A 401k plan is a type of tax qualified pension plan available through many employers in the United States. These plans are named after section 401k of the federal tax code and may contain both employer and employee contributions. 401k asset allocation describes the process through which 401k contributions are invested into 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 are no guarantees about the size of the participant's eventual withdrawal benefits. These plans are administered by investment firms or brokers that assume a fiduciary role, actively managing the money on the participant's behalf. Each plan contains a number of different investment options, most of which are typically mutual funds; some plans, however, contain certificates of deposit (CD) and other types of conservative securities. During the 401k asset allocation process, the participant must decide how much money to invest in each mutual fund, CD or other type of underlying security.
Many investment firms use standardized 401k asset allocation models in which funds are split between aggressive, moderate, and conservative mutual funds. Aggressive funds normally contain mostly stocks and other types of growth instruments that have no principal guarantees. Moderate funds contain a mixture of growth instruments and conservative instruments such as bonds. Conservative funds contain bonds, CDs and other securities that provide investors with little potential for growth but minimal principal risks. Aside from offering 401k asset allocation models based on types of securities, some firms also create allocation models that contain securities issued by firms in particular industries or entities based in certain nations.
Over long periods of time, stocks have traditionally grown at a faster rate than other types of investments. Young professionals who are attempting to maximize their earnings often choose to invest primarily in 401k asset allocation models than include stock funds. People who are close to retirement age often choose to invest in allocation models that are mainly comprised of low risk fund options. While investment professionals often make recommendations that are partially age based, 401k participants make the final investment decision and some young investors choose to invest conservatively and some seasoned investors choose to invest aggressively.
After a 401k plan participant decides upon an asset allocation plan, the plan custodian has to regularly re-balance the account. The percentage of money that the investor holds in each type of security should roughly remain the same. Therefore, if the value of one type of investment rises, the fund custodian may have to sell some of the shares in that fund and reinvest the proceeds in another type of security to redress the balance of the account. Many investment firms allow plan participants to change a 401k asset allocation selection at any time.