For young 401(k) plan participants who until now have only seen a bull market in stocks, our current bear market is a wake-up call. If you’re a Millennial, it’s time to learn all you can about tax-deferred saving and investing.
First, there’s good news:
Share prices of diversified large-cap equity funds like an S&P500 Index fund are about 30% below their peaks. You should take advantage of these lower prices by contributing all you can to such funds. Don’t wait for stocks to “bottom.”
If you’ve been “auto-enrolled” into a 401(k) plan and “defaulted” into a so-called “target date fund” that corresponds to your expected year of retirement (2055, for example), most of your contributions are already buying stocks anyway. Consider maximizing your biweekly contributions and direct them into stock funds. These low prices may not last.
If you’re still 30 or 40 years away from retirement, you’re in luck. Your savings have time to multiply. And if you don’t already understand compound interest and the “Rule of 72,” now is the time to learn.
Surveys show that many Americans don’t understand the formula by which profits (and debts) can snowball. To see how compounding works, go to a site like moneychimp.com. The free calculator can show you, for instance, that if you already have $10,000 in a 401(k), add $6,000 every year for 40 years, and earn 6% a year (net of fees), your account reaches almost $1.1 million.
Now the not-so-good news about 401(k) plans:
· Not all 401(k) plans are created equal. The bigger and more profitable the company for which you work, the better your 401(k) plan is likely to be. At best, it will have low fees and a contribution from your employer that matches part of your contribution. If you’re really lucky, your employer will voluntarily add even more to your account, in addition to a match.
· You may not have access to a 401(k) plan in every year of your career. Ideally, you’ll move steadily up the corporate ladder, receiving regular promotions and an ever-growing salary. But, as the current pandemic shows, stuff happens. You may be out of the workforce for certain periods. You may stay home with your kids. Or you might spend years in a “gig” job or at a small firm that has no retirement plan at all.
· 401(k) plan fees can cause non-trivial erosion of your savings. It costs money to operate your plan and to manage your investments. If your plan has overall fees of 1.5% a year, your 6% average growth rate effectively drops to 4.5%. Remember the $1.1 million we referenced above? Net of 1.5% annual fees, it would be only about $729,000. Fees matter, as Jack Bogle, the late founder of Vanguard, was famous for saying.
· Inflation has as much impact as fees. If you save for 40 years, your nest egg at retirement might have only about half the purchasing power that the same amount of money has today. In other words, you may need about twice as much savings as you think you’ll need.
· Taxes—the taxes that you aren’t paying on the money you contributed to your 401(k) plan each payday—will come due in retirement. As you withdraw your tax-deferred savings (the IRS requires annual withdrawals after age 72), taxes could consume between 0% and 25% of your withdrawals, depending on your tax rate.
· Over the next 30 or 40 years, you’ll need to finance a house, cars, and educations for your children. Those expenses may reduce your ability to save for retirement. To “catch up,” you may need to accelerate your savings rate between ages 55 and 65.
· Finally, you must be lucky. You have to hope that, when a bull market occurs, you already own a large number of shares of stock or stock mutual funds. A roaring stock market obviously helps you a lot more when you have $100,000 invested than when you own $1o,000 worth of stocks. Conversely, people between the ages of 55 and 65 today, with big 401(k) balances, are suffering big losses unless they’ve already moved most of their money out of stocks and into bonds or an annuity.
So, how should you respond to today’s wake-up call?
Let’s assume you’re still under the age of 40. If you don’t participate in a guaranteed corporate defined-benefit pension (not many of us do) and you don’t expect to inherit a lot of money (most of us won’t), then you need a fresh perspective. You need to think about your 401(k) or IRA as your own personal “pension fund,” and yourself as a pension fund manager.
You need to look ahead and estimate how much monthly income you’ll need in retirement, over and above what you’ll receive from Social Security. You need to recognize that your savings should eventually be about 25 times the amount you’ll need to spend each year in retirement. You need to plan to be debt-free by the time you retire. You need to consider working until you’re age 70, so that you can save more and maximize your Social Security benefits.
Speaking of Social Security, if a politician tells you that Social Security “won’t be there” when you retire, or that it’s “unworkable” because the country is carrying too much debt and “can’t afford it,” or if he or she characterizes it as a “Ponzi scheme,” don’t believe it. Social Security can be whatever Americans decide they need it to be. The recent stock market crash only highlights the importance of Social Security. But that’s a topic for another day.