What will you be doing when you retire? Retirees are usually very wealthy with hordes of money to burn. It's common for them to drive expensive luxury vehicles to their country clubs where they trade in yachts as they discuss the deal with thousand dollar bottles of cognac. Medical bills will seldom be a problem at this age because the Federal government has lovingly crafted a Ponzi scheme pyramid called Social Security with plenty of Medicare benefits that not only will foot the bill, but finance a carefree high life replete with villes of margaritas. Well, as much as we would like to imagine this happening, in reality it's just a pipe dream.

Retirement Spending

Paradoxically, as things currently stand those of modest income are slated to have a much nicer retirement. With the median household income in the USA being somewhere north of 40,000 dollars, those under that threshold will have little change in their income though they are no longer working. The "normal" age of retirement has been extended to 67 to where you get an "average" benefit at which level the maximum Social Security payout is around 25,000 dollars a year, pro rated to your pre retirement income. Those who made less get less but those who made more won't get any more than those 25 grand a year unless you delay retirement into your 70's. Thus, people of modest means will be making similar levels of income before and after retirement and thus enjoy the same standard of living. If anything a part time job might help them make more as retirees than they ever could during their normal working years. Those used to higher standards of living, namely the middle class, are in for a nasty surprise.

With ever lower savings rates which last year were negative 1.1% as in the average american borrows 1.1% more than they earn, the middle and upper middle classes are slated for a rude awakening with the financial encounter of the worst kind. For example, let's pick a level of income that defines "wealthy": $80,000 a year. At this point, depending on deductions they may very well have an effective take home pay between 50 and 60,000 dollars a year. Even though they made a lot of money and paid a lot of taxes, the maximum Social Security benefit they can reap is again in the mid 20,000's. For all intents and purposes that's less than half what they were used to earning and spending! That means that in order to continue the same standard of living without having to sell off a bunch of stuff and/or declare bankrupcy, they will need to have prodigious savings they can rely on to either generate income or withdraw to make up the difference. Enter the 401k!

What is a 401k?

This review will focus on reviewing the 401k offered specifically by Fidelity Investments. However, I will start with an explanation of what a 401k is, what it can do, how it can be used so that when I explain its offering by Fidelity everything can make more sense to the prospective consumer. If I inspire you to save that extra little bit so you can retire more comfortably, even better and you can show me gratitude by mailing me a check at..... just kidding!

A 401k is a tax sheltered (and deductible) investment account where you can deposit your earnings directly out of your paycheck to which your employer will match a certain amount. The maximum you the little guy can contribute tax free is 15,000 dollars a year if you're under 50 and 20,000 dollars a year over that age. All contributions are tax deductible, meaning that up to that level you can deduct it from your taxes. That means that if you make 50,000 dollars in one year, but you contribute 10,000 dollars to the 401k, you are only taxed on the 40,000 dollars and the 10,000 that go into the 401k are not.

IRA's (Individual Retirement Accounts) work the same way as 401's; both these types allow for contributions to be tax deductible and the both are tax sheltered meaning you don't have to pay taxes on dividends, capital gains or income produced from the investments as long as it's not withdrawn from the account. However, an IRA is individual, not employer sponsored and has a maximum contribution of only 4,000 dollars per year, 5,000 if you are over the age of 50. Usually 401k's are given by fairly large employers which allow for better deals with the brokerage institution in question, in this case Fidelity. However, the options for investment will also be restricted to select funds available from the broker, unlike a regular brokerage account or an IRA which are usually pretty open to almost the entire market's worth of investment vehicles. You also cannot select individual securities in a 401k like you can in an IRA. If you max out your 401k and still have money to invest, you can still contribute to an IRA for that year but it will only be tax sheltered. You can't double dip the tax deductions and cannot deduct the amount of IRA contribution off your full income tax if you already contributed to a 401k.

Roth 401's or IRA's are a bit different because though the money can grow tax sheltered, but you cannot deduct your contributions off your income. However, when you retire you can withdraw money from the accounts tax free, making them ideal for people who have high levels of income throughout their lives and expect to still have a high level of income after retirement such as those who invest in real estate or plan to work into ripe old age.

However, the main perk of the 401k is that the more you contribute, your employer will contribute more as well, which is the only legal way of which I am aware of making free money without either working or taking investment risk. Another perk of 401's (and IRA's as well as 403's where the employer does not contribute) is that they are also immune from lawsuit. Should you get divorced, sued or incur financial losses as a result of legal proceedings, these accounts are sheltered and not counted as part of your "suable" wealth. 401 and 403's come with a catch: unless you are able to proove debilitating illness forcing you to retire prematurely (like a bad stroke), you have to pay income tax on all withdrawals prior to age 59 1/2 plus a 10% penalty! So these truly are retirement accounts you keep growing until you are ready to stop working and not "rainy day" savings.

How to Use a 401k

The short answer: contribute as much as you can as often as you can as early as you can in your life. If you can max it out, by all means do so.

The more you contribute, the more your employer will contribute which is tantamount to doubling your money overnight. It will vary from employer, but a typical plan is to match the contribution from 4 to 6% of your contribution or current income. If you have a good income and on top of this contribute 15,000 dollars a year, you can maximize your savings even before you start to consider the power of compounding capital appreciation. That's free money; take advantage if you can!!!

Because a 401k is tax sheltered investment vehicle, some investments are more appropriate there than others. Tax free municipal bonds (on which you don't have to pay taxes on the interest but have far lower yields) and other investment vehicles that try to minimize taxes like tax managed index funds are poor choices. What you should hold in your 401k should be decided on the basis of how much you are saving, how you plan to use it and how long you have to retire as to what the most appropriate assets should be. Real estate investment trust indexes (REITI's) and small cap index funds are more appropriate for young people. The beauty of holding these volatile but highly lucrative asset classes in a tax sheltered account is firstly because they generate a lot of taxable gains and secondly because they can be sold off for a profit many years later and rebalanced into bonds 5-10 years prior to retirement. Bonds are basically loans that you make to a certain entity where the interest and repayment schedule are stipulated when you issue them. They will provide income when retired in the form of interest but this is taxable as income so in later years it does make a difference to try and hold them in a tax sheltered account.

About Fidelity

Fidelity is an investment company that runs a plethora of money management services from brokerage accounts, insurance, mutual funds and other devices that by their own admission will "make your money work harder for you". As a matter of fact, so ample is their scope that they are the largest investment company in the world with over one trillion dollars run under their umbrella.

They have been very successfully been helping people from little Joe Schmoes with IRA's all the way to large institutional corporations make money with their money since 1946 when the Johnson family of Boston Massachussets founded it. There are numerous headquarters sprinkled through the northeast though Fidelity has enjoyed success in reaching small businesses or individuals for their retirement accounts because more than any other investment company they open small offices in places such as shopping malls where you can speak 1 on 1 with a live person about your investments.

Fidelity: Establishing a 401k

You get a 401k is your employer sponsors it. Because there is a certain amount of paperwork and legal supervision involved, Fidelity as well as other companies used to not bother with small businesses. Nothing personal, but in order for it to be worthwhile for an investment company so that a workplace can offer a 401k, there needs to be a significant sum of money on the table. Gone are the days of only multimillion dollar corporations offering such benefits. With the increasing trend of Americans to go self employed and work in small businesses, investment companies have capitalized on this phenomenon and are offering 401k's to ever smaller clients.

Using the 401k: Website and Interface

Fidelity has a pretty fancy website at www.fidelity.com that holds all kinds of goodies. However, since a 401k typically has fewer options, including the Fidelity one and does not offer the ability to buy individual securities, a lot of the website that helps you research or trade investment vehicles really isn't going to be used and is not present. Once you log into your 401k it feels almost like a chopped down, 20% version of the regular website, and there is nothing wrong with that except that sometimes the screen looks a little empty. That's perfectly OK given what you need the website to do. Everything that is neccessary to access, monitor, view and manage your 401k is present.

Essentially, you need to pick from a list of investment vehicles where your money is going to go. You start by checking off boxes on the funds where you want your money to go. Then, when you decide which funds to utilize, you are taken to the next screen where you will specify percentages. This is important because it will dictate where your money will go in what proportions. If you make 50,000 dollars a year and decide to contribute 10% of your paycheck, every time you get a paycheck that amount will be deducted and deposited into the 401k. From that point, your money will be deposited into the appropriate funds in accordance to the percentage. So, if that 10% of your pay ends up being 5,000 dollars a year and you select three different funds, you can divide that 5,000 dollars a year any percentage way you want between those three. A typical percentage might be 50% in a US stock fund, 20% in a foreign stock fund, and maybe 30% of that in a bond fund. Again, your target allocation could vary significantly from that sum, but the take home message is that it's up to you to decide.

One nit I have to pick with regards to asset allocation is that there is very little reading material offered by Fidelity on their website and you are mostly on your own. If you know the difference between cash, stock and bond, you probably don't need it but many don't and there are other investment companies that do a far better job of helping the prospective investor decide what is best for them. There are funds offered by Fidelity that essentially take the planning out of investing and do all the allocating for you, but that is a topic for the next section.

Investment Vehicles in Fidelity's 401k

This is a very difficult topic to review because the funds present in 401k's, particularly Fidelity, have a lot to do with what your company originally asked for. Generally a 401k will have a more limited selection than a brokerage account; in many cases you might not even have access to all of Fidelity's funds and in some even just a few. You can read on for more details, but at the inception make sure that you ask "Fidelity Spartan Funds" be added. These are index funds that mirror the returns of the whole stock as well as bond markets as a whole at a very low price which means after 30 or 40 years you will have gained the most money possible especially with regard to other investors who utilize active management.

There are funds out there that try to specialize in certain areas or even "beat the market", but essentially all of this is due to chance. Over long spaces of time, particularly those for which the 401k was designed, the markets, be it stock or bond are impossible to predict, let alone beat reliably. The best way to capitalize the greatest gains are to be evenly diversified through investment vehicles that incur the lowest possible losses. Part of the reason why funds that employ managers who research and pick stocks is because they have to pay a team of managers to do that work which over the long haul does no better than if you were to throw a bunch of darts at the financial pages and invest in those stocks. Such (futile) effort generates lots of fees and though the fund manager makes out nicely, you will make out that much less.

Special attention must be paid to Fidelity's "freedom" funds. Essentially, these are funds that have a number designation that represents the year in which you plan to retire. Therefore, the Fidelity freedom 2040 fund will maintain an asset allocation that would be consistent with an average person with average needs who would consider retiring around 2040. The idea is very nice being that in earlier stages the fund tries to be more aggressive to grow capital and then turns more conservative later on in an effort to preserve your nest egg while maximizing income generating capacity for retirement. Certainly it's better to invest your money here than in some money market fund or treasury bond device as it has the potential to grow more over time thanks to broad stock market exposure. It offers "freedom" for someone who has difficulty picking and choosing between asset classes or individual funds. However, these funds actually invest in a large number of these above mentioned overpriced and inefficient. The fact that they are invested in so many different funds totally negates any real or perceived advantage of active management, and it works more like an index but charges you 1% instead of 0.1% of your money per year which over time makes a dent in your earnings. Even then though, the indexes are far better diversified. The asset allocation of the funds is very unbalanced as it has too many growth stocks while not enough value which over time makes for a more volatile, less diversified portfolio. While the funds for younger people tout themselves as being aggressive, they have very low exposure to small cap or foreign stocks and very conservative bond selections which defeat the purpose of an aggressive asset allocation to grow capital. Case in point is that while a friend of mine has been using this type of fund while I have been relying on the total market index, though he has more bonds than I do which is supposed to protect a portfolio from drops in the market, his portfolio tanked more than mine during market hiccups and took longer to recover. In the face of all these lost gains he is paying ten times more than I am in expenses. Needless to say, he is starting to get interested in the concept of index funds!

In addition to costs, There are those who say that the other part of why funds never end up outperforming the market for long is due to taxation as actively managed funds eventually sell stocks they think have gone up enough. People have recently spoken of actively managed funds being better in the real of smaller, younger and more volatile companies, the hot "small-cap" arena. However, this is not true either. A recent study by Vanguard investment group actually found that over the long term actively managed funds don't beat their index benchmark even as far as small cap stocks are concerned! So much for using a tax sheltered account for a supposedly "strong" small cap fund.

So don't go for all these expensive "five star" funds that the Fidelity magazine will try to push, as they won't beat the market over many decades anyway. Don't go for actively managed funds that your coworkers find darling and clamor to add into the mix. Furthermore, stay away from Fidelity's "advisor" funds. They are funds run by supposedly the best stock pickers in Fidelity's universe such as Will Danoff of Contrafund fame. Supposedly, they are investment geniuses that are allowed special smaller funds with a smaller and more nimble asset base to manage and therefore supposedly stand a better chance of beating the market. History will quickly prove these people wrong. Fred Schwed, who wrote Where Are the Customer's Yachts? was paraphrased and admired by Warren Buffett at the latest Berkshire Hathaway stockholders meeting about this subject. Wall Street's most successful investors are assumed to have inordinate amounts of skill. Mr. Schwed actually suspected this was wrong long before the presence of index funds. His example has to do with 400,000 contestants facing off in pairs flipping coins to determine the winner who would go to the next round. To start off with, there would be 200,000 winners and 200,000 losers, the number of winners dwindling with every coin flip. Just like investors who have long streaks of beating the market year after year, some coin flippers will continue to win round after round. As is written in the book, "Eventually there are about a dozen men who have won every singe time for about fifteen games. They are regarded as the experts, the greatest coin flippers in history, the men who never lose, and they have their biographies written".

Well, history will proove them wrong but not after these funds charge you with 1% or more of your moneys every year and in some cases a 5% load of every dollar you invest. No, instead, for the very long term as you would be seeking for a 401k, the best way to go is by investing in broad market indexes. Fidelity actually has the least expensive and therefore the best overall index funds in the case of their "Fidelity Spartan" offerings which is what you want to invest into. For a more thorough explanation of these funds, consider scrolling to the bottom of this review and reading my essay on Fidelity Investments where I discuss each one in detail. However, a quick and dirty recommendation would be to stay entirely in the stock world until you are within 10-15 years from retirement at which point it would be advisable to add a total bond market presence into the portfolio in a percentage that is consistent with your risk tolerance or need for income.

Customer Service

This overlaps a lot with any potential review of Fidelity Invesments itself. However, one of Fidelity's distinguishing features is the ability to meet face to face with a representative to either help you craft the 401k for your company/business or to meet in person to help facilitate account openings, financial advice etc. Though a lot of people like to do business online, it's certainly a nice perk for those who like that human contact. In our case, they have been very nice, but my only criticism is that their suggestions for financial advice have been very vague and not emphasizing index funds as much as they should. I guess if they did then they would call themselves "Vanguard", but that's a whole different discussion!

Conclusions

Any 401k can be a real lifesaver to many Americans who would like to continue their standard of living into retirement, especially because the middle class cannot really rely on social security. Fidelity's offering, when utilizing the excellent "Spartan" funds can help you build one of the highest yielding, most streamlined and best diversified portfolios around. Unfortunately Fidelity is not very vocal about getting you the investor to buy into their splendid Spartan index funds. Certainly they get to make more money from you in the absence of being vocal about including or using these devices which should be the backbone of anyone's portfolio. There are even some Fidelity 401k's that don't offer index funds in certain categories, or any at all!

If there were more educational materials, encouragement and above all unrestricted access into their low cost index funds, I would have no problem giving Fidelity 5 stars. I subtract one star for their less than helpful format and another for not giving you proper access to their best investment vehicles. Certainly any 401k is better than none, and configured right Fidelity's can be the king of the hill, but their reluctance to divulge what could make them tops irks me a little. I would still recommend Fidelity for their accessibility, friendliness to small businesses and overall ease of use. Just make sure that when the rep comes to speak with your company, be vocal about having as many "Spartan" funds as possible and avoiding their ripoff "Advisor" or "Freedom" funds.


If you would like to know more about its corporate culture, individual funds and how Fidelity operates, click on the link for my critique and commentary of Fidelity Investments

Recommended: Yes