Want to know a secret? The two keys to 401k investment and retirement success* are:
- Save and invest aggressively when young
- Manage risk well in allocations as you approach and enter retirement
I know those are oversimplified but they are accurate. Knowing this, when was the last time you evaluated how much you’re saving or made changes to the investment mix in your 401k; or for that matter, any of your investment accounts? If you’re like most Americans, it’s been a while.
According to an ICI.org analysis of over 30 million defined contribution plans in 2018, only 7.1 percent of 401(k ) participants made changes to the allocation of their existing 401k balances and only 4 percent made changes to new contribution allocations. Compare this to finding from this same research taken ten years earlier (2008) where 14.4 percent made changes to the allocation of their existing balances and 12.4 percent made changes to new contribution allowances and it’s apparent people do not stay on top of their retirement savings investments. Some of this complacency is due in large part to a long-running bull market where complacency towards risk management has taken control. You may be saving well, but if you’re not managing risk it will come back to bite you.
Recent research from Research Affiliates reiterates that there are two keys to success in the investment world: investor contributions and investment returns. “Well, duh! Of course!” you may say. But what seems simple is rarely easy. Contributions and returns today can have a large influence on how well your retirement plan serves you into retirement. But, as this research also shows, each of these has distinct effects over your time of saving.
Let’s take a look at both of these and I’ll make some suggestions for you to implement immediately if you want to grow and protect your retirement savings.
“When” trumps “How Much”
When you save can be more important to success than how much you save. The obvious challenge with trying to save when you’re younger is that there are competing demands on a smaller income.
You’ve probably seen the multitude of tables that illustrate the dramatic impact saving early can have on your future. Not too long ago I was able to illustrate this to a young man who came seeking advice. We looked at the tremendous impact of just a single annual Roth IRA contribution beginning in his twenties and lasting for just twenty years (ignoring taxes and inflation).
We assumed a 25-year-old making an annual contribution of $5,500 into an account earning 6% annually. Over twenty years this creates a balance of ~$207,038 at age 45. With no further contributions, at his age 65, the balance would be ~$663,998. Only $110,000 of this value represents contributions.
Now, take the same case above but reduce the annual savings rate to $3000 for the first 20 years. At 45 he has ~$112,929 and at 65 ~$362,178. He actually contributed $60,000.
The takeaway with our example is that starting early makes a huge difference and the more the better. Even if you can’t save the maximum amount, just start saving now! Unfortunately, many savers wait until their 40’s to begin saving, putting themselves at the detriment of time instead of using time early to multiply their money.
While the rate of return is certainly important, it’s more important that you ‘just do it!’ when you’re younger. For example, in the initial scenario above, if the rate of return were 8% instead of 6% over the first twenty years the increase in the balance is about ~$55,000. That’s certainly better, but not nearly as important as the fact he started early. Considering 55 percent of Americans have less than $10,000 in retirement savings (Cameron Huddleston – GOBankingRates) I’d say he’s off to a great start.
Rate of Return Matters More – Later
In the latter stages of saving (like in our 45-65 example above), the rate of return on your money, rather than adding more to it, is the principal driver of the ending value when it’s time to start living off of your life savings. I’m not suggesting that contributions are unimportant; but the facts are that your rate of return is more important. A $25,000 contribution in one year into a balance of $750,000 is only 3% of the total. An 8% ROR producing $60,000 on that same balance is much more significant. Higher rates of return on larger pools of money in later years makes a bigger difference than additions (combined they’re even better obviously). The problem here is that just when this ROR need is most prevalent is when you must begin to think about reducing risk ergo rate of return to some degree.
Allocation Matters Most
So how do you balance return needs knowing there’s a risk trade-off? A primary way is to be in the right part of the market at the right time. We refer to this as ‘asset allocation’. However, because no one can time the market, most investors embrace a buy and hold approach that allocates assets across many asset classes in the thought that the winners will outweigh losers over time. Just ride it out and let time be your friend.
Our approach by comparison is to actively monitor the different asset classes and market sectors and do our best to regularly navigate between them, even being willing to move out of them altogether to seek to avoid periods of extreme volatility (risk of loss).
Another way to increase return is to use lower-cost instruments. Your 401k account and many advisors most likely offer mutual funds. Many mutual funds have internal fees and sales charges that are typically more expensive than comparable exchange-traded funds (ETF’s).
With respect to the younger readers – start now.
With respect to older readers – proper positioning matters considerably more to risk and return than any time in your life.
If you want clear direction for your retirement and you’d like a no obligation analysis of your holdings, please call to arrange a time to do so. You may be shocked at what you really own!
* Asset Allocation does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.