Self Directed 401(k)s ... A Really Good Idea

How to Take Control of Your 401(k) should be a must read for everybody over the age of 18.

It says this about learning to invest our own money for our own retirement and benefit:

"This may surprise you, but there's a good chance you can take direct control of your nest egg at work, choosing investments beyond the two dozen or so mutual funds that most employers offer in their savings plans. Doing so can be risky, but here's why you should consider taking a shot at it.

About one in five employers, according to Plan Sponsor Council of America (PSCA), offers a self-directed brokerage option, in which workers with 401(k)s and related accounts can buy stocks, bonds and other assets. Also, three-quarters of employers -- and 86 percent of those with 5,000 or more plan participants -- permit "in-service withdrawals" (typically starting at age 59 1/2), where holdings can be pulled from accounts and rolled into IRAs.

Yes, this is a scary idea: people taking the wheel of their savings plans and, possibly, crashing into crazy investments. Most workers with these options, in fact, take a pass; less than 1 percent of plan assets are invested through self-directed accounts. . . .

But I'm betting that, if you pursue either option, you're smart enough to do so gingerly. In which case, the potential payoff is that you get a jump on building income for retirement.

More people are recognizing the importance of having investments that generate cash in later life. This way, you aren't dependent on capital gains to meet expenses. What's less appreciated, though, is the value in identifying and assembling these investments early -- say, five or 10 years before retirement. If you can get a head start on building income at age 55 or 60 (or earlier) . . . the compounding effects can move you closer to the point where you're living off the returns of your portfolio in retirement, rather than eating into the portfolio itself.

Dividend-paying stocks -- and an important concept called "yield on cost" -- are a good example of how this can work. Yield on cost is calculated by dividing a stock's current dividend by the amount originally paid for each share. Let's say you buy a stock for $12, and it pays a 3 percent annual dividend, or 36 cents. And let's say that after a year, the share price hits $16, and the company increases the dividend to 48 cents.

At this point, the payout is still 3 percent (48 cents is 3 percent of $16). But not for you. You paid $12 for your stock; thus, you're getting a dividend of 48 cents on $12 -- or 4 percent. So, your yield on cost is 4 percent. In other words, you're now earning a higher yield on your original investment, which puts more money in your pocket. If you're able to invest in companies with a long history of paying dividends -- where those dividends increase annually and the increases outpace inflation -- your yield on cost eventually should outshine the return on other investments.

Now, let's return to your 401(k), which likely holds the bulk of your retirement savings. Chances are good that the mutual funds in your account are yielding about 2 percent (or less) -- hardly the stuff of retirement dreams. (Inflation alone is running about 2.9 percent.) But if you could gain access to a wide range of investments, you could assemble -- today -- a group of dividend-paying stocks (again, with a steady history of payouts and dividend increases) that yields about 3.5 percent. Ideally, over time your yield on cost on these shares would rise significantly. . . .

How could this help you? Remember: A 4 percent rate of withdrawal from a nest egg is traditionally considered a safe starting point. If you're thinking about drawing down your savings at that rate, "the growing yield on cost alone may meet your distribution needs in retirement," says Farrell.
If all this sounds too easy, you're right to be cautious. Dividends, of course, can be reduced or eliminated. (In 2008, Bank of America's quarterly payout was 64 cents; today it's a penny.)

Companies don't always meet growth estimates. And some people simply aren't meant to manage their money: They buy and sell too frequently; they pick less-than-stellar investments (read: Enron); and they get hammered with trading fees.

That said, the need for dependable and growing income in later life is clear -- and if you can start the process early, so much the better. My advice: See what options you have with your 401(k). If you're able to take the reins, sit down with a financial adviser and discuss investments that fit your comfort level and future needs. The ride could be safer than you think."

Summing Up

My belief is that if you're reading this, you can learn to invest for yourself and do better than the "pros" will do for you. Especially if you know others who are doing the same thing. This "no cost" cooperative networking or clubbing effect can be a powerful one indeed.

And three other things as well --- (1) a money saver, (2) a performance enhancer and (3) a peace of mind producer, too.

And it won't cost a penny to accomplish all that. Saving expenses of even 1% on a portfolio that earns in total 5% is a 20% cost savings. And saving that 1% on a return of 8% represents a 12.5% savings.

As the writer says, "yield on cost" is a most powerful device. And more so in an investing environment like today's low yield one. Dividend paying blue chip stocks have become a great substitute for bonds. Particularly those stocks which will increase dividends through higher earnings over time.

To me it makes sense to acquire the skill to invest on your own (it's not that hard), and there is every reason to believe that a properly diversified self managed portfolio of dividend paying stocks will outperform both a mutual fund and a professionally managed portfolio over time

Time is on the side of the individual investor. Avoiding advisory costs and commissions can be a big contributing factor to an individual's investment portfolio performance.

Add in the yield on cost factor that is so favorable today, and you can get to peace of mind very quickly.

At least that's my take.

Thanks. Bob.