Your Retirement Savings Plan
Your employer-sponsored retirement plan offers a variety of investments to choose from. How do you know which ones may be right for your needs? And how much should you direct to each one? The keys to answering these questions are to understand your options and consider how they relate to your own personal circumstances.
Asset classes: the building blocks
When choosing investments to pursue your retirement accumulation goals, you’ll need to balance the amount of risk you take in your investment mix (or “portfolio”) with the potential for returns. Generally speaking, the riskier the investment, the higher the return potential. But with this higher return potential comes a greater chance of loss, including the loss of your original investment dollars (your “principal”).
There are three basic asset classes to choose from, and each has different risk/return characteristics.
- Stocks: Stocks represent ownership in a company — i.e., when you own stock in an organization, you actually own a small portion of that company. Stocks are the riskiest of the three asset classes, but historically have offered the greatest return potential over time. Stocks are offered in many different categories; some tend to be riskier than others. For example, the stocks of large, well-established companies are typically less risky than those of smaller, younger firms. Similarly, stocks of companies based in developed nations, such as the United States, are typically less risky than stocks of companies in “emerging market” regions, where economies are not considered developed. Also, differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country can adversely affect the value of these securities.
- Bonds: Bonds are essentially loans made to a company or government (the “borrower”) by the bondholder (you). In return for the loan, the borrower promises to pay income at a stated interest rate. However, there are no guarantees that steady repayments will occur or that the bond (or how much you paid for it) will maintain its value. For this reason, bonds typically fall in the mid-range of the risk/return spectrum. Like stocks, bonds come in a variety of categories, and some tend to be riskier than others. Bonds issued by the U.S. government tend to be more stable, while high-yield or “junk” bonds are typically among the most risky. U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest.
- Stable value/cash: These investments are designed to protect your investment dollars while pursuing modest returns. They’re also used as a place to temporarily “park” your money while you decide on an investment strategy. Although this asset class generally carries a lower risk of loss to principal, it does have the risk that your investment returns won’t beat the rising cost of living, potentially reducing your purchasing power over time. And although many cash investments strive to preserve your principal, there is no guarantee that they will be able to do so.
Mutual funds: instant diversification
For the most part, investors cannot purchase individual stocks, bonds, and other “securities” through a retirement plan. Rather, they can access them by choosing from a variety of mutual funds.
Mutual funds pool the money of many different investors to buy a series of securities. By investing in a fund or several funds, you own small portions of each individual security. The fund’s manager chooses securities for the fund based on its stated objective, which is usually growth, income, or capital preservation. Generally, growth funds invest in stocks; income funds, in bonds (or dividend-paying stocks); and capital preservation funds, in stable value or cash securities. (Please note that while dividend-paying stocks are intended to provide income, the amount of a company’s dividend can fluctuate with earnings, which are influenced by economic, market, and political events. Dividends are typically not guaranteed and could be changed or eliminated.)
Investing through mutual funds is an ideal way to utilize an investing principle known as diversification, which is the process of combining different types of investments in your portfolio to help manage risk. The thinking is that when one investment performs poorly, another may be holding steady or gaining in value.
Asset allocation: putting the pieces together
After familiarizing yourself with the investment options in your plan, the next step is to put together your mix, or “asset allocation.” Although many factors will contribute to your asset allocation, three are particularly important — your savings goal, risk tolerance, and time horizon.
- Savings goal: How much do you need to accumulate in your plan to potentially provide the income you’ll need throughout retirement? Targeting a goal will help you develop your strategy. After all, before mapping a route, you should first know where you’re going.
- Risk tolerance: How much loss — 5%, 10%, 15% — would it take to make you worry? Risk tolerance refers to your financial and emotional ability to withstand dips in your account value as you pursue your goal, and also helps you determine how to allocate your plan contribution dollars among the investments you select.
- Time horizon: How much time do you have until you will need to tap the money in your account? The longer you have, the more time you may have to ride out those dips in pursuit of long-term results.
Generally speaking, a large goal, a high tolerance for risk, and a long time horizon might translate into an ability to take on more risk in a portfolio. The opposite is also true: smaller goals, a low tolerance for risk, and a shorter time horizon might warrant a more conservative approach.
In many cases, your plan’s education materials will provide tools to help you set a goal, gauge your risk tolerance, and choose investments for your strategy. You might also seek the assistance of a financial professional, who can provide expertise and an objective viewpoint.