The most expensive thing most people will buy in their lifetime is retirement. Perhaps you’ve never thought of “buying” retirement, but that’s exactly what you do when you contribute to a 401(k) plan – you’re saving today to afford income in retirement. When you consider that income may need to last 10, 20, even 30 years, it’s easy to understand why retirement is not cheap.
However, a simple plan can dramatically reduce the out-of-pocket cost of retirement for 401(k) participants. The plan involves just three steps and can be easily followed by participants with no investing knowledge at all.
Step 1 – Start saving early
The younger you start contributing to a 401(k) plan, the better, due to the power of compound interest. The principle – which Albert Einstein reportedly called the “eighth wonder of the world” – is straightforward. When savings are invested, they earn interest – or investment earnings. These earnings then earn their own earnings. This snowballing effect can turn even small 401(k) contributions into a substantial nest egg over time.
The following table demonstrates how $1,200 in annual 401(k) contributions would grow over time with compound interest based on different interest assumptions. As you can see, the greatest account growth occurs in later years.
Step 2 – Invest appropriately
Investing your 401(k) account appropriately will typically lower your retirement’s out-of-pocket cost. Investing appropriately involves constructing – and maintaining – a diversified investment portfolio based on your time horizon (time to retirement). A well-constructed portfolio balances your growth potential with risk of losses. Striking this balance is important. Otherwise, you could miss out on returns by investing too conservatively when young or sustain unrecoverable losses by investing too aggressively when older.
Given the stakes, you may want professional advice investing your account. Fortunately, most 401(k) plans today offer one or more of the three basic forms of advice:
1. Fund-based – this advice is delivered by a mutual fund – usually a Target-Date Fund (TDF). There is no easier way to access professional advice. To do so, you just need to invest 100% of your account in the TDF that best matches your estimated retirement date.
2. Advisor-based – this advice is delivered by a financial advisor. This advice generally takes two forms 1) a lineup of custom portfolios for you to choose from or 2) one-on-one advice.
3. Algorithm-based – this “robo” advice is delivered by a computer algorithm – a set of rules that constructs investment portfolios based on your responses to a questionnaire.
Step 3 – Reduce 401(k) fees
Cost matters when saving for retirement! When 401(k) provider fees are paid from plan assets, they can dramatically handicap the growth of your account over time.
The following table demonstrates this principle by showing how different 401(k) provider fees would affect a 401(k) participant’s account balance after 40 years of saving – assuming $5,000 in annual contributions and a 7% annual rate of return. The provider fees came from a recent small business 401(k) fee study conducted by Employee Fiduciary, a 401(k) provider. Note that reducing expenses by just .5% over the life of your account can result in more than an additional $100,000 for retirement. (It is important to note that while reducing fees is important, it’s not the only thing that matters.)
Step 4 – Get the maximum employer match
Maximizing your employer’s 401(k) plan match is one of the most important “must do” strategies of retirement planning. It really is free money you receive from your employer after you make pre-tax contributions to your retirement plan from your paycheck. Where else are you going to get 100% return on your money? If you fail to contribute to your 401(k) plan, you give up the opportunity to receive the employer’s matching amount.
“It ain’t rocket science!”
Saving for retirement can seem overwhelming given its cost. However, nearly any 401(k) participant can afford it by following the simple 3-step plan outlined.
So…if it’s so easy, why aren’t more people doing it? In my experience, many savers have a problem “sticking to it.” It takes decades for this long-term plan to work its magic, so it requires persistent discipline. For many, it’s often tempting to deviate from the plan at times by discontinuing contributions, making emotional decisions based on current market conditions, borrowing money from your 401(k) account or disregarding provider fees. Avoid these pitfalls and you’re well on your way to funding a successful retirement!