401(k) Retirement Planning – 4 Steps to Retire On-Time

The priciest thing that most people will buy in their lifetime is retirement. Perhaps you’ve never thought of “buying” retirement, but that’s exactly what you do when you contribute to a 401(k) plan – you’re saving now to afford income in retirement. When you consider that income may need to last 10, 20, even 30 years, it’s easy to understand why retirement is not cheap.

The good news? A simple plan can dramatically reduce the out-of-pocket cost of your retirement. This plan involves just four steps and doesn’t require any investing knowledge at all to follow. 

Step 1 - Start early

The younger you start contributing to a 401(k) plan, the better. The reason - compound interest. The principle – which Albert Einstein reportedly called the “eighth wonder of the world” - is straightforward. When savings are invested, they earn interest - or earnings. These earnings then earn their own earnings. This snowballing effect can turn even small 401(k) contributions into a substantial account balance over time.

However, compound interest needs time to work its magic. That’s why it’s so important to start saving for retirement at a young age. To demonstrate the importance, check out the table below. It shows the monthly contribution necessary to achieve a $2 million 401(k) account balance at age 65 (assuming a 7% interest rate) based on the age that savings start. As you can see, the monthly contributions become much steeper the older the age saving starts – not to mention the total contributions necessary to achieve the $2 million goal. 

*Subject to IRS annual contribution limits

Step 2 – Contribute regularly 

Dollar-Cost Averaging (DCA) involves the investment of a fixed dollar amount at regular intervals over a long period of time. You employ this strategy – whether you know it or not - when you make regular 401(k) contributions by payroll deduction. That’s because the share price of most 401(k) investments fluctuate daily – which means you’ll buy a different number of shares each payroll. When shares are more expensive, you'll buy fewer of them. When they're cheaper, you'll buy more of them. 

DCA helps avoid the pitfalls of emotional investing. When the stock market is down, investors often get fearful and sell investments – resulting in missed gains when the market rebounds. On the flip side, when the market is soaring, investors often rush in to buy investments that are at or near their peak price. DCA makes it simple for 401(k) participants to participate in the long-term gains of an investment.

Below is an example of how DCA works. The shares purchased throughout the year have a DCA of $56 per share. Assuming a $70 share price at 12/31, this participant would earn a $1,506 gain for the year = $7,506 ($70/share * 107.22 shares) - $6,000. 

Step 3 – Invest appropriately

Investing your 401(k) account appropriately involves constructing - and maintaining – a diversified investment portfolio based on your time to retirement. Your portfolio should balance growth potential with risk of losses. Striking this balance is important. Otherwise, you could miss out on returns by investing too conservatively when young or sustain unrecoverable losses by investing too aggressively when older. To invest appropriately throughout your working years, you must properly employ three investing principles - asset allocation, diversification, and rebalancing. 

That’s a tall order. If you’re like most 401(k) participants, you’ll need professional help to invest your account appropriately. Fortunately, there’s a very good chance your 401(k) plan offers some form of professional investment advice. There are three major forms available today:

1. Fund-based – this advice is delivered by a mutual fund – usually a Target-Date Fund (TDF). There is no easier way to access professional advice. To do so, you just need to invest 100% of your account in the TDF that best matches your target retirement date. 
2. Advisor-based - this advice is delivered by a professional financial advisor. This advice generally takes two forms 1) a lineup of managed portfolios for you to choose from or 2) one-on-one advice. 
3. Algorithm-based – this “robo” advice is delivered by a computer algorithm - a set of rules that constructs investment portfolios based on your responses to a questionnaire. 

Not investing your 401(k) account appropriately can be a costly mistake, so you want to get professional help if you need it. An Aon Hewitt study found professional advice increased the median investment returns of 401(k) participants by 3.32% annually.

Step 4 – Lower fees 

A 401(k) plan is never free. All 401(k) providers charge fees in return for administration services such as asset custody, participant recordkeeping, Third-Party Administration (TPA), and professional investment advice. These administration fees can either “direct” or “indirect” in nature: 

• Direct fees – these fees can be deducted from your account or paid your employer. They are highly transparent. When these fees are deducted from your account, their dollar amount must be disclosed in your annual fee notice. 
• Indirect fees – these fees are paid by plan investments. They’re often called “hidden fees” because they lack the transparency of direct fees. Their dollar amount can be buried in the fund expense ratios of your annual fee notice. The two most common forms are revenue sharing and variable annuity “wrap” fees.

It’s important to minimize the administration fees paid from your 401(k) account because they stop accruing compound interest once they are paid out. That means you won’t just miss out on their principal amount in retirement – you’ll also miss out on their future earnings. These losses could add up to hundreds of thousands depending upon the amount and timing of the fees.

To demonstrate the erosive effect of fees on a 401(k) account, check out the table below. It shows how much an account balance would be reduced by different annual fee amounts after 35 years (assuming a $10,000 annual contribution and a 7% interest rate). As you can see, the fee principal is less than a quarter of the total loss.

In short, minimizing the fees paid from your account can help you retire years earlier or with a lot more money in your account.

Making retirement affordable is not rocket science!

Saving for retirement can seem futile given its cost. In truth, nearly any 401(k) participant can afford it by following a simple 4-step plan. 

The hardest part about the plan in my view? Sticking to it. It can take decades for this long-term plan to work its magic. In the meantime, it can easy to deviate from the plan periodically by discontinuing contributions, investing emotionally based on current market conditions, or disregarding provider fees.