Five Questions to Ask When Taking a Hands-On Approach to Your 401(k)

Morningstar

More and more 401(k) investors are opting to be hands-off. A recent report by the Investment Company Institute and the Employee Benefits Research Institute found that 41% of 401(k) participants were invested in a target-date fund at the end of 2012.

But not all 401(k) participants are following that trend. Just 15% of all 401(k) assets are in target-date funds, so many 401(k) investors have clearly opted to take a hands-on approach with at least a portion of their portfolios.

The reasons are likely as varied as the participants themselves. Some may not like delegating their investment decision-making to the extent that owning a target-date vehicle requires them to do, and they believe that they can generate better investment results than one of these prepackaged funds. Or perhaps they've done their homework and determined that the target-date fund lineup in their plans isn't very good. Finally, many investors started making their investment choices before the advent of target-date funds and aren't inclined to delegate their decision-making at this late date.

If you're considering taking a hands-on approach to managing your 401(k) portfolio, or you are already doing so, here are some of the key questions to ask.

1. Do you have the right qualifications?
You don't need to be an investment professional or know how to calculate beta to manage your 401(k) successfully. But you should at least fulfill a few basic criteria. For starters, you'll want to have a working knowledge of the merits of diversification, asset allocation, and keeping overall portfolio costs down. You also have to have at least a dash of humility and understand, as Morningstar's investor return data suggest, that it's difficult to generate a consistent track record by trading frequently among asset classes or sectors or dabbling in narrowly focused investment types.

A dose of performance analysis is also valuable in determining whether to actively oversee your 401(k). Have you tracked your performance relative to a simple benchmark composed of index funds with the same asset allocation or compared your personal portfolio's performance to that of a target-date vehicle? Unless you have a proven track record of meeting or beating those benchmarks, consider "phasing in" your management of your 401(k), using the target-date fund for the bulk of your portfolio and self-managing 10% to 20% of your assets until you've established a measurable track record. These guardrails are especially important if you're using actively managed funds or plan to invest via your company's brokerage window; if your plan is to use a buy-and-hold approach with index funds or a simple balanced portfolio, they're probably not necessary.

2. How good are your raw materials?
Also take a close look at your investment options. How good are the raw materials--that is, the non-target-date funds--within your plan? Do you have the core building blocks you need to construct a sturdy portfolio?

At a minimum, you'll want to see high-quality, low-cost core options within the three major asset classes: domestic equity, international equity, and bond. (Morningstar's Fund Analyst Ratings can help you assess both quality and cost.) If your sole options in some of these asset classes are overly specialized--for example, if the only bond fund is a U.S. Treasury fund--that's a signal that you'll need to augment your 401(k) holdings with other investments outside the plan. The same is true if your plan excludes an asset class that's important to you--for instance, if you want to tilt toward small-cap value or emerging-markets stocks, but your plan offers nothing in these areas. Also beware if the entire lineup consists of the "house brand" of funds from a second-tier fund family, as very few firms do a strong job in all three asset classes. (Unfortunately, if this is the case, it's likely that the target-date lineup will consist of "house brand" funds, too.)

If you find your 401(k) plan lineup is lacking on any of these fronts, you may have an escape hatch: You can use what's called a brokerage window, which allows you to select investments from a wider menu that will typically include mutual funds, exchange-traded funds, and possibly even individual stocks. Before you go that route, make sure you read up on all of the logistical issues related to the brokerage window, including what commissions and fees you'll pay and whether there are limits on how often you can buy and sell.

3. What's your asset allocation plan?
Once you've assessed your choice set, the next step is to consider how you'll dole out your money among the major asset classes. Twenty-, thirty-, and even forty-somethings will want to keep the bulk of their money in stocks, which offer better long-range appreciation potential, albeit with higher short-term volatility, than bonds, cash, or stable-value investments. As retirement draws closer, however, it makes sense to shift at least a portion of the portfolio to those safer assets to ensure that a bum stock market doesn't derail your planned retirement date.

But how much, specifically, to invest in these asset classes? Morningstar's Lifetime Allocation Indexes provide some guidance by age band and risk tolerance--even on how much to invest in more specialized categories such as commodities and Treasury Inflation-Protected Securities. You can also find some valuable asset allocation intelligence embedded in target-date funds, even if you don't plan to invest in one. Morningstar's Target-Date fund reports provide the glide paths--asset allocation plans for each age band--for the target-date series from the largest players. These reports also show you the industry averages for each age group.

In addition, you can drill into the specific asset allocations for the target-date series that Morningstar considers best of breed: those from T. Rowe Price and Vanguard. For example, if your planned retirement date is 2040, you can see that Vanguard recommends an 89% equity weighting and a dash of foreign bonds. T. Rowe's 2040 option is similarly equity-heavy but also includes positions in commodities and high-yield bonds and a lighter stake in foreign stocks.

4. Is fine-tuning in order?
Off-the-shelf sources of asset allocation guidance can be a good start, especially if you're just laying the groundwork for your 401(k) plan or aiming to check the reasonableness of your existing mix. But they may not fit every situation. If you have multiple pools of money--for example, a rollover IRA or your spouse's 401(k) geared toward the same goal--it's worthwhile to use Morningstar's X-Ray tool to see how all of these accounts work together.

Those with multiple accounts may benefit from a "take the best, leave the rest" approach to each account. For example, say your husband has access to ultra-low-cost equity index funds through his 401(k) plan, but his plan's bond choices are lousy. He could maintain an equity-heavy portfolio that you compensate for by holding more bonds in your plan, assuming your fixed-income choices are good. Such a strategy has the valuable side benefit of reducing the number of holdings you'll have to oversee on an ongoing basis.

You'll also want to take into account the presence of other assets in your retirement plan--for example, if you also have a pension or if real estate assets are a big share of your net worth. Your asset allocation may also look different if you have an ultra-risky career path (you'd want a safer investment mix), or one that's very secure.

5. What's your oversight strategy?
It's not enough to get your plan up and running at a single point in time. You'll also need to have a strategy for keeping your plan in working order--checking up to make sure that the fundamentals of your investment choices are intact and performing in line with your expectations, rebalancing periodically, and gradually shifting your portfolio into more conservative assets as the years go by.

Given that you don't face tax or transaction costs in your 401(k), it may be tempting to tinker with your portfolio on an ongoing basis, shifting the pieces around to capitalize on short-term trends or firing a manager after a weak year's worth of performance. But less is more, in my view, when it comes to this type of portfolio oversight. Some plans allow you to turn on automatic maintenance features, such as automatically rebalancing and increasing your contributions when you get a raise. Creating at least a bare-bones investment policy statement, in which you lay out the triggers for changing individual holdings or altering your asset allocation mix, can help enforce discipline and ensure that you don't upend your well-laid plan when the markets get rocky.

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