Is Your 401 O(k)?

Posted on February 15th, 2013

Yesterday Fidelity Investments, the nation’s largest 401(k) administrator announced that balances hit record highs. Here’s a link to the details on MSN Money.
Some of the data highlights are as follows:
  • Balances are 12% higher than last year
  • The average balance totals $77,300
  • Workers age 55+ averaged only $143,000
  • Older workers saved more in the range of 11.4% while the average overall was closer to 8%
401(k)s are an important vehicle for many when it comes to retirement. If employers have a matching program, contributing to a 401(k) the easiest money a saver can make. Add to that the funds typically come out of paychecks before the money can be spent and the tax deferred nature of the accounts, and you’ve got a pretty good program to follow.
The problem with 401(k)s is usually the investment options contributors have to choose from. Typically, there are 10-15 mutual funds that include bond and stock funds and have a profile from value to growth. If you’re lucky you may get an international choice or a planned retirement date fund. 
While this might seem to be an adequate set of choices, there’s no way to protect this investment in poor market times, except selling and going to cash. During the credit crisis of 2008 and 2009, 401(k)s took hits like all other un-hedged portfolios. What I’m saying is there’s no way to directly hedge, but we can get creative with protection in other ways.
Most mutual funds under-perform the broad markets and 401(k) funds are no exception. Just look at the growth in balances over the last year from Fidelity’s report. Workers saved about 8% and their employers matched about 3%, so of the 12% growth in balances, 11% of it was from additional assets contributed to the portfolios. Let’s not forget that comparably the equity market grew by 13% last year. I know this is crude math, but if the asset contribution was 11% and the total growth was 12% then I’d say it’s fair to claim the performance of Fidelity’s investment choices at about 1% growth severely under-performed in 2012. Of course there is a good portion of these funds that have bond allocation, but by comparison PIMCO’s total return ETF (BOND) has eked out a 9% gain over the last year; still better than those 401(k) allocations.
Based on this, our normal position on 401(k)s is to contribute enough to get your maximum employer match. After that, fund your other retirement accounts where you can manage your investments with choices in ETFs that will beat their counterpart mutual funds, not to mention build your own hedges.
For those of you with money in non-retirement accounts, we’ll remind you of  Buy and Hedge Iron Rule #5: Harvest Gains and Losses.  Because you can’t hedge in your 401(k), we suggest placing your relative hedges in a taxable account. Remember all your assets are part of your net worth, so include your 401(k) money. The reason why you would hedge in your taxable account vs. your other retirement accounts is to harvest a tax benefit. If the market treats you well, your hedges should lose money as your main bucket of investments grow. Typically the hedge losses offset some of the gains when it comes to tax time, but as we know, you aren’t going to pay capital gains taxes out of a 401(k) or retirement account. The hedges that lost money in a taxable account are able to be claimed as investment losses.
Based on this, I usually point most people to choose 401(k) investments that can have a relative hedge established in a taxable account. That usually comes in the form of US large cap growth mutual funds because a hedge on the SPY can suffice as a relative proxy. If the market does take a tumble and the 401(k) drops in value, the hedge (most likely in the form of puts) in the taxable account will grow to offset it. When choosing the puts to hedge, consider ones that have an expiration of greater than a year. If the hedges do become profitable, they are taxed at the long-term vs. short-term rate and will save on the end of year bill as well.
Bottom line, 401(k)s are great ways to pay yourself while planning for your retirement AND get a little more help from your employer. However, their investment choices leave performance to be desired and are unprotected. Be sure to have a multi-account plan to protect your assets and harvest losses to take advantage of hedge tax treatment. 

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