If you want to retire comfortably, it's crucial that you
regularly contribute to your 401(k), 403(b), TSP, or other employer-provided
retirement plan if one is available to you. Unless you're already well versed
in investing, the abundance of investment options can seem overwhelming. But
allocating your retirement plan contributions doesn't have to be complicated.
In fact, there are just two big factors you need to consider -- and the rest, in
a decent employer-sponsored plan, is just details.
Factor 1: When do you
need the money?
The more time you have before you need your retirement savings, the more market
volatility you can handle. Even once you reach retirement, you won't
need all of your money at once, so it makes sense to keep your money
in different investments based on when you need to spend it -- stocks
for money that won't need to be spent for several years, bonds for money you'll
need in the next few years, and cash for the money you'll spend within the next
year or so.
Factor 2: How much do
you need?
The less you need to withdraw from your retirement account in retirement, the
more aggressive you can afford to be with your investments. Your allocation to
bonds and cash should be based on your near-term and medium-term spending
needs. You can keep money you won't need in the near future in higher-risk,
higher-return assets like stocks, which may take years to realize the solid
returns they have historically achieved.
Plug those factors into
your employer's plan
With those two key factors in mind, it should be much easier to make solid
choices within your retirement plan at work, no matter how complicated that
plan may seem. No matter how many options you have available, you should be able
to break down each of your plan's options into one of five categories:
- Stock funds
- Bond funds
- Cash or money market funds
- Target date plans
- Advanced options
Stock funds are options that own equity stakes in
companies. These have the highest long-term potential return rate of any option
typically offered in company retirement plans, but they also have no day-to-day
guarantees and are frequently subject to high volatility. There are two key factors you'll want to
consider in making your choices: internal costs and diversification. From a
cost perspective, the lower the fund's internal costs, the better off you'll
be. From a diversification perspective, a broadly diversified option is often a
better choice than one that limits its internal options. The phrase "index
fund" is frequently a decent indicator of diversification, but be wary of
"sector index funds," which are only diversified within a small slice
of the economy.
Bond funds hold corporate or government debt. They
generally return more than cash but less than stocks. Bonds come with
"maturity dates," or dates when they are expected to pay in full and
cease to exist. Those maturity dates put a cap on the total potential return
for bonds.
Bond funds within retirement plans are often split by
short-term, medium-term, and long-term durations, matching bonds of similar
maturity dates within each option. Your objective with bond funds is to match
the duration of the fund with when you expect to need the money. With interest
rates as low as they are right now, though, long-term bond funds may be more
dangerous than you'd otherwise think, as their return potential is capped by
those low interest rates.
Cash or money market funds are useful options for
holding money you expect to need in the very near future. They may also be the
"default" investment if you decide to put money in your retirement
plan but don't specify any other investment choice. If you have money piling up
in your cash or money market option, and you don't expect to need that money in
the near future, you should look for an alternative option with better
long-term prospects.
Target date funds allocate your capital based on your
expected retirement date, investing in a manner that shifts from more
aggressive to more conservative as that target retirement date gets closer.
These plans may make sense if you're just getting started or you want
the ultimate "one-stop" investment. But you'll want to watch the fees
-- not only the fees the target date fund charges directly, but also the fees
charged by the holdings that the target date fund itself holds.
Keep it simple -- and get investing
If you want to retire in comfort, getting started early and investing
consistently throughout your career is more important than any other
factor. So don't let the confusing array of choices in your company's
retirement plan keep you from making the simple and straightforward decision to
invest in the first place.
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