The funds in your 401(k) may yield only about 2%
By Glenn Ruffenach
Last Update: 12:01 AM ET Jun 11, 2012
This may surprise you, but theres a good chance you can take direct control of your nest egg at work, choosing investments beyond the two dozen or so mutual funds that most employers offer in their savings plans. Doing so can be risky, but heres why you should consider taking a shot at it.
About one in five employers, according to Plan Sponsor Council of America (PSCA), offers a self-directed brokerage option, in which workers with 401(k)s and related accounts can buy stocks, bonds and other assets. Also, three-quarters of employersand 86% of those with 5,000 or more plan participantspermit in-service withdrawals (typically starting at age 59), where holdings can be pulled from accounts and rolled into IRAs.
Yes, this is a scary idea: people taking the wheel of their savings plans and, possibly, crashing into crazy investments. Most workers with these options, in fact, take a pass; less than 1% of plan assets are invested through self-directed accounts. Indeed, according to David Wray, president of PSCA, 401(k) participants are not retail investorspicking individual stocks is way out of their thinking.
But Im betting that, if you pursue either option, youre smart enough to do so gingerly. In which case, the potential payoff is that you get a jump on building income for retirement.
More people are recognizing the importance of having investments that generate cash in later life. This way, you arent dependent on capital gains to meet expenses. Whats less appreciated, though, is the value in identifying and assembling these investments earlysay, five or 10 years before retirement. If you can get a head start on building income at age 55 or 60, said Charles Farrell, chief executive at Northstar Investment Advisors in Denver, the compounding effects can move you closer to the point where youre living off the returns of your portfolio in retirement, rather than eating into the portfolio itself.
Dividend-paying stocksand an important concept called yield on costare a good example of how this can work. Yield on cost is calculated by dividing a stocks current dividend by the amount originally paid for each share. Lets say you buy a stock for $12, and it pays a 3% annual dividend, or 36 cents. And lets say that after a year, the share price hits $16, and the company increases the dividend to 48 cents.
At this point, the payout is still 3% (48 cents is 3% of $16). But not for you. You paid $12 for your stock; thus, youre getting a dividend of 48 cents on $12or 4%. So, your yield on cost is 4%. In other words, youre now earning a higher yield on your original investment, which puts more money in your pocket. If youre able to invest in companies with a long history of paying dividendswhere those dividends increase annually and the increases outpace inflationyour yield on cost eventually should outshine the return on other investments.
Now, lets return to your 401(k), which likely holds the bulk of your retirement savings. Chances are good that the mutual funds in your account are yielding about 2% (or less)hardly the stuff of retirement dreams. (Inflation alone is running about 2.9%.) But if you could gain access to a wide range of investments, you could assembletodaya group of dividend-paying stocks (again, with a steady history of payouts and dividend increases) that yields about 3.5%. Ideally, over time your yield on cost on these shares would rise significantly.
To see how this might work, I asked Charles Carnevale, founder of FAST Graphs, a website with a nifty set of stock-research tools, to calculate how yield on cost for several investments could change over time, based on analysts current growth estimates. I picked Coca-Cola Co. , Johnson & Johnson and Procter & Gamble Co. , each of which meets our criteria: an attractive current yield and a history of increasing payouts.
At the moment, the three stocks yield roughly 3.0%, 3.6% and 3.2%, respectively. In five years, the yield on cost for these stocksagain, based on the companies projected growthis expected to reach 4.6%, 4.7% and 4.8%. In five more years (should the current growth rate hold), the yield on cost for each would exceed 6%.
How could this help you? Remember: A 4% rate of withdrawal from a nest egg is traditionally considered a safe starting point. If youre thinking about drawing down your savings at that rate, the growing yield on cost alone may meet your distribution needs in retirement, says Farrell.
If all this sounds too easy, youre right to be cautious. Dividends, of course, can be reduced or eliminated. (In 2008, Bank of Americas quarterly payout was 64 cents; today its a penny.) Companies dont always meet growth estimates. And some people simply arent meant to manage their money: They buy and sell too frequently; they pick less-than-stellar investments (read: Enron); and they get hammered with trading fees.
That said, the need for dependable and growing income in later life is clearand if you can start the process early, so much the better. My advice: See what options you have with your 401(k). If youre able to take the reins, sit down with a financial adviser and discuss investments that fit your comfort level and future needs. The ride could be safer than you think.
Glenn Ruffenach writes for SmartMoney.com