Chances are, if you’re in the workforce today your company no longer offers a defined-benefit pension plan. Those have pretty much gone the way of the dinosaurs and been replaced with defined-contribution plans instead, also known as 401k plans. Whether this switch is to the benefit of employers or employees is the subject of some debate, which I’m not going to get into. What I am going to get into is something called “rebalancing”.
401k Basics
Before I get into too much detail, let’s go over some 401k basics. Every year in February, my employer makes its annual 401k match. Like most companies, my employer matches a certain percentage of my contributions. Most 401k plans do something similar, though the percentages and amounts vary by company. My employer matches employee contributions dollar for dollar on the first 4% of my pay that I contribute to my 401k, and then matches 50 cents per dollar on the next 2% of my pay that I contribute. So, if I contribute 6% of my pay to my 401k, my employer kicks in an additional 5%.
So, say over a year’s time that 6% of my pay comes out to $1,000. If I contribute 6% of my pay then basically, I’d be putting $1,000 into my 401k, and my employer contribute $833 into my 401k. My $1,000 contribution automatically turns into $1,833. This is free money, and this is precisely why it is so important to at least contribute up to the company match. Now, some employers actually give you the matching portion with each and every paycheck and some (like mine) make an annual lump sum contribution instead.
Your 401k plan has a number of investment options, so you can diversify your investments into different risk categories. My personal 401k allocation is as follows:
- U.S. Stock Index Fund: 60%
- International Stock Fund: 20%
- Intermediate Maturity Bond Fund: 15%
- U.S. Small Cap Stock Fund: 5%
I’m heavily invested in stocks because I’m in my 20′s and have a long time to go before retirement. I can ride any ups and downs in the stock market and not have to worry too much about not having enough when I retiree. Of course, as the years go by and I get older, I’ll shift more into bonds and less in stocks.
What is Rebalancing?
Over time the money you’ve invested will grow at different rates. Historically, stocks tend to outperform bonds. So, say that for five years, my stock funds are growing at an 8% annual rate, and my bond funds are growing at a 4% annual rate. Since my stock funds are growing at such a faster rate, over time it throws my allocation percentages off. Rather than having 85% in stocks and 15% in bonds, I could very easily have 95% in stocks and only 5% in bonds. What happens is that without doing anything, my 401k has become more concentrated in stocks and more susceptible to risk. The solution to this is to monitor your 401k investments and rebalance your 401k investments when they start to stray too far from your target allocations (I typically use a 5% threshold). This forces you to in essence buy low and sell high. In this example, you’re basically selling stocks (which have increased in value relative to bonds) and buying bonds, which is the key to successful investing.
Another thing that can throw your allocations off is your employer match. For example, my employer makes its annual contribution almost entirely in company stock, rather than the specific investments I put my own contributions into. Now, I’m of the opinion that your 401k should not consist of stock in the company you work for. It adds an additional element of risk. If my company goes under, and I have a big share of my 401k in company stock, then not only am I out of a job, but my retirement fund takes a big hit as well due to the company stock being worthless. So, when my employer makes its annual 401k match contribution, I immediately transfer it to other investments.
You see, whether it’s different rates of return on your investments or employer contributions being made in company stock, things happen that will throw your 401k investments out of synch with your targeted allocations. When this happens, it is important to reallocate your investment holdings to get things back the way you want then.
Practical Advice
You should be receiving periodic statements showing your 401k balance and what specific investments you have money in. Rather than simply looking at the total and filing it away, take a minute and actually look through your statement. Compare it to the last statement you received. Have some funds grown much faster than other funds? Are you over-weighted in any fund? These can be indicators that it may be time to rebalance your 401k.
The actual process of rebalancing is actually quite simple. Most plans have a website where you can log in and make changes to your investments. They should even have an option to rebalance based on your current contribution percentages. This will basically take whatever investment percentages you are currently contributing, and rebalance all of your investment holdings to those percentages. Some plans even have a toll-free number that you can call, provide some account information, and have them rebalance your 401k.
I know this isn’t the sexiest investment topic out there, but it’s an important one. I know personally that my 401k is going to be my most important retirement tool, so it’s important to do what I can to make the most of it.
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