Between you and I, who is coming out ahead in this transaction?
You give me a $100 bill. Seconds later, I give you $150 back. I then say to you, that I’m willing to make this transaction with you twice a month. Plus, you can increase the amount you give me up to a certain amount, and I will still give you a 50% return immediately. Therefore, if you contributed $500 twice a month, I would give you $750 twice a month.
Who benefits here?
Obviously, you do.
To those that are offered this investment, what percentage of people do you think take advantage of it? Any rational person, with a 1st grade education would maximize this opportunity, right?
So how many people do you think make this investment when offered? 99.99%? 95? 85?
What‘s your guess?
If you guessed 16%, you’re correct. Yes, you heard me correctly. Only 16% of people under the age of 25, contribute enough to get a 401K match, says Ramit Sethi, in his book I Will Teach You to Be Rich. (Recommended Read)
November on Gen Y Wealth, is all about optimizing your employer’s benefit package (401K, health insurance, etc…). Working in the benefit industry for some time now, it never ceases to amaze me how many people don’t take an extra hour or two out of their year to evaluate their options.
A bad decision can cost you thousands of dollars a year. A good decision can save and even make you thousands of dollars per year. You’re looking at swing of more than $5,000 a year.
You saw above that 84% of people under the age of 25, leave free money on the table in their 401(k)s. Unfortunately, it doesn’t get much better for everyone else. Annika Sunden, in her book Coming up Short: The Challenge Of 401(k) Plans, explains that the amount of people that don’t contribute enough to get their full employer match is around 50%.
Knowing these facts, I find no better place to start than discussing the 401K plan.
What is a 401K Plan? | The History
To understand the 401K plan and its importance, let’s talk a little history.
Until 1981, nobody even heard of a 401(k). Instead, employers offered defined benefit pension plans.
These pension plans were simple. An employer would set aside money, on behalf of the employee, toward a large pool of funds. The funds were commingled and invested by a large institutional investor.
Once an employee retired, they would receive a guaranteed payment for the rest of their life. Simple, right?
However, around 1980 many businesses were struggling to keep up with their pensions. Pension plans cost a lot of money to maintain.
In 1981, a guy named Ted Benna changed how everyone from then on saved for retirement. Mr. Benna found a loophole in the U.S. tax code under section 401(k) that allowed employers to have self-directed 401(k) accounts for each individual employee.
Soon, employers stopped contributing to defined benefit plans and shifted the burden to save for retirement to the individual, saving themselves a lot of money.
It wasn’t that bad for a while because the market was going up. From the years 1981 – 2000, the stock market returned on average 16.63%.
Everyone was happy. Baby boomers were making double-digit returns. The mutual fund companies charged high fees that nobody noticed. There was actual a great relationship between Wall St. and the individual investor.
Unfortunately, you know how it ends. The bubble bursts in 2000 and all the baby boomers are in shock. Anyone who was throwing darts to select mutual funds for the past 20 years, were caught with their pants down around their ankles. They didn’t know the concept behind asset allocation, diversification, tax-efficiency, etc… All they knew is that they were making a killing and it was because of the geniuses on Wall St.
So why does this matter? It’s important that you understand that it’s your own responsibility to save for retirement. It’s not your employers or the Governments. It’s your own and the 401(k) is your one of the best investment options to do so.
Defining the 401(k) Plan
A 401(k) is a self-directed retirement account that is set up between you and your employer.
A 401(k) isn’t an investment itself. It’s a type of account that you can invest in.
You invest in a 401(k), by automatically contributing a certain percentage of your paycheck. Some employers will match a portion of your contribution i.e. the above example.
Depending on which type of 401(k) you choose to contribute towards (Traditional or Roth) there are tax benefits.
In a Traditional 401(k), you contribute pre-tax earnings. Contributions and earnings can than grow tax free until retirement, at which they can be withdrawn and taxed as ordinary income.
In a Roth 401(k) you contribute after tax money. Contributions and earnings, can than grow tax-free, and more importantly, be withdrawn tax free at retirement.
The tax benefits, along with the automation of savings and the employer matching, make a 401(k) one of the best investment options available.
Is a 401(k) the Best Way to Save?
You have probably heard of the term asset allocation. What most people haven’t heard of and which is just as important, is asset location.
Asset location is the decision of what account type you choose to invest in. There are multiple options such as 401(k)s or other employer-sponsored plans, IRAs, taxable accounts, etc… that you can choose from.
I created an asset location flowchart. This should help you decide if a 401(k) is right for you:
Also, I suggest you see for yourself, what investing option will give you the highest after-tax return once you retire. Play around with the below calculators.
- Roth 401K vs. Traditional 401K Calculator
- Traditional 401K vs. Roth IRA Calculator – This calculator doesn’t include matching contributions. If your employer matches contributions, than that investment will always win.
Investing in your 401K
Once you know, that a 401(k) is the best place for you to invest, you can begin to design your asset allocation.
(The following are a few excepts, put together from previous posts I have written on investing. I suggest you read the following, while also checking out the links)
Asset allocation is how you choose to divide your 401(k) between asset classes such as stocks, bonds, and cash to maximize your chance of achieving your retirement goals, with the least amount of risk.
Why Is Asset Allocation Important?
A famous study known as “The Detriments to Portfolio Performance” published in 1986, found why the return of one fund can be so different from the return on another fund. Overall the study looked at 91 pension funds over a 10 year period and came to the following conclusion:
Only four factors determined the rate of return between the funds:
- Investment Policy or Asset Allocation
- Security Selection
- Market Timing
Out of those four factors, 93.6% of the fund’s performance was determined by its asset allocation decision. Factors such as individual security selection, market timing, and costs accounted for only 6.4% of the returns.
Rules of Thumb for Investing Inside of your 401(k)
I listed a few asset allocation rules of thumb below, to give you a general idea about what your asset allocation should look like in your 401(k).
Asset Allocation Rule of Thumb # 1 – Your Age in Bonds
This rule of thumb says that your age should determine your allocation to bonds. Therefore, if you were 25 years old, 75% of your portfolio would be in stocks and 25% would be in bonds.
Personally, I believe this to be a little conservative for younger investors. Having 25% of your portfolio in bonds, when retirement can be over 40 years away, is a lot of opportunity cost. However, if you have a very low risk tolerance, this allocation might give you the best chance of succeeding.
Asset Allocation Rule of Thumb # 2 - 120 Minus Your Age
This rule of thumb states that you should have 120 minus your age in bonds. Therefore, a 25-year-old, would have a portfolio of 95% in stocks and 5% in bonds.
If you really wanted to simplify your retirement portfolio, this rule is a good one to follow. I would recommend this strategy for someone with an average risk tolerance.
Asset Allocation Rule of Thumb # 3 - Maximum tolerable Loss X 2 = Maximum Equity Allocation
I find this asset allocation rule of thumb, works well for beginner investors outside of their 401(k).
If you had a goal that was 10 years away, like saving for a down payment on a house, how much of your investment are you willing to lose?
If you could accept a 10% decrease in your portfolio, your allocation to stocks would be 20%.
Beyond just asset allocation, it’s also important that you look at your portfolio’s diversification. I have previously written an extensive post on portfolio diversification, that I recommend reading.
Limiting Company Stock
Another investment option that your employer might offer is company stock. As a general rule, I wouldn’t put more than 10% of your portfolio into such stock.
Even if you think the company you work for is the next Microsoft, it’s still best to limit company stock. For every one Microsoft, there are hundreds of companies whose stock goes down due to bad management. Therefore, not only is your retirement portfolio going down, so is your job security.
Rebalancing your 401(k)
If you don’t have a rebalancing plan, now is the time to start. The 60 minutes it takes to rebalance, is well worth it.
Over time, a small increase in return makes a large difference. Over 40 years, a $10,000 initial investment will turn into $452,593 with a 10% return. However, with a 10.5% return, a $10,000 investment will yield $542,614!
Rebalancing has proven over time, to earn a slightly higher return than portfolios that don’t rebalance. If you’re interested in an extra few hundred thousand dollars at retirement, I suggest you implement a rebalancing strategy for your 401(k)
The last topic this guide will discuss is 401(k) vesting. Since employees now change jobs frequently, understanding how your 401(k) is vested is more important now than ever.
When employers match contributions, they typically do so with a vesting schedule. A vesting schedule is implemented, as in incentive to decrease employee turnover.
In your 401(k), there are two types of contributions:
Your own contributions, coming from your salary, are always 100% yours. Therefore, if you left your job today, you can rollover 100% of your own contributions.
Employer contributions are typically on a vesting schedule. Depending on the type of vesting schedule, contributions are not yours, until you fulfill the vesting requirements.
The two types of vesting schedules are:
- Cliff - In a cliff, employer contributions become 100% yours at a certain date. For example, say your employer has a three year cliff. Therefore, it’s not until you have accrued three years of employment, that matching contributions are 100% yours.
- Graded – In a graded vesting schedule, matching contributions are yours in a series of stages. For example, an employer can vest 25% each year you stay. Therefore, if you stay only one year, 25% of the matching contributions are yours. If you stay three years, 75% are yours.
If you plan on making a career change soon, it’s very important that you know your employer’s vesting schedule. Often times, staying an extra one or two months, can be the difference between a few thousand dollars.
Getting Started with your 401(k)
Not taking full advantage of a company match, is one of the biggest mistakes I see in most of Gen Y’s financial plans. Other mistakes I see include, bad choice of asset allocation, forgetting to rebalance, and disregarding vesting schedule.
These mistakes might seem small now, but over the span of your working life, they compound into million dollar mistakes.
If you have any additional questions about your 401(k) or other type of employer sponsored plan, please let me know in the comments.