I have some bad news. Planning for retirement is a lot harder today than it was for our parents.
Pensions are a thing of the past. But you probably already knew that. Less than 13% of employees currently participate in a pension plan, and that number keeps going down.
But here’s the good news: the rise of 401(k)s and other retirement savings plans ultimately give you way more flexibility and control of your financial life, but only if you know what you’re doing…
There’s a ton of confusion around 401(k)s. How much should I be saving? How much income will I have in retirement? What the heck should I invest in?
The even better news is it’s really not as hard as you think to be light years beyond your peers when it comes to saving and investing for retirement. Read on to find out how!
What Is a 401(k)?
Back in the early 1980’s, an obscure provision of the tax code was launched into a multi-trillion dollar industry. This allowed average Americans to invest money tax-deferred (you only pay taxes when you take money out, not when you put it in) for retirement.
Fast forward to today, and almost all employers offer a 401(k) plan based on that premise. This is referred to as a “defined contribution” plan, as opposed to the “defined benefit” pension plans of the past. “Defined contribution” is a fancy way of saying that you are able to contribute a certain amount to the plan, whereas “defined benefit” says that you will be guaranteed a certain amount of income in retirement.
According to the Investment Company Institute, there are over 54 million workers that participate in a 401(k) plan, and those plans account for over $5.4 TRILLION dollars!
How does a 401(k) Work?
When you get hired at a new company, almost always one of the benefits is an offer to participate in their 401(k) program. When you enroll, you can select a certain percentage of your paycheck that goes straight into your 401(k) account (without being taxed!)
Most companies also give a company match to incentivize you to contribute to your account. This is essentially free money, just for participating in the plan.
For example, if your employer matches 100% of your contributions up to 4% of your salary, that means for every dollar you contribute up to 4% of your paycheck, they will put in another dollar. That’s like a 100% return on investment. To put that in perspective, with a bank account you’d be lucky to get a 2% return. In the stock market over the long term, you might get a 10% return. I challenge you to find any investment that will give you a 100% risk free return!
With all those people contributing to their 401(k)s, you may be wondering how you stack up against the competition? How much should you be contributing each year?
The Employee Benefits Research Institute (ERBI) recently did a study that showed the average annual contributions by age range of those participating in a 401(k) plan. Someone just starting out in their career contributes around $3,000 while someone nearing retirement will contribute a little over $7,000.
Age range Average employee contributions
25-34 $ 3,169
35-44 $ 5,054
45-54 $ 6,488
55-64 $ 7,287
So if you’re the average worker making the average contribution, how much can you expect your investment to grow every year? According to the How America Saves 2018 report from Vanguard, the 5 year return on a 70/30 Stock/Bond portfolio was around 10% per year.
That matches up pretty well with a decent estimate of the long term estimate of the annual stock market return. So assuming inflation was 3% per year, your annual return accounting for inflation would be 7%.
If you contributed like the average worker above, how much would you have saved (in inflation adjusted dollars) at age 65? You’d have about $940,000. Just under the holy grail of a $1 million retirement account.
Do You Want to Be Average?
Of course, average contributions and average returns don’t really tell the whole story. Do you really want to be like the average American when it comes to retirement? There is story after story showing that as a whole, workers are not saving nearly enough for retirement.
There’s a rule of thumb (based on the famous Trinity Study), that you can safely withdraw 4% of your nest egg every year in retirement. So if you had a $1 million balance at retirement, you could safely withdraw $40,000 per year.
Think about your current spending, and what you might need in retirement. Ignoring social security (probably best to assume it’s not going to be around, or at least not in its current form, when you retire), you may need to adjust your contributions to hit your goals. Need $50,000 per year? You’ll need a $1.25 million balance. Need $100,000 per year? Make sure you’re contributing enough to hit $2.5 million by retirement.
Mistakes to Avoid
When I got my first job out of college, I got a mountain of brochures and related paperwork about the company 401(k) plan. Needless to say, it was overwhelming!
But once I sorted through everything, logged into my account, and researched the investments available to me, it all started to make more sense.
If you get nothing else from this article, hopefully I can help you avoid some of the early mistakes I made (and lots of other people make) to put you one step ahead of the pack.
Mistake #1: Not Getting the Company Match
At the beginning of my career, I was overwhelmed by the amount of data to sort through in regards to my 401(k) options. Fortunately, I decided to just DO SOMETHING while I researched and figured out what the best investment allocations were for me.
If you do nothing else, you must at least contribute enough to get the company match. As stated above, this is FREE MONEY! It doesn’t get much better than that.
Assuming you made $50,000 per year and your company matched 4% of your contributions, after 40 years and a 7% return that is over $400,000 you are leaving on the table by not taking advantage of the company match! I don’t know about you, but I could think of a lot of things to do with $400,000.
Mistake #2: Leaving your Contributions in Cash
I was guilty of this when I first started investing. There were dozens of investment options, and while I was contributing enough to get the company match, I was just letting it sit in cash while I researched the best asset allocations, mutual funds, etc. The best time to be fully invested in the market is when you are young and have many years ahead of you. The market will always go up and down, but owning 100% cash is a guarantee of a loss year after year once you take inflation into account.
If you only invested in a cash account per the contribution schedule above, you’d have about $220,000 at retirement, compared to the $940,000 you could have had if you invested in the market. If you’re too scared of the ups and downs of the market, consider putting more of your money into bonds. You may have a lower (though more stable) return over 40 years, but at least you won’t be losing money every year by just holding cash.
Mistake #3: Paying High Fees
There are two types of mutual funds: actively managed funds and index funds. An actively managed fund picks the stocks they invest in with the intention of beating the market. An index fund just picks an index (say the S&P 500) and invests in the stocks in that index so that the performance matches it as closely as possible.
While there are a lot of smart people on Wall Street, did you know that most actively managed funds actually UNDERPERFORM against an index fund? In fact, over 70% of actively managed funds do worse than an index fund. Even Warren Buffett, famous for beating the market year after year, recommends the average person invests in index funds.
The secret comes down to fees. Actively managed funds have to pay all those geniuses who sit around and pick stocks all day. An index fund has the simplest (and cheapest) investing strategy – buy the stocks in the index.
If you’re invested in actively managed funds at say, a 1% annual fee, compared to an index fund at 0.1% fee. Even if the managers can match the index, the fees will slowly eat away at your retirement savings. In this scenario, over a 40 year career, that extra 0.9% fee will cost the average American almost $200,000! Lesson learned – small fees over time can add up in a big way.
Albert Einstein is said to have called compound interest the “most powerful force in the universe”. When it comes to your 401(k), you can clearly see that even small adjustments can amount to massive changes over time.
It is scary to think that small mistakes can cost you hundreds of thousands of dollars in retirement, but it is equally empowering to know that just making minor improvements can reverse the trend and set you up for a life of leisure once you sail away into retirement.
What mistakes have you made in your 401(k)? What improvements have you made to save/invest even more money?