Are You Doing Your 401(k) Rollover Wrong?

Leaving the money in an ex-employer’s plan, as nearly half of those in the Vanguard sample did, means it’s still earning compound returns, but you can no longer make new contributions, limiting overall growth. (And there’s always a chance you’ll forget about it.)

The remaining 18 percent of workers who left jobs rolled their 401(k) funds into an IRA or a new workplace plan. With both routes, your money keeps earning returns and you can keep making contributions.

If you’re not moving right into a new job, or your new workplace doesn’t provide a retirement plan, an IRA rollover might be your only option to keep saving. But IRAs are not required to look after your interests in the same way 401(k)s are.

The U.S. Department of Labor requires workplace retirement plans to select a qualified default investment alternative (QDIA) for employees who don’t choose their own investments. The QDIA rule ensures 401(k) assets are invested in a diversified, professionally managed investment account or fund — but it doesn’t apply to IRAs.

So, if you want to put your IRA into something that offers significant growth, like a stock fund, you must tell your IRA custodian to do it. If you don’t, the rollover sum, and your subsequent contributions, probably will stay parked in cash.

And that’s a wasted opportunity, financial advisers say. Over the past 20 years, U.S. large-cap stocks as a group have gained an average of 10.58 percent a year, nearly seven times the annual average growth for cash accounts (1.54 percent), according to Morningstar data.

Let’s say you are 45 years old and have $50,000 in an IRA that’s invested in a stock fund. With a 7 percent rate of return  your account would be worth more than $193,000 at age 65, even if you don’t contribute another dollar yourself. In a cash account? With 1.54 percent annual growth, you’d have only about $68,000 at 65.

Investment priorities change as you age

There is a place for cash in a balanced portfolio, especially as you get closer to retirement. Cash offers less growth but more stability. (Typically, so do bonds.) Older workers may want to reduce the risk of a market downturn eating into their savings.

But financial planners typically recommend a more aggressive posture until late in your career, to maximize returns and build the biggest nest egg possible.

How to do that with an IRA? First, figure out what you want your account to do for you, at this stage of your life. Consider these factors:

• Your goals. Is the money just for your retirement, or do you have other plans for it, such as buying a home, helping put a grandchild through college or leaving an inheritance?
• Your time horizon. When do you anticipate needing the money? When you retire, or at some point later? The more time you have, the more aggressively you can invest, because your IRA will have more time to rebound from the stock market’s inevitable ups and downs.
• Your risk tolerance. Can you stomach those ups and downs? The more volatility you can put up with without losing sleep, the more aggressive your investments can be.

A financial adviser can help you work through all this, if you are in a position to hire one.

Next, apply the answers to those questions as you shop for an IRA provider. Talk to agents with financial firms you are considering and spell out your concerns. Does your money default into a cash account? What other investment options are available and what do you have to do to select them?

If you’ve already rolled a 401(k) into an IRA, look at your account statement to see how your assets are allocated. Is it in a money market account or CD, or in something growthier, such as a mutual fund? If the answer is not clear, dig into your account online, or pick up the phone and ask your IRA custodian.

Target date funds can take out the guesswork

Once you’ve made clear your desire to avoid cash, you’ll have to pick another destination (or destinations) for your retirement savings. IRAs typically offer a wide range of investment options, from cash and bond accounts to stock-based mutual funds and exchange-traded funds (ETFs). Some IRAs also let you pick individual stocks and other securities.

A good way to minimize volatility is to diversify your investments. Mutual funds and ETFs do that by investing in a wide variety of stocks. You can build your IRA portfolio out of individual funds but be prepared to do some homework (or consult a financial adviser). Large providers like Fidelity, Schwab and Vanguard offer thousands of funds to choose from.

Target date funds may provide a simpler solution. They are also diversified, investing in a range of stock and bond funds. And, unlike traditional stock funds, TDFs evolve as you age, adjusting the asset mix to meet your changing needs.

For example, when you’re younger a TDF typically will weight investments toward stocks to maximize long-term growth. As you approach retirement, the fund manager (or the algorithm, if you use a robo-adviser) reduces volatility by shifting assets into more stable categories. A chunk of your retirement fund might still end up in cash — but only when it makes the most sense for you, and ideally after you’ve fed your IRA on years of investment growth.

“For most workers, the most important factors are portfolio allocation and time to retirement. These are both solved by target date funds,” says Bret Almstedt, senior vice president and director of retirement plan services at Johnson Financial Group in Milwaukee, Wisconsin. “Target date funds take the emotion and guesswork out of investing and let workers/investors control what they can control — saving as much as they can afford toward their future goals.”