401k plans are tax-qualified retirement plans offered by US employers. They are defined contribution plans, meaning there is no guarantee of withdrawal benefits. Investment firms manage the plans and offer different investment options, including mutual funds and CDs. Participants must decide how to allocate their investments, with some firms offering standardized models. Stocks traditionally offer higher growth rates, but some choose low-risk options. Plans must be rebalanced regularly, and participants can change their allocation at any time.
A 401k plan is a type of tax-qualified retirement plan available through many employers in the United States. These plans are named after Section 401k of the Federal Tax Code and can contain both employer and employee contributions. 401k asset allocation describes the process by which 401k contributions are invested in different types of sub-accounts.
Pensions such as 401ks are defined contribution plans as opposed to defined benefit plans, which means that a participant’s employer deposits a fixed amount of money into the account but there is no guarantee as to the size of any withdrawal benefits of the participant. These plans are administered by investment firms or brokers who assume a fiduciary role, actively managing the money on behalf of the participant. Each plan contains a number of different investment options, most of which are typically mutual funds; some plans, however, contain certificates of deposit (CDs) and other types of conservative securities. During the 401k asset allocation process, the participant must decide how much money to invest in each underlying mutual fund, CD, or other type of security.
Many investment firms use standardized 401k asset allocation models in which funds are split between aggressive, moderate, and conservative mutual funds. Aggressive funds typically contain mostly stocks and other types of growth instruments that don’t have principal guarantees. Moderate funds contain a combination of growth instruments and conservative instruments such as bonds. Conservative funds contain bonds, CDs and other securities that offer investors little growth potential but minimal principal risks. In addition to offering 401k asset allocation models based on security types, some companies also create asset allocation models that contain securities issued by companies in particular industries or entities headquartered in particular countries.
Over long periods of time, stocks have traditionally grown at a faster rate than other types of investments. Young professionals who are looking to maximize their earnings often choose to invest primarily in 401k asset allocation models that include equity funds. People nearing retirement age often choose to invest in allocation models that consist primarily of low-risk fund options. While investment professionals often make recommendations partially based on age, 401k participants make the final investment decision, and some young investors choose to invest conservatively and some experienced investors choose to invest aggressively.
After a 401k plan participant decides on an asset allocation plan, the plan custodian must rebalance the account on a regular basis. The percentage of money the investor holds in each type of security should remain roughly the same. Therefore, if the value of one type of investment increases, the fund custodian may have to sell some of that fund’s shares and reinvest the proceeds into another type of security to restore the account balance. Many investment firms allow plan participants to change a 401k asset allocation selection at any time.
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