One of the first SavvyRecommendations was the PBS Frontline documentary, The Retirement Gamble, which notes that retirement is big business in America and wonders if the system is costing workers and retirees more than what they are getting in return. The bottom line as outlined in this documentary? Fees are a killer! No doubt that is true.
In September 2013, nearly one year ago, I offered The Failure of the 401(k) report, written by Robert Hiltonsmith of Demos, which concludes that retirement security has deteriorated in the past generation and that workers retiring in the next two decades can expect to receive only 65 percent during retirement of what they made during their working years; far below the amount required for Americans to enjoy a secure and dignified retirement.
Considering these two SavvyRecommendations, one might conclude that I am not a fan of 401(k) plans. However, nothing could be further from the truth. In fact, I believe that 401(k)s can be a good retirement plan and are the best retirement vehicle available to the vast majority of workers.
Are there other investment options out there? Absolutely. However, they also have issues. How about real estate? Possible, but generally it takes a tremendous amount of capital to get started. Individual stocks traded in a brokerage account? Yep. It can be done. However, if you are going to trade stocks – assuming you don’t want to do it blindly or based on what your barber recommends – I suggest you prepare to commit a lot of time to studying financial statements and really learning about individual companies and their economic and competitive environments.
There are two keys to taking advantage of 401(k) plans. First, something I have touched on previously, is to minimize fees. While good for the person/institution collecting the fees, they are not so great for you, the individual investor. Study the 401(k) documentation provided by the administrator of your plan. Pay careful attention to not only the objective of each of the respective available funds, but also the fees. If available, your best option will likely be index funds (including lifecycle, or target date, funds), which are able to keep their costs lower due to their passive management.
Second, you have to maximize contributions to your plan to reap greater benefits; namely a more comfortable retirement. To say that I am not a fan of the old maxim that you should contribute 10% of your salary to a 401(k) plan would be an understatement. I encourage people to think in absolute (i.e. exact dollar amounts) vice relative (i.e. as a percentage of something) with regards to investment goals.
Of course, it is likely that when you first start with a new employer and you are a younger individual, you will not be able to maximize contributions right away. That’s okay. The key is to start with what you can and develop a concrete plan to increase your contributions until you reach that goal. It is not enough to believe that you will maximize contributions “one day” with a vague plan about how and when it might happen. Specificity is important!
There will likely be three key factors to your plan. These are the three my wife and I considered as she slowly arrived at the point where she is now maximizing contributions to her plan: how much you can start with or are currently contributing, the frequency of your paydays, and anticipated increases to your salary.
For a number of years, her contributions were stagnant at about $10,500 per year while she pursued her college degree and we made some home improvements. However, about three years ago we made the decision to work toward maximizing her contributions. Her factors when we first formulated the plan? She was contributing $400 per paycheck, she gets paid 26 times per year ($400 x 26 = $10,400), and we anticipated that she would receive two pay increases per year & her car loan would be paid off about two years into the plan. The chart below illustrates execution of the plan. Note that she paid off her car loan in November 2012 and increased her contributions to $673 per paycheck ($673 x 26 = $17,498) late that year as we were positioning her to maximize her contributions in 2013 in anticipation of the IRS limit going from $17,000 to $17,500.
Your starting amount may be less than my wife’s and you may only be able to increase your contribution level by $25 per year. However, those are not the key factors. The most important elements are that you recognize you must maximize contributions and you must have a definitive plan for how you will get from point A – where you currently are – to point B – where you need to be. As noted by Winston Churchill, “He who fails to plan is planning to fail.”
And you SavvyReader, are you embracing a 401(k) plan or its equivalents, such as the TSP?