I am asked this question often, which is good because if someone is not saving enough we can make adjustments and get them on the right track. The people I worry about are the ones who don’t ask this question, either of me or of themselves. Maybe they are afraid of what the answer might be or they figure their employer or the custodian of the plan is looking out for them. Well, typically they aren’t.
In 2006, the Pension Protection Act went in to place. This was a nice step towards increased retirement savings, even for the most complacent of employees. This Act allows employers to automatically enroll their employees in the company 401(k) plan. Everyone has the ability to opt out, but they have to request it. Due to human nature, we tend to follow the path of least resistance, so the results were a huge increase in 401(k) plan participation. According to a recent study done by Aon Hewitt Associates, the participation rate in company 401(k) plans is now at 85% compared with 67% for companies who do not have an automatic enrollment program.
So if you are automatically enrolled in to your company’s 401(k) plan, will you have enough money to retire? The answer is: Not likely. You will need to dig a bit deeper in to your personal situation.
The Pension Protection Act I mentioned also allows companies to set an initial default contribution amount. So a company could automatically enroll an employee in their 401(k) plan, designating for example, 3% of that person’s salary for deposit in to the 401(k) plan. This has turned out to be good and bad. The good news is that the complacent employee is participating in the 401(k) plan and automatically contributing 3% of their salary, unless they make the effort to opt out. The bad news is that 3% savings per year of your salary is not likely going to get you through retirement, unless you are expecting to really reduce your standard of living.
Let’s assume our complacent employee is named Larry. Larry makes $50,000 a year and is 35 years old. He plans to retire at age 65. If Larry adds 3% per year to his 401(k) plan (because he just can’t be bothered to opt out or add more), he will have added $45,000 over 30 years (this is before any investment gain).
If Larry made no investment selections for his 401(k) plan (which we know he probably wouldn’t, as he is Lazy Larry), then he would have automatically been invested in the money market. This would amount to about $45,000 in today’s dollars of spending money when he turns 65. Even with some Social Security, that isn’t going to last Larry long.
The good news for Larry is that his 401(k) plan also has an automatic escalation. This would allow his plan to automatically increase his savings by a set amount (perhaps by 1% per year up to a certain set point), which would ensure that Larry saves a bit more every year.
Some more good news for Larry is that his company plan also has default investment allocations related to his age. What this means is that the plan would have some investment options with more stock exposure for younger investors, slowly adding more bonds as the person ages and thus gets closer to retirement. These funds are not necessarily the best investment option for everyone, but for Lazy Larry, they make a big difference.
If his company plan enrolls him automatically, starts him with a 3% contribution rate, increases that 1% per year up to 10%, and he is invested in an age-based mutual fund (we’ll assume 8% return over the 30 years), his 401(k) could be worth approximately $398,000 at retirement. If his company does some sort of matching contribution each year, this would grow even more.
$398,000 is a lot of money, but at a 5% withdrawal rate per year ($19,900), Larry will need to supplement that with some Social Security as well as some other savings.
We know from this exercise with Lazy Larry that the less he has to do, the better it is for him in the long run. The increased company influence in the employee options can have a major impact.
What if your employer plan offers you no guidance?
For those who may not have any guidance coming from their company plan, there are several things you can do to help yourself:
- Check with your HR department to see if you can set up an automatic increase in your retirement savings per year.
- If your company offers a match, invest at least enough to maximize it (if not more). According to a study done by Financial Engines, 39% of 401(k) participants do not save enough to receive their full match; for employees under 40, the number is 47%. Those people are essentially passing up free money.
- If you change jobs, move your 401(k) plan to an IRA. Most people who have a 401(k) plan of less than $5,000 take a distribution when changing jobs. This results in a penalty of 10% (if they are under 59 ½) and income taxes will be applied as well. That typically means that their $5,000 is reduced to $3,500, and most people I talk to who have “cashed out” their former 401(k) plans have no idea what the money was spent on.
- If you don’t understand what to invest in, don’t wing it. Ask a professional advisor, not your neighbor or the guy in front of you in line at Starbucks or your brother-in-law. An advisor can help you select the best portfolio from within the investments offered in your specific plan. This is a service we offer for free to our existing clients.
The difference between a good solid investment allocation and a haphazard one could be substantial. Let’s say one portfolio gets a 3% return over 30 years and the other grows at a rate of 9%. If you started with $10,000 in your 401(k) plan and added $5,000 per year, at 3% growth you would have $366,376 at age 65 and with a 9% return, $1,406,260. Those balances make for two very different retirements. A balanced portfolio that you understand will also make you more likely to stay on track and not panic.
When dealing with your own 401(k) plan, take some time to put a plan in place and make sure you are your own best advocate. Even if you are afraid to find out what you should be saving, I promise that having a plan will give you much more peace of mind than the unknown.
This article was written by retired Merriman Wealth Advisor, Cheryl Curran.
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