Why You Need to Rebalance Your 401(k)

Just like regular exercise, changing your oil, and cleaning out your fridge every once in a while, rebalancing your 401(k) is a simple but important maintenance habit for modern life and a major tool in the cultivation of your personal wealth and financial health.

To get the 411 on 401(k) management and asset allocation, we sat down with Michael Sosnowski, a Certified Financial Planner® and Director of Transamerica’s Advanced Markets team.

Understanding target asset allocation

When you participate in a 401(k) plan, you select a target asset allocation. A target asset allocation is the amount of risk you’re willing to expose to your investments. That risk is calculated based on the balance between investments in equities (stock markets, which are riskier) and fixed instruments (bonds, which can be less risky), often expressed as a percentage. A target asset allocation with a perfectly balanced amount of risk would be 50% equities and 50% fixed instruments.

If you have selected a Target Date Fund for your 401(k), then you don’t need to rebalance because the portfolio manager will keep your target asset allocation on schedule for the target date you chose. “I call this the set-it-and-forget-it plan,” says Sosnowski.

When you’re young, you’re able to expose your money to greater risk because you have time to ride out market volatility and potentially increase your returns. As you age, you might want to reduce your risk by shifting your asset allocation toward less risky investments.

Sosnowski offers one generally accepted rule for calculating asset allocation: The percentage amount you should allocate to riskier equities is your age subtracted from 100. So, if you’re 30 years old, your target asset allocation would be 70% equities and 30% fixed instruments. He points out, however, due to increasing life expectancy (hurray for that!), some folks have begun calculating asset allocations based on the equation: 120 minus your age.

Why rebalance?

Whatever your target asset allocation is set to, the balance between those percentages can shift over time due to market fluctuations, changes in your contribution amounts, financial goals, and risk willingness over time. Rebalancing your 401(k) sets you back to the target asset allocation that best suits your retirement goals.

Say you’ve calculated your target asset allocation and determined you want a balanced 50/50 strategy. If the stock market is doing well in a particular year, it could cause your target asset allocation to shift to 60/40, that is 60% equity investments and 40% fixed instruments. That might be more risk than you’re willing to take on. Rebalancing your 401(k) will bring you back to 50/50.

According to Sosnowski, 401(k) rebalancing is an important habit because it keeps you honest as an investor. When one investment outperforms another – in this case, a stock outperforming a bond – rebalancing forces you to take your gains and reinvest them into something less risk-averse. It’s the strategy of selling high and buying low – a strategy that runs counter to the human tendency to become discouraged when an investment drops in value, causing many people to sell off an investment at a low price. Then, when the market inevitably trends back the other way, fear of missing out on the upswing causes people to jump back in — buying investments at a higher price — not something you want to do with your retirement investments on the line.

Additionally, as you age and as your day-to-day financial needs change in relation to your salary, you might want to adjust the amount you're contributing, or change your target asset allocation entirely, depending on your goals.

“What a lot of people don’t realize,” says Sosnowski, “is just how responsible you are for your 401(k). It used to be you worked a certain number of years and retired with a pension. Now, the risk has been shifted onto individual people, and they have a personal responsibility to keep their eye on the target. 

Visiting your 401(k) account periodically, monitoring 401(k) asset allocation, and utilizing tools such as rebalancing and contribution auto-escalation can help keep your retirement goals in focus.”

When should you rebalance?

Sosnowski suggests at least rebalancing annually, or semi-annually if you have a more complicated portfolio. That might include investments in things like real estate or international and emerging markets. But regardless of the makeup of your portfolio, he reasserts the importance of making a habit out of understanding your 401(k) and becoming an active participant in its management.

As you age, your willingness to expose your money to risk might decrease, so it’s important to assess your target asset allocation every so often. Sosnowski says you should also always ask yourself how much you can or want to contribute, and you should seek to maximize your contributions because you’re laying the groundwork for your retirement right now. Everything you do in the present will only increase the power of compounding interest in the future. Speaking of capitalizing on the present, he points out some people even recommend a five-year schedule that starts out with an aggressive 90% equity exposure between ages 25 and 30, followed by a 10% drop in equity exposure every five years after that.

How do you rebalance?

Rebalancing can be really simple. Sometimes it’s as straightforward as logging into a dashboard and clicking a button. Other plans may require more active management, but most, if not all 401(k)s, should be easily accessible online. Sosnowski says lots of plans will even offer automatic rebalancing at set time intervals. All you have to do is log in and set it to rebalance on a set date every year.

Things to Consider:

It’s your responsibility to remain active in your 401(k), which can help keep you on track toward retirement.
  • Try to rebalance your 401(k) once a year to keep your retirement in focus.
  • Is your target asset allocation right for you? Make sure to calculate your risk based on your age, financial needs, and goals.
  • If you have a Target Date Fund, you don’t have to rebalance your 401(k).

A final note

Sosnowski stresses the importance of participation in your 401(k) plan beyond just signing up and leaving it to the abstract. “Lots of people never actually calculate their projected 401(k) balance at retirement. They just think, ’30 years is a long time, and I’m contributing every paycheck, that’s good enough.’ But really they should log in to look at their plan and make use of the different calculators offered by most companies. When you see where you stand relative to your retirement goals, your retirement picture becomes much more real, and you start to see which management opportunities you need to take advantage of to pursue the retirement life you’ve imagined.”

Don’t have a 401(k)? Or want to roll over your current retirement account?

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

Neither Transamerica nor its agents or representatives may provide tax, investment or legal advice. Anyone to whom this material is promoted, marketed, or recommended should consult with and rely on their own independent tax and legal professionals regarding their particular situation and the concepts presented herein.