Millennial 401K Investing

Lost Cave1Companies have finally started getting better with how they enroll new workers in retirement savings plans, which are commonly called 401K plans.  These are defined contribution plans, which mean that the employee and employer each make a specific contribution to the plan.  After that, the employer has no responsibility to make other contributions should the investments in the plan not perform well.  This is different from defined benefit plans like pensions where the employer is responsible for paying a specific monthly payment when the employee retires.  With a 401k plan, you get what you get.

Luckily, you’ll probably end up much better off in a 401k plan than you would have with a pension plan.  This is because pension plans have a defined payout that is well below market returns to ensure that the employer will be able to cover the costs.  With a 401k, you can get market returns and do very well if you just follow a few, simple rules.  These are:

  1.  Invest in a way that is appropriate for the time you have until you need the money.
  2. Don’t touch it until you retire.

The first rule means that you need to be investing mainly in stocks, which can change price rapidly but provide a larger return over long periods of time when you are young, and then move into cash and interest-paying investments when you’re near retirement and don’t have time to come back from a big market drop.  The second rule means you don’t take money out of your 401k for any reason, including taking loans from your 401k, until you are ready to retire.  Because workers commonly break both of these rules, 401k’s have gotten an undeserved bad name in some cases.

One issue is that employees don’t enroll in the plans when they start working or invest too little of their paycheck to even get the company match (this is free money you’re leaving on the table), which is like pulling money out (breaking rule # 2).  The other issue is that they leave the money in a money market fund, which won’t event keep up with inflation, instead of putting it into stock mutual funds where they could get a return of 10-15% per year (breaking rule #1).  This means they’ll reach retirement with $500,000 instead of $20M, even if they save regularly.

To combat this, employers have started automatically enrolling new employees in the 401K plan with a reasonable initial contribution, although one that is still often too small.  They have also started putting them into target date mutual funds as the default rather than the money market fund.  This is also a great improvement since many employees have a great deal of inertia and end up just leaving things alone.  Without automated enrollment, many employees didn’t enroll for years if ever, giving up a lot of time, which meant a lot of compounding.  With a money market as the default, many employees just left their money in savings rather than investing. This new system means they are at least contributing a bit more and they are getting much better returns than they were in the money market fund.

If you were to just leave things alone in this scenario and not do something stupid like stop the contributions or take the money out, you would be looking at a comfortable retirement.  Still, you could often do a bit better, which will mean millions of dollars more at retirement.  Here are a few tweaks:

Up your contribution:  You should be contributing at least enough to get the full employer match, but this is often only 5% of salary or so.  To ensure a rock star retirement with travel and vacation homes, instead of a good book and small apartment retirement, up your contribution to 15% of your salary.  Note that this will also cut your tax bill, so you’ll actually be increasing the amount you keep.  Ideally you should contribute 15% right from the start before you’ll miss the money.  If you’re already locked in, try increasing your contributions each time you get a raise until you reach the 15% limit.

Reconsider the target date fund:  Target date funds include a mix of bonds and stocks.  They start with more stocks and then increase the percentage of bonds as you approach retirement.  This isn’t terrible, but some funds have a relatively large percentage of bonds when you’re young and others may not have enough bonds to provide sufficient protection when you near retirement.  Some target date funds also charge high fees (greater than 1% per year) because you end up paying for both the fees the funds charge and a fee for the company that selects the funds.  An article by Maggie McGrath and Janet Novack in the February 29th Forbes estimates that workers could end up with 15% less at retirement if they pay just 0.7% more in fees each year.  Again, that is millions of dollars.

To improve on your investments, consider investing directly in low-cost index funds if that is a choice in your 401K.  If not, see how the fees of the other funds that are offered compare to the fees charged by the target date fund.   If they are lower, consider switching out of the target date fund and choosing your own investment mix.

When choosing funds, keep it simple (and low in fees).  Really all you need is just one stock fund that invests in the whole market, or one that invests in large caps and another that invests in small caps and split your stock investment between them.  If you want, you can mix a little international in there, but not more than maybe 20-25% of your 401k.  Each of those funds will take its turn as the leader at different times.  In general they will all increase in value over long periods of time (more than 5-10 years).

While you’re younger than 30, and maybe even 45 or so, you might consider investing only in stocks.  Stocks will return 10-15% over long periods of time, compared to maybe 5-10% for bonds and other income-producing assets.  While you’ll need the stability bonds provide when you get closer to retirement, why give up that extra return while you still have time to wait through the bear markets and declines that will inevitably come with an all stock portfolio.  Certainly you’ll see a lot more rises and falls in the value of your 401K if you’re entirely invested in stocks, with some drops of 40% or more at times, but because the amount of return you can get from companies growing is a lot more than you can from making loans to companies or just receiving a share of the profits, stocks will do better if you have 40 years to wait.  Again, the difference will be millions of extra dollars at retirement.

So, contribute 15%, minimize fees, and increase your stock allocation when you’re young.  All of these moves will allow you to supercharge your 401K account.  When you’re ready to retire you’ll be glad to be able to invest for yourself in a 401k rather than rely on a stodgy old pension plan.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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