A 401 (k) is a crucial tool for building wealth during retirement. Elective salary deferrals and employer matching contributions can fund a defined contribution plan, both of which benefit from tax-deferred growth. When you retire, these savings can become a primary income source.
If your 401(k) isn’t providing the returns you want, what should you do?
Various factors can cause underperformance, but there are effective strategies to counteract them.
Reasons for 401(k) Underperformance
A 401(k) plan operates as an investment vehicle, and similar to any investment, assured high returns are not guaranteed. Unlike secure options such as certificates of deposit (CD) or low-risk bonds, there are reasons why your plan might not deliver satisfactory results.
Reason 1: Excessive Caution
Being overly cautious in your investments, considering your age, time horizon, and objectives, could lead to subpar 401(k) performance. Generally, a younger age allows for more risk tolerance, given the longer period to recover from market downturns and increased volatility.
Traditionally the stock market has yielded annual returns of around 10%, which drops to 7% when adjusted for inflation. If your 401(k) investments are generating only 5% or 6% due to excessive investment in bonds or low-risk stocks, your savings might fall far short of your financial goals.
Reason 2: High Fees
Fees, which encompass administrative costs and fund expense ratios, can significantly erode your 401 (k) returns. For instance, as of 2021, the average fee for large 401 (k) plans with $ 50 million in assets was 0.88%, and for smaller plans with $ 5 million in assets, it was 1.19%.
While most 401(k) fees have decreased lately, it’s crucial to recognize that not all plans are equivalent. Subpar returns might not necessarily result from your investment choices but rather from the fees you incur.
Reason 3: Increased Stock Market Volatility
Markets can be unpredictable and volatile, even on good days. During heightened volatility, your 401(k)’s value can plummet due to declining stock prices. Numerous factors can trigger price fluctuations, many of which are beyond your control as an investor. Factors like speculations about interest rate hikes, inflation, and global health crises have contributed to recent spikes in market volatility.
Strategies for Addressing Underperforming 401(k)s
If your 401(k) is experiencing losses or failing to deliver anticipated returns, having a coping strategy can be beneficial. Several actions can enhance your returns and bring you closer to your investment objectives.
#1 Diversify 401(k) Investments
Diversification involves not concentrating all your investments in one place. By diversifying, you spread risk while maintaining the potential for rewards. If your 401(k) is underperforming, ensuring proper diversification can be helpful.
Many 401 (k) plans offer mutual funds, index funds, and exchange-traded funds (ETFs) as investment options. Each represents a collection of securities tailored to a specific fund objective. Analyzing the contents of your mutual funds or ETFs can help gauge your level of diversification and identify any necessary adjustments.
#2 Review Plan Fees
Reducing 401(k) fees is a strategic move that might not directly increase investment performance but can retain a larger portion of your returns. While you might have limited control over administrative fees, you can choose funds with lower expense ratios to avoid high fees. For reference, the average expense ratio for equity funds is 0.47%, while for bond funds, it’s 0.39%.
#3 Exercise Patience
During periods of heightened volatility causing poor 401(k) performance, sometimes the best course of action is to wait it out. If you’re relatively young and the volatility appears short-term, continuing or even increasing your 401(k) contributions can be beneficial. This approach leverages dollar-cost averaging, allowing you to purchase investments at a discount if stock prices drop due to volatility.
Navigating a 401(k) Loss
If your 401(k) is experiencing losses, start by identifying the reasons behind the downturn. Common causes include stock market volatility and poor investment decisions. To recover lost ground, consider diversifying your portfolio, minimizing fees, and staying composed during market downturns.
Addressing Stagnant 401(k) Growth
If you consistently contribute to your 401(k) but witness minimal growth, it could stem from excessively conservative investments or high fees. Evaluating the performance and costs of each investment within your plan can help determine whether adjustments are necessary, including potentially moving your funds to a different investment.
Potential for Total Loss in a 401(k)
Although a 401(k) can incur losses—often temporarily—due to market volatility, most losses tend to be temporary. Diversification can mitigate risk, ensuring that not all your investments are equally affected during market downturns.
In Summary
Feeling dissatisfied with your 401(k)’s performance might be disheartening, but there are actions you can take. Understanding your plan’s contents and associated costs can fine-tune your strategy. Additionally, supplementing your 401(k) with investments in an IRA or online brokerage account if you’re interested in individual stocks, real estate, or other securities can further boost your savings.