Make the best of a bad 401(k)

(Money Magazine) -- You're probably feeling a lot better about your 401(k) these days, and not without reason. The average balance for experienced workers, after declining 19% in 2008, bounced back 29% last year, including new contributions.

But it's important to remember that short-term market gyrations are unlikely to determine your ultimate success or failure as a retirement saver.

In the long run, it's how much you're investing (as much as possible, of course) and how good your plan is that are the key determinants of how well you'll do in your 401(k). While you can control the former, unfortunately the latter is pretty much out of your hands.

And the truth is, many 401(k) plans have serious design flaws, from awful investment choices to missing company matches to outrageously steep fees.

"About one-third of 401(k) plans tend to be really bad, another third are questionable, while the top third are acceptable to varying degrees," says Matthew Hutcheson, an independent 401(k) fiduciary in Portland, Ore.

If you're trapped in a lousy plan, don't ditch it. A 401(k) is a savings vehicle that you can pretty much set on autopilot. And even subpar plans give you valuable tax benefits. Still, it's crucial to understand how good your plan is and how to compensate for its shortcomings. That will brighten your retirement prospects even in murky markets.

Among the most common issues you're likely to face:

MISSING ASSET CLASSES:

While the average 401(k) offers workers 18 funds to choose from, you really need only seven or eight -- as long as they cover the key types of investments needed to construct a fully diversified portfolio. Alas, that's not often the case.

Even the nation's biggest 401(k) plans fall short in some key areas. Take Procter & Gamble. The consumer product giant's $1.2 billion plan lets workers invest in a choice of nine funds, in addition to P&G stock. But if employees are looking for investments other than stocks that will protect their portfolios against the ravages of inflation, they're out of luck. The P&G plan does not offer funds that specialize in real estate investment trusts (REITs), emerging-markets stocks, or Treasury Inflation-Protected Securities (TIPS) -- which are all classic inflation hedges.

To be fair, P&G does offer workers access to profit-sharing and employee stock-ownership plans in addition to the 401(k). Still, if a plan the size of Procter & Gamble's doesn't include all the tools a worker could need, you can see why the odds are slim that a smaller plan will. And in fact, a recent survey by the consulting firm Hewitt Associates found that a majority of plans are missing several key elements.

The solution: Your first step is to check if your 401(k) has a so-called self-directed brokerage window. This feature allows you to bypass your plan's limited offerings and invest in just about any stock or fund of your choosing.

For example, Caterpillar doesn't offer real estate funds in its plan. But like 26% of providers, the construction-equipment firm makes available a brokerage window through which employees have access to a myriad of funds that do.

You'll probably be charged $50 to $100 a year for using this window in most plans, as well as trading fees and commissions on your trades. Still, that could be worth it if you don't trade too frequently within your 401(k).

If your plan doesn't offer such a window, bring your other retirement accounts into the mix. Say your plan offers enough choices to diversify into U.S. stocks and bonds as well as foreign developed-market equities -- but lacks an emerging-markets option. If that's the case, take full advantage of what your 401(k) has, and use your Roth IRA to invest in an emerging-markets fund. If you don't qualify for a Roth IRA or a tax-deductible IRA, use your taxable brokerage account to gain emerging-markets exposure.

FUNDS WITH LOUSY RECORDS:

Most 401(k) funds are actively managed. And the sad truth is, most of them are run by stock and bond pickers who lag the indexes they're paid to beat. Indeed, 63% of stock funds that invest in large companies failed to beat their benchmarks over the past five years. So, what if you have the misfortune of being in a plan chock-full of losers?

The solution: First, see if you can sidestep those actively managed funds by going with index funds, says Chicago financial adviser Leisa Aiken. Because index funds buy and hold all the stocks in a particular market or segment, they just about match the return of a given asset class.

The good news is that overall, more than seven in 10 401(k)s offer at least one index fund. And among large plans, 97% have at least one index option that tracks U.S. stocks, while 42% provide at least one intermediate-term bond index choice. So there's a good chance you can put the bulk of your 401(k) money in those offerings.

Once you do that, you can fill out the rest of your asset-allocation strategy in several ways. For starters, look for the least objectionable actively managed funds in your 401(k) to invest in specialized asset classes.

To pick the best of your bad lot, go to Morningstar.com. Plug in the fund's name, and the site will show that portfolio's "percent rank in category." Ideally you'll want to go with a fund that finished in the top 50% of its category over the past five years. This won't guarantee the fund can repeat, but it's at least a sign of sustained solid performance. If your plan lacks choices that accomplish this feat, put your money into the ones that come the closest.

If your spouse has a 401(k), use your bad plan to invest solely in index funds. And if her plan offers better actively managed funds, use it to diversify your collective kitty.

RISKY TARGET-DATE RETIREMENT FUNDS:

Many 401(k) plans now automatically default you into a target-date fund, all-in-one portfolios that expose you to a mix of stocks and bonds, and then automatically shift to a more conservative blend as you age. Their appeal: You can literally set them and forget them.

But during the market crash, some target funds failed to deliver the secure retirement investors expected. The AllianceBernstein Retirement Strategy funds, for instance, took a big hit because of their bigger-than-average stake in stocks. AllianceBernstein's 2010 fund, designed for those retiring this year, lost 33% in 2008.

Unfortunately, most 401(k)s offer just one set of target funds, so if you want to put your plan on autopilot, you may be directed into one that's riskier than you'd like.

The solution: Start by figuring out your target fund's current mix of stocks and bonds, as well as what blend it will shift to at retirement. That shifting mix will be among the biggest determinants of the fund's potential returns -- and risk.

Morningstar studied the performance of 2010 target funds and found that those with 65% or more of their assets in stocks lost 27% or more in 2008. Meanwhile, most funds with less than 40% in equities fell less than 21%.

How can you tell if your target fund is taking on more risk than its peers? One way is to look up the asset allocation of the average target fund that's just entering retirement phase. You can do that by going to iShares.com. This family of exchange-traded funds runs a set of ETFs that tracks the S&P target-date indexes. So if you look up the iShares S&P Target Date 2010 Index fund, you'll find that its exposure to stocks is about 50%.

If your plan's target-date offering is much more aggressive -- and you're uncomfortable with that -- you can elect to go with the target that's five or 10 years closer to retirement. So if you're 50 and plan to retire in 2025, instead of going with the 2025 fund, try the 2020 or 2015 offering.

Before the financial crisis, only 6% of plans didn't offer workers a matching contribution as an incentive to boost participation. But that number spiked last year, as another 12% of employers reduced or suspended their matches.

There's relief in sight: About a third of firms that cut matches are planning to bring them back this year, including Ford and Black & Decker. But not all plans are restoring them to pre-crisis levels -- for instance, FedEx is bringing back half its previous match -- which means there will be less free money to help you achieve your long-term goals.

The solution: If you have a missing or reduced match, there's no getting around the fact that you'll have to make up the difference by saving more.

How much more? Typically, a full match is 3% of salary. If you don't think you can put away that much more now, plan to gradually boost your contribution over the next few years, says Ann Arbor financial adviser Rob Oliver.

The question is, Should you use your matchless 401(k) or a Roth IRA to invest that extra savings? In most cases -- unless there are a host of other serious problems with your plan, such as extremely high fees (see the next section) -- your 401(k) will still make the most sense, says Vic Hess, a financial adviser in Tucson.

One exception: If you're in such a matchless plan and expect to have a higher tax rate at retirement, max out your Roth IRA. Then put additional savings into the 401(k).

In the long run, it's the fees your 401(k) charges that can make or break you -- a GAO study found plans charging 1.5% in annual investment expenses are likely to give you a 20% smaller nest egg than those charging just 0.5%.

Ideally, your 401(k) should cost you no more than 1% of assets each year in total expenses, though the reality is you're most likely to meet that goal if you're in a large-company plan. Large 401(k)s can typically charge less, in part because they qualify for so-called institutional-share-class funds, or cheaper versions of funds that individuals can get on their own. Among plans with over $1 billion in total assets, 57% use these cheaper share classes for most of their investment options.

Still, some big employers have not fully leveraged their ability to cut expenses. In 2008, Wal-Mart was sued by employees in part for offering only retail-share-class funds in its 401(k) rather than the cheaper versions. While the suit has been working its way through the courts, Wal-Mart has made some changes. The company added institutional-share-class target-date funds to its 401(k) and plans to offer more of these lower-cost options.

The solution: Start by assessing how much your plan actually charges. This can be tough, because plans are not required to disclose all their costs.

While the federal government is debating how to improve fee disclosure, the private sector has stepped in. BrightScope.com, a San Diego startup that rates 401(k)s, has launched an online tool that gives you a free personal fee report. So far the company has expense data for 31,000 401(k)s, which cover more than 50% of participants.

Once you register and supply information about your investment choices, click on "fee details" to find out the estimated percentage of your 401(k) that you are paying in expenses each year.

Another click gives you a breakdown of the fees by category, such as management expenses, advisory fees, and record-keeping costs. (One caveat: Since most of the data are pulled from government documents, they may be two or more years out of date.)

If your 401(k) is not yet rated by BrightScope, ask your plan provider or benefits office for the information. Or if you don't mind crunching numbers, you can dig into the plan documents to get a rough idea of the fees your plan charges.

Even if your plan is pricier than average, you may do well to contribute anyway, especially if you don't intend to stay with your company for more than a few years.

Remember, you can sock away more tax-sheltered money annually in a 401(k) than in an IRA -- a total of up to $16,500 this year, plus another $5,500 if you're 50 or older.

And once you leave your job, you'll be free to roll your balance over into a low-cost IRA where you can use broad-market exchange-traded funds, which typically charge just 0.20% of assets or less. So by filling up your plan now, you are ensuring that more of your assets will grow tax-deferred in the future.

Still, if your 401(k) levies sky-high fees -- say you work for a small plan and it charges 3% or more -- and you expect to remain at your company for the long term, your best move may be to contribute just enough to qualify for a full match. Then invest additional savings in a low-cost IRA or in tax-efficient funds within a taxable account.

It's hard enough to overcome one or two big flaws in your plan. But what if your 401(k) is lousy on all three counts?

The solution: In that case, your best move may be to lobby your employer for a better plan. But be strategic about it. "You will get better results if you go in armed with hard data," says Dan Maul, head of Retirement Planning Associates, a 401(k) adviser in Kirkland, Wash.

So before you march into human resources, do some research on your plan's fees -- as well as those of your company's primary industry competitors. You can look at your plan's documents and check BrightScope.com. And don't forget to gauge your funds' recent track records. If you show how your funds consistently fail to beat their benchmarks, you might be able to leverage that to get more index fund offerings.

Another smart move is to enlist colleagues in the lobbying. "Most benefits officers want their plan to be well regarded, and they'll pay attention if they receive a pattern of complaints," says Trisha Brambley, president of Resources for Retirement, a 401(k) consultant in Newton, Pa.

Finally, remember your boss has more money in the 401(k) than you do. So you may find a better reception than you expect. Indeed, two-thirds of 401(k) plans tried in the past two years to negotiate lower fees with their service providers. And half tried to swap into cheaper funds.

That makes sense. Cutting costs and improving performance are sound long-term goals not only for you, but your company as well.