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To meet retirement goals as affordably as possible, 401(k) participants must do three basic things – save early and often, invest appropriately, and keep account fees to a minimum. Investing appropriately involves constructing - and maintaining – a 401(k) investment portfolio that balances growth potential with the risk of losses.Striking this balance is important. Otherwise, a 401(k) participant could miss out on gains by investing too conservatively when young or sustain unrecoverable losses by investing too aggressively when near retirement.
In short, 401(k) participants must invest appropriately throughout their working years to afford retirement as soon as possible. That’s a tall order for most participants when you consider the complex investing principles participants must apply to invest their account appropriately – specifically, asset allocation, diversification, and rebalancing.
In my experience, most 401(k) participants lack the expertise to properly apply these principles. If you’re in this boat, I have good news - professional 401(k) investment advice is more accessible than ever. Just about every 401(k) plan today offers at least one of the three basic forms – fund-based, advisor-based, or algorithm-based advice. Below is a description of each, including their pros and cons.
401(k) Investing Principles
To construct and maintain an appropriate 401(k) investment portfolio throughout your working years, you must properly apply three investing principles:
- Asset allocation involves the allocation of an investment portfolio among different asset categories, such as stocks, bonds, and cash based on the time horizon and risk tolerance. In general, young participants should invest heavily in stocks – which have higher growth potential, but more volatile. Older participants should invest more conservatively.
- Diversification involves picking investments with uncorrelated returns for asset allocation. This way, if one investment is declining, others are more likely to be growing, or at least not declining as much – minimizing the risk of large losses.
- Rebalancing involves periodically buying or selling assets in a portfolio to maintain the desired level of asset allocation.
Don’t trust yourself to properly apply these principles? Join the club. Below are the professional advice options your 401(k) plan may offer.
Fund-based Investment Advice
Fund-based investment advice is delivered by a mutual fund – usually a Target-Date Fund (TDF). There is no easier way to access professional advice. To do so, you simply need to invest 100% of your account (no less) in the TDF that best matches your estimated retirement date.
Pros
- The easiest form of professional investment advice to access.
- Set it and forget it. TDFs offer automatic rebalancing. Further, their asset allocation will gradually shift to fewer stocks and more bonds (i.e., become more conservative) the closer you get to retirement.
- Low cost. The investment expense of a Target Date Index Fund (TDIF) can be less than 15 bps (0.15% of assets) annually.
Cons
- Advice can’t be personalized to meet individual investment goals.
- TDFs comprised of actively-managed investments can get expensive.
- Insurance companies can add variable annuity wrap fee to otherwise low-cost TDFs.
- TDFs offer no participant engagement or coaching.
Advisor-based Investment Advice
Advisor-based advice is delivered by a human financial advisor. This advice generally takes one of two forms: 1) a lineup of managed portfolios for you to choose from, or 2) one-on-one advice. This advice can be delivered in-person and highly-customized to meet individual investment goals – factors that can help you stay engaged when saving for retirement.
Pros
- Advice can be personalized to meet individual investment goals.
- 401(k) participants often require personal motivation to keep their retirement savings on track. A human financial advisor can be like a personal trainer for your 401(k) account.
Cons
- Cost. Usually the most expensive form of professional advice.
Algorithm-based Investment Advice
Algorithm-based (“Robo”) advice is delivered by a computer algorithm - a set of rules that construct investment portfolios based on an investor’s responses to a questionnaire. Because this advice lacks the personal engagement of human advice, I think it’s most fair to compare it to TDIFs - since both options construct investor portfolios using low-cost index funds. The big difference between the two? Cost. Robo advice can cost 40-60 bps (0.40%-0.60% of assets) more annually.
Pros
- The advice can be personalized to meet individual investment goals.
Cons
- Comparable to TDIFs, but usually more expensive. Doubtful their higher cost will be offset by higher returns since both options construct their investor portfolios using index funds.
- Has a computer application ever motivated you to do anything? Me either. A human advisor can do a better job of motivating you to keep your retirement savings on track.
Professional Advice Improves Investment Returns!
An Aon Hewitt study found that median investment returns for 401(k) participants using TDFs, managed accounts and one-on-one investment advice were 3.32% greater than returns earned by participants that picked an investment portfolio themselves. In short, professional advice is proven to help participant investment returns.
If you’re not an investment professional, I strongly recommend you get professional help investing your 401(k) account. This help is more accessible than ever, making 401(k) investing a snap – even for participants with zero investing knowledge.
