The chances are good that your 401(k) isn’t.
We need not look far to learn that 401(k) plans are imperfect or worse, so instead of lumping on more criticism about how you and your employer have botched your 401(k), let’s discuss how to make the most of a not-so-great situation.
Step 1: Don’t blame shift. There is a time for criticism, so keep reading, but too many people use the imperfections in, or a lack of understanding of, their retirement plan to feed the self-deceptive siren’s call to inaction.
Yes, it’s true that there is systemic as well as plan-specific dysfunction in many 401(k)s—and 403(b)s, TSAs, TSPs, SIMPLEs, 457s and whatever other “defined contribution” retirement plan you might have at work.
Yes, it’s true that 401(k) plans are often needlessly complex and confusing, often filled with a seemingly endless array of choices, designed more for plan sponsors than for participants.
Yes, it’s true that 401(k) investment options are notoriously poor and over-weighted with fees.
Yes, it’s true that defined benefit pension plans—when the company you dedicated yourself to for many years would continue to pay a stream of income through your retirement—were helpful but are now largely extinct.
Yes, it’s true that Social Security benefits will likely provide less—or at least less value—for future generations than for present and past, putting even more pressure on our own ability to save for retirement.
But 401(k) and equivalent vehicles are still the best way for most Americans to create a tax-privileged reserve that is designed to generate future income when we’re no longer capable of doing so. Even justifiable criticism shouldn’t be an allowance for negligence on our part.
Step 2: Control what you can. Despite the many maladies likely infecting your 401(k) plan, we still have control over the elements that determine our investing success the most—the amount we contribute and the allocation of the portfolio.
You’ve heard the grandfatherly wisdom of saving 10%. Well, as it turns out, it just might work. A crude calculation suggests that if you save 10% of your income right out of college through retirement age, you’ll likely have saved enough to generate approximately 66% of your pre-retirement income in retirement. If you add Social Security benefits and subtract your annual savings, you’ll likely have more disposable income than in your last day of work.*
If you are able to increase your annual contribution amount to 15%, you’d have enough to generate 99% of your pre-retirement income, so anything you get from Social Security would be a travel bonus.
But life is not a linear Excel calculation. Life changes and tends to get more expensive in the middle when we’re supporting the 2.5 kids, yellow lab and the picket fence. Therefore, you’ll likely need to save more at the front end when you have fewer expenses and on the back end after the kids have moved out, so consider the 10% rule of thumb as less of a cap and more of a floor.
Saving more helps reduce the risk of falling short of your goals. Saving more enables you to take less equity risk, thereby reducing the stress of bear markets, allowing you to sleep better and stick with your strategy.
Regarding the optimal portfolio allocation, the weight of evidence suggests that the bulk of our long-term returns are attributable to proper asset allocation, not security selection. That is, the proportionate arrangement of your mutual funds is more important than the funds themselves. And since the vast majority of actively managed mutual funds get beaten by the index they’re chasing, you’ll have probability working for you if you use passively managed index funds if they’re available.
Here’s a generic example of a model portfolio from Bill Schultheis’ Coffeehouse Investor model. Neither Bill nor I would suggest that this should be your portfolio, but it helps illustrate the concept of diversification through asset allocation.
Your portfolio should be customized based on your ability, willingness and need to take risk and will likely include more or less exposure to these and other asset classes.
In the book The Only Guide You’ll Ever Need for the Right Financial Plan, co-authors Larry Swedroe, Kevin Grogan and Tiya Lim instruct that an investor’s ability to assume risk is largely determined by time horizon—when will you likely need the money? Your willingness to accept risk involves “the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough,” while the need to bear risk “is determined by the rate of return required to achieve the investor’s financial objectives.”
Often, however, we are not the best suited to gauge our own ability, willingness and need to take risk. Instead, consider using risk tolerance tools available through your 401(k) plan, or better yet, talk to a financial advisor who doesn’t have a stake in the outcome of your risk analysis.
Once you have determined an optimal allocation for your 401(k) portfolio, it’s time to put the plan on autopilot, thereby reducing your personal tracking error. Adjust both your current allocation and your future contributions, and if you have an automatic rebalancing feature that will periodically bring your portfolio back into alignment with your new allocation, use it. If not, rebalance manually, selling high and buying low.
Step 3: Talk to your human resources department. Once you have done all that is within your power to make the most of your 401(k), it’s time to talk to company leadership about making the plan even better. If yours is one of the majority of plans that has high expenses, low transparency and poor investment options, suggest they consider a change. You might not think your opinion will carry any weight, but you’re unlikely to see the plan improve unless people like you are questioning its effectiveness.
Imperfect though they are, even bad 401(k)s can be made into an excellent tool for wealth accumulation by those who dedicate themselves to making the most of this foremost retirement planning vehicle.
If you enjoyed this post, let me know on Twitter @TimMaurer.
*Assumes saving 10% per year on a $50,000 beginning salary at age 22 that increases with inflation at 3% earning 8% per year before retirement at age 67 (Social Security full retirement age) and 5% thereafter.