cost, you need to decide how to spread that money across available choices. This is where it gets a little complicated. Each employer plan is required to offer you several different choices that have different risk/return characteristics. At a minimum you will probably see a “money market” option, a “bond” option, and a “stock” option. Many employers also offer “target” funds that have a retirement year in their name. Each individual person will need to decide on an allocation that makes sense for them based on their risk appetite and time horizon. The key is that less risky options like the money market will earn less while more risky options such as stocks historically earn more over time.
One tip that I think applies to everyone: Don’t invest in your employer’s stock in your 401(k). Your job is your investment in your employer. You need to diversify. Anyone heard of Enron and WorldCom???
MEA is truly the basics. There’s a lot more to know if you want to learn. Your employer may offer online/printed education so check with your HR person. Also, do a quick search on the internet and you will get a million articles. Finally, consider working with a financial planner to get truly personalized advice for you and your situation. A planner can answer all of your questions and help you get on the right path quickly, often in under an hour.
*There is actually a 401(k)s for Dummies book. I’ve never read it and this post is not intended to be an endorsement!