Risks of 401k Plans

If the first 10 years of this century are widely considered a "lost decade" for investors, what could the next 10 years have in store for us? In this new environment of heightened volatility and tighter correlation across asset classes, investors must transition from a "buy and hold" posture to a "protect and grow" strategy, which intrinsically requires making frequent and regular investment allocation changes over the years.

Unfortunately, 401(k) plan participants—who, for the most part, do not receive any financial guidance on their investment selection and retirement planning—could find themselves completely unprepared for how to adopt a more tactical approach for their plan assets.

This unpreparedness, combined with the extinction of traditional defined benefit pension plans, exposes American investors to significant retirement income risks. Outside of the fortunate few who can count on pension plan income in their golden years, the overwhelming majority of American investors are reliant on 401(k) plans or similarly structured defined contribution programs, and will therefore usually not have any guaranteed amount of retirement income beyond social security.

With this in mind, here are four risks that each individual with a 401(k) plan should be aware of:

1. Overly aggressive allocations. Market upheavals and uncertainty over the past 10 years have left most 401(k) plan participants feeling dazed and confused when it comes to setting up asset allocations within the various plans they have. A large number opt to leave allocations alone, even if they are oriented toward a more aggressive posture, regardless of their age or projected retirement date, simply because they want to "just earn back" what they lost in the most recent downturn.

It is critically important for each 401(k) plan participant to invest based on his or her own risk tolerance, which encompasses current age, projected retirement age, and appetite for risk versus expectations for returns. Most plans sponsors today offer a short risk tolerance questionnaire that should help to narrow down your particular mix of stocks and bonds. At a minimum, if you have a 401(k) plan, you should go through this questionnaire if you haven't already. Depending on where you are in your saving and investing life today, your current asset allocation could be all wrong from a risk perspective.

2. Inflation risk. With all the talk of deflation nowadays, the risk of inflation may be the farthest thing from your mind. Don't be lulled into a sense of complacency. For a nation as heavily indebted as the United States, there will always be the risk of eventual increases in the prices of goods and services, and therefore the cost of living, which will result in a reduction in your purchasing power.

Inflation risk and interest rate risk are closely tied, as interest rates generally rise with inflation. As interest rates rise so does inflation. Over the past 10 years, inflation has been kept in check, only through the aggressive action of our Federal Reserve. The way this is done is by reducing or keeping interest rates low, but the danger with this action is the devaluation of the U.S. dollar and the chance that inflation can creep in.

3. Longevity risk. Be aware of the risks of outliving your money. Now that investors are, for all intents and purposes, on their own when it comes to future retirement income, they bear the great risk of drawing down their retirement savings too quickly and outliving assets. Think very carefully about your future withdrawal rate while in retirement, as too much too soon could accelerate the depletion of your retirement assets.

There has been quite a buzz in Washington about adding annuities to 401(k) plans in order to give participants the ability to plan for and receive systematic payments from these plans, which may help to create a "defined benefit" component to the 401(k) plan structure.

4. Risk of concentrated stock. Having too much of one company's stock inside of your 401(k) plan can get quite risky. Just look back over the past 10 years alone. How many companies are gone or have been complete devalued from an equity perspective? Keep your exposure to any single company's stock to 5 percent or less and you can reduce the risk. You simply cannot afford the alternative.

The responsibility for retirement planning, now more than ever, falls squarely on the 401(k) plan participant. Whether you feel you can go it alone or not, bear in mind the key potential risks that you face and prepare accordingly.

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