13 Jan Deep Dive: Your 401(k) plan could be a gold mine if you do these two simple things
President Trump has made it clear that he wants no change to the tax advantages of 401(k) and similar retirement accounts, ending an uproar from certain parts of the country.
What got lost in the news was that many Americans don’t even fully exploit their 401(k) plans in the first place.
So we can use this moment in time as a nudge: How can we get the most out of our employer-sponsored retirement plans? The answer is simple: Participate and allocate.
To prepare for the New Year last January, I wrote the following article: This long-term investment leads to a guaranteed 100% return on Day 1. It described the problem of millions of Americans who leave money on the table by failing to participate in employer-sponsored retirement plans. It also made clear just how lucrative the plans can be for people who can remain committed to them over the course of their careers.
Access to plans and participating in them
A major problem is that many American workers have no access to tax-deferred employer-sponsored retirement-savings plans. According to the Pew Charitable Trusts, U.S. Census data indicate that “over one-third of all workers do not have access to either a defined-benefit or defined-contribution plan sponsored by their employers.”
But that also means two-thirds of full-time workers do have access. Forty-four percent of part-time workers have access to plans.
So a lot of people have access. The next question is: Are you participating? If not, why not? Many employers make matching contributions. Those vary, but let’s consider a modest match of 3%. If you contribute 3% in pre-tax money each pay period to your 401(k) or similar account, your employer kicks in another 3%. This explains the “guaranteed 100% return on Day 1” referenced in my earlier article.
What if you think you can’t afford to make matching contributions? Maybe you can sacrifice elsewhere to make it possible. When we choose sample numbers for discussion, a reader’s first reaction may be that they are too high or too low, but that’s not the point. You can use your calculator and work out more appropriate numbers.
Let’s say your salary is $50,000 a year, your employer offers a 3% matching contribution and you are just starting a career. For you to take full advantage of your employer’s generosity, you need to contribute $1,500 a year to the 401(k) account. That’s $125 a month. Can you afford that? If not, what can you sacrifice in order to do so? You can refrain from buying new cars, eating out frequently and purchasing full-boat cable TV.
To proceed with our example, maybe as your career progresses you are getting 3% annual raises. Great — keep 2% and increase the 401(k) contribution by 1% of your salary each year. This hopefully keeps the annual increase from being too painful. As the years go by, with promotions or a few hops from company to company (which seems necessary for younger workers, as employers tend to value their new hires over their loyal, productive employees), your salary may increase significantly. If you keep increasing your 401(k) contributions by 1% of your salary per year, you will eventually max them out. The annual limit is now $18,500 in 2018.
For a detailed discussion of contribution matches, downside protection and stock-market cycles, see my previous 401(k) article.
How to invest the money
An employer with a 401(k) or similar plan will contract with a plan administrator to offer a variety of mutual funds for you to choose from. This is when many people throw up their hands out of the belief that making the investment decision is too complicated. But it’s not. There’s a good chance that your plan includes index funds, which have low annual expenses and seek to match the returns of broad stock indexes, such as the S&P 500 SPX, +0.67%
The idea is that index funds, with their low expenses, are likely to perform better than actively managed funds, in great part because of the low fees, but also because it is so difficult to pick winning stocks. It turns out that the long-term annual average annual return for the S&P 500 is about 10%. The market can swing wildly, and even if it falls, your subsequent 401(k) contributions are buying indices at lower prices, enhancing your return when the market recovers (as it always does).
In May, John Buckingham, the editor of the top-rated Prudent Speculator newsletter, explained why he thought most younger workers building up retirement savings should be 100% invested in stocks.
In February, in his Wealth of Common Sense blog, Ben Carlson described the performance of what he calls “the Bogle Model,” which is a combination of three low-cost Vanguard index funds. Vanguard founder John Bogle has been a big proponent of index funds and low fees for decades.
Carlson cited research showing that the simple Bogle Model fared quite well when compared with the wide array of investment styles used to manage more than 800 college endowments.
The idea of the Bogle Model is to have such a diverse “all-weather” investment portfolio that you are not only protected when the U.S. stock market is weak, you can also benefit when other markets are strong, while also having a significant portion invested in bonds, which are always paying interest. The suggested portfolio is:
• 40% in the Vanguard Total U.S. Stock Market Index Fund
• 20% in the Vanguard Total International Stock Market Index Fund
• 40% in the Vanguard Total Bond Market Index Fund
One might not expect a portfolio that is 40% invested in bonds to be competitive with stock portfolios run by some of the most highly regarded managers for wealthy universities, but the long-term performance numbers speak for themselves. Carlson said this portfolio would have annual expenses of only 0.07% of assets. In comparison, the annual expenses of many actively managed mutual funds exceed 1%. Saving nearly 1% a year on fund expenses may seem relatively modest, but those savings compound tremendously over time.
In his 2016 letter to shareholders, Berkshire Hathaway BRK.B, +1.68% CEO Warren Buffett said: “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
When the world’s most famous stock picker says most investors should stick with index funds, it pays to listen. It also pays to read Buffett’s letter, no matter how familiar you are with investing, because you will learn a lot and be entertained as well.
Your 401(k) plan may not offer these attractive index funds. But you might be able to create your own all-weather portfolio through the funds that are offered. Some plans allow you to open a brokerage account within the plan, through which you could mirror the Bogle Model precisely.
Remember, participate and allocate. It’s that simple.