My article on 401K and 457 programs generated a lot of email. So first, a big thank you for reading, responding and caring about your future. Second, I need to clarify a few points. While my research indicated that you cannot take a loan from a 457, a few people mentioned that they could from their plans. I did more digging and managed to find an IRS document that addresses the different retirement plans, and I was only half-right. A 457 for a governmental agency can have a loan program; a 457 for a non-profit (non-church) cannot have loans.
I also mentioned the minimum age for a 457 withdraw is 50 ½ years old. Someone emailed that his plan allows withdraws upon retirement, which his state offers after 20 years of service, regardless of age. I tried many different IRS documents, and I couldn't find anything specific on this issue. I did find one document that generically refers to "separation" without an age restriction, but all non-IRS research indicated an age restriction. I'll plead no lo on this one and suggest you contact your administrator to see what age restriction, if any, may apply to your 457.
I've got my account... where's my money?
You're on board with the idea of setting aside some of your pay to help supplement your pension. So, the next question is, how does setting aside $100 or $200 a month help you retire wealthy? The answer is the power of the stock market.
When you open your 401K or 457 account, you will be asked which investment options you want your funds to purchase. The money you deposit into your account every month is used to buy the investments that you select and hold them in your name. Depending on how your program is established, you may have anywhere from four to 12 different investment options. You will probably have one option that is a money market account. This is the most conservative, safest investment... but it also pays a measly interest rate. Most money market accounts are earning two to three percent. The majority of the investments will be mutual funds. Mutual funds historically return much higher rates, earning eight to 12 percent. Unless you are close to retirement, mutual funds are where you want most, if not all, of your retirement money to be.
What is a mutual fund?
Before we look at a mutual fund, let's look at the stock market. Companies create shares of ownership in the company, called shares of stock. Large companies literally have millions or billions of shares outstanding, making it difficult for any one person to purchase too much of the company and act as an owner. The price of a share fluctuates in the market based on many factors. A competitor introducing a new product can drive down a company's stock, while better-than-expected profits can increase a company's stock. High oil prices can drive down a number of stocks, while another interest rate cut can bring up a number of stocks.
Choosing which companies to buy stock in is hard work. Plus, to see significant earnings, you have to invest a lot of money in one company. Since most of us don't have a lot of money (think "millions," not "thousands"), if we buy a bunch of stock in one or two companies, we lack diversification. Diversification is a fancy word for not keeping all your eggs in one basket. See, if you buy thousands of shares of XYZ and it does really well, you make a fortune. However, if XYZ does poorly... or even goes out of business... then you lose your fortune. Most of us cannot afford to risk losing the majority of our money.
A mutual fund mitigates the risk. The fund collects money from thousands of investors, like you, and pools the money to buy large blocks of stock in various companies. Because the fund pools millions of dollars, it can buy large blocks in many companies, spreading out the risk that a poor (or unlucky) choice might wipe out your savings. The fund also hires professional managers to look after the fund. They follow the stock market closely and regularly research the stocks the fund owns, as well as the stocks the fund might buy in the future.
The value of the mutual fund share is determined by the value of all its assets (stocks, bonds, cash, options, futures) divided by the number of shares. As the value of the assets increases, the value of the fund shares increase, earning you more money towards retirement.
Types of Funds
Mutual funds are divided into numerous categories that explain their investment objectives. Below is a list of common terms and objectives, but it is by no means exhaustive. In fact, there can be a mutual fund for almost any objective if enough people contribute.
- Income Funds: Income funds are not quite as safe as money markets, but they are designed for stability. They invest in government bonds and high-quality corporate bonds, as these generally do not fluctuate in value significantly and they yield predictable returns. The objective of these funds is to avoid losing money while generating a reasonable return. These funds are for those near retirement or those with no tolerance for risk.
- Balanced Funds: Balanced funds take a middle of the road approach, buying bonds and investing in traditionally stable companies. By purchasing stock in respected companies, the fund can increase in value faster than an income fund. Keeping a significant amount of money in bonds helps reduce risk, making the fund value less likely to encounter large swings (good and bad).
- Small-, Mid- and Large-Cap Funds: These funds invest in company stock based on how much a company is worth, or its "capitalization." A company's capital is determined by multiplying the number of shares outstanding by the price per share. These different funds give you the ability to benefit from specific stock market swings. While it's not a firm rule, small-cap stocks are frequently newer companies with the largest potential for growth, but also a higher potential for losing money. Large-cap stocks are the big-name companies you hear every day. Their stocks may not rise and fall as dramatically as small-cap companies do, but their proven track record brings value. Mid-cap funds buy the companies in the middle, taking advantage of the benefits (and risks) of small- and large-cap funds, just to a lesser extent.
- Foreign Funds: These mutual funds purchase stocks in overseas markets, utilizing researchers who specialize in those particular countries. Remember, the economy, for better or worse, is global and there are plenty of companies based overseas that have great potential. The risks for these funds are a little higher, as your money is invested in countries where you cannot vote and in currency that may or may not become more valuable over time. Personally, I only put about 10% of my money in foreign funds.
- Specialty Funds: These can be based on specific markets, such as technology, gold or energy. They can also be targeted towards specific goals, such as renewable energy or socially responsible production. The market specific funds can be a virtual goldmine if you time it right... or a complete bust if you time it wrong (remember the dot-com bubble of 1999?). For the most part, if a technology or energy company is worth holding, a small- or large-cap fund will probably buy it anyway. If you feel strongly about a particular cause, nothing is more admirable than putting your money where your mouth is. Just realize that it may not be the most profitable option for your money.
True. The stock market has been in a funk on-and-off for the past two years. However, remember that you are not investing for two years from now. You are investing for 20 or 30 years from now. And history has shown that the stock market out-performs almost every other type of investment. A solid mutual fund will return, over time, eight to 12 percent growth per year. That type of growth allows money to double every six to nine years. To put that in perspective: if you invest $10,000 at 12 percent, in six years you'll have $20,000 and $320,000 in 30 years... without ever adding another dime of your own money!
Normally, you will want to spread your investment among two or three mutual funds. You can choose different categories to help control risk, as well as again avoid placing all of your eggs into one basket. There are a number of ways to research mutual funds. Read the prospectus and annual report, as these show the investment objectives of the fund as well as its historical performance. No, the past isn't a guarantee of the future... but it's a decent starting point. There are a number of research companies too, with Morning Star being one of the most popular.
Conclusion
Mutual funds are universally accepted as the best way to invest your retirement money. The mutual fund buys stocks and bonds (and other, more complicated investments... but those can be for another article) on behalf of all the contributors. The fund uses professional managers to make the best decisions possible, and gain the highest return possible within the fund objectives. Certain funds are riskier than others, meaning that you can make or lose more money. But in the long run, smart investments in the stock market can be expected to yield very good returns, leaving you a nice retirement nest egg to supplement your pension.
