401k Plans Only Work if you Contribute
From time to time, I’ll read about how bad 401k plans are for investors like you and me. Apparently, most people don’t even realize they’re paying fees on top of other fees to invest in certain funds. And while a minority of companies do it right, by providing low cost index and ETF funds, most, sadly do not. It’s up to you the investor, to thoroughly research your asset allocation and the funds you plan to invest in. But all these points become moot if you don’t contribute enough in the first place.
The news cycle has been inundated with talk of government pension reform lately due to the upcoming elections. But pensions are a type of defined benefit(DB) plan in which the benefit on retirement is determined by a set formula, and not investment return. Pensions sound(ed) great! As part of your total employee compensation, your company(or the government) would guarantee you a certain amount of money every month once you retire. Unfortunately, underfunding and low investment returns have revealed the open-ended nature of risk to employers. This risk is one of the main reasons why most companies now offer a 401k instead.
The Best of the Rest
A 401k is what’s known as a defined contribution plan. Your contributions are limited to $17,000 per year and it’s up to you to invest this money. And therein lies the problem. Most people don’t contribute enough to their 401k! It’s human nature to want instant gratification, and having money just sitting in your retirement account doesn’t do much to satiate your desire to spend. Ever heard of the Stanford Marshmallow Experiment?
Fees and asset allocation are important factors to consider, but young investors need to focus on increasing their rate of savings. Think about it like this. When you’re fresh out of college, your retirement accounts are low, so every contribution you make will significantly increase the percentage of your total account. After you’ve built up your accounts, each dollar that you put in will have less and less of an impact to the overall total value.
Let’s Look at Some Examples
Robert is 25 and has $50,000 in his 401k. He holds all cash positions, so no investments in stocks or bonds. If he contributes the maximum $17,000, his 401k goes up 34% to $67,000. This return outpaces the best year the stock market had in the past 35. 1% expense ratios are a big deal when your account starts treading in low-mid 6 figures, but until then Robert needs to focus on his contributions.
Alicia is 45 and has $500,000 saved up in her 401k. A $17,000 maximum contribution at this point will only increase her 401k by 3.4%. She’s invested in an active mutual fund that charges a 1.7% yearly fee, which effectively wipes out half of her contributions. At this point, Alicia would be well-served to research some low cost passive investment alternatives to reduce her fees.
These examples illustrate the power of large contributions towards the beginning of one’s career. The impact of your contribution on your total account value will significantly decrease as time goes on. Still not convinced? Let’s look at a graphical representation. Assume that you contribute $17,000 from the time your 25 up until you retire at age 65.
We can clearly see that there is a steep drop-off after about 10 years. Even though we are contributing the maximum amount of $17,000, our account value will not go up more than 5-10% ignoring investment gains. In fact, these gains would increase the total account value and produce a more dramatic decline.
What’s the Takeaway?
Contribute now and work to increase contributions on a yearly basis. DB plans like Social Security haven’t worked out too well, In fact, some states are on the brink of declaring bankruptcy in their pension fund. 401k plans may have their flaws, but they are the best option investors have for now.
Readers, do you contribute enough to your 401k? If not, why not?! Would you prefer getting paid less and having a DB plan like a pension?
-PF ProTags: 401k, defined contribution, Rate of Savings