Designing Your First 401(k) Plan

Steven Leibensperger and the 401(k) savings plan are contemporaries. Steven, 24, is a graphic designer who's just starting his first full-time job. The 401(k), 27, is America's most popular retirement vehicle, with 50 million participants holding $2.7 trillion worth of investments.

Shared youth, though, doesn't mean that Steven knows how to invest in his 401(k). He's inclined to be cautious. "I'm not the biggest risk-taker," says Steven, who's from Bethlehem, Pa. "I don't gamble." He has no experience with stocks or funds, so, he says, "I'll split the money up somehow." There has to be a more scientific approach.

Steven does know that he should take advantage of the matching contribution to his 401(k) plan made by his employer, Crayola, the crayon company. A company match is about the closest thing there is to free money.

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Stocks' long-term edge

But that raises the question of where to invest among the 14 funds his plan offers. If Steven follows his young peers, he'll overestimate the risksQand forgo pots of money. The first 401(k) opened for business at the start of 1981, when the Dow Jones industrial average was at 964. Since then, the Dow, which stood at about 13,500 in mid December, has returned more than 11% annualized. Yet, even with that history, nearly half of all young plan participants put nothing into stocks or stock funds, instead selecting fixed-rate and stable-value options that currently return about 5%.

Some young investors do know the score. We asked one, David Levy, how he's investing in his 401(k) and what Steven should do. Levy, 23, a portfolio manager for Kenjol Capital Management, an advisory firm in Austin, Tex., is unambiguous. Steven "should invest 100% of his contributions in the stock market, with a strong international exposure," Levy says. He specifies 40% to 60% overseas, although that number may be on the high side given the growing reliance of nominally domestic companies on foreign sales.

Levy suggests investing most of the domestic part of the 401(k) in whichever segment of the stock market is doing best. Today, that segment includes funds that emphasize large growth companies, such as Apple, Cisco Systems and Coca-Cola. Levy suggests Steven revisit his fund picks twice a year.

Levy's system means Steven should know enough about the market to be able to determine which styles -- say, small-company stocks or value stocks -- are working best, but he doesn't have to be a finance geek. Levy also suggests placing about 5% of a 401(k) in alternatives to standard stocks, such as real estate and natural-resources funds.

Rare win for bonds

Levy's own 401(k) gained 7% in 2007 through early December. He would have done a bit better with Treasury bonds. But, over time, stocks return much more than bonds.

In any case, Steven shouldn't be intimidated by the lengthy list of choices in his 401(k) or agonize over the specific funds. Many 401(k) plans offer so many choices, including both actively managed funds and index funds, that it's tempting to spread your money too thinly. Two or three funds are enough to start, says Tim Swanson, chief investment officer for National City Private Client Group, in Cleveland. Swanson, who is 40, also favors large-company stocks. He urges Steven to start with a big allocation there -- and to tune out the market's daily moves, particularly on dark, down days.

Stumped by your investments? Write to us at portfoliodoc@kiplinger.com.

Kosnett is the editor of Kiplinger Investing for Income and writes the "Cash in Hand" column for Kiplinger Personal Finance. He is an income-investing expert who covers bonds, real estate investment trusts, oil and gas income deals, dividend stocks and anything else that pays interest and dividends. He joined Kiplinger in 1981 after six years in newspapers, including the Baltimore Sun. He is a 1976 journalism graduate from the Medill School at Northwestern University and completed an executive program at the Carnegie-Mellon University business school in 1978.