Content provided by our partner Bryan Kuderna, CFP®, LUTCF ~
It is up to each individual to define what constitutes an ideal retirement. For some- a weekly picnic at the local park on a checkered blanket, for others- jet setting around the world’s most exotic locales. However, the destination, or at least the choices within that destination, are a product of the journey. While it’s not the only path traveled, the 401(k) is probably the most recognized and often misunderstood journey. In 1978 Congress passed The Revenue Act which included a provision in the Internal Revenue Code called Section 401(k). This section allowed employees to avoid being taxed on deferred compensation. Now, over 55 million American workers hold more than $5.7 trillion in employer sponsored 401(k) plans, according to the Investment Company Institute ( https://www.ici.org/401k/faqs/faqs_401k ).
This article won’t spend too much time addressing the mechanics, taxation, and uses of a 401(k), please listen to my podcast- The Kuderna Podcast, or revisit my article “Why Your 401(k) Stinks” for that info. Rather we will address how to fund and manage the investments within your retirement plan. The 401(k) is continually referenced, but much of this insight applies similarly to other employer-sponsored retirement plans based on where you work (i.e. 403(b)- teacher, 457(b)- police officer, Thrift Savings Plan- government worker, etc.).
According to a 2018 study by TD Ameritrade, 96% of people know exactly how much they pay for streaming media (i.e. Netflix, Hulu, Spotify, etc.), but only 27% know the fee structure of their 401(k). A third of these investors thought there were no fees at all in 401(k) plans. In reality, 95% of all plans include fees. There is typically an administration cost to the plan, underlying fund charges, and possibly individual service fees that the employee bears. The total costs to the employee average 1% of invested assets ( https://smartasset.com/retirement/what-are-401k-fees ). Larger plans typically have lower fees, while smaller companies often have higher fees.
Dollar Cost Averaging
How much an employee wants to contribute to their 401(k) is up to him/her. The 2020 contribution limit is $19,500, and $26,000 for workers over the age of 50. Employees can contribute a set dollar amount from their paycheck up to this limit, or most opt for a percentage of compensation. Side note, everyone should always familiarize themselves with a possible company match as this can create extra retirement savings (i.e. Company X matches 100% of contributions up to 3% and 50% of the next 2%. So, an employee making $100k contributing 5% to their plan will get a match of $4k.). As you can realize, these contributions are usually spread throughout the course of the calendar year via your paychecks, as opposed to one or two lump-sum contributions. This type of funding, whether intentional or not, is Dollar Cost Averaging at it’s finest. Investing a set amount of money spread over several periods can reduce the impact of market volatility. In theory, the investor is buying less shares at a premium and more shares at a discount.
This is the part many employees get confused on what they are responsible for if anything. Nowadays, most 401(k) plans with auto-enrollment have a default investment option. The default is typically a form of “Target Date Retirement” or “Lifecycle” fund based on the employee’s age. These funds (usually with a name like Target 2045 Retirement) are a mix of mutual funds comprised of more equities the further off retirement is, and transition to more fixed income as the target date gets closer. This method offers somewhat of a “set it and forget it” option to the participant. Employees can also manually choose one of these target dates based on their goal to retire earlier or later than normal, or maybe because they prefer the conservative allocation of a 50-year-old even though he/she is in their 30’s. There are still plans that do not have a default option, you would be shocked at how many people I’ve met with large sums of money, even into six figures of retirement savings, sitting in cash! They mistakenly thought the money was just invested in some investment called “401(k)”, not realizing it’s only a vehicle to hold funds, in their case contributions to a money market fund. The average 401(k) plan offers 25 different investment options ( https://www.ici.org/pdf/ppr_14_dcplan_profile_401k.pdf ). Employees who want to design their portfolio should keep a close eye on rebalancing, allocations can become overweight based on performance, especially if there’s a concentration in company stock. They must also periodically review overall allocation and current phase of career, the choices selected at age 35 may no longer be desirable at 55. The fee conscious investors may have the choice in their plan to select Index Funds or more passive options if they wish.
Next time you land yourself a new job and read the summary plan document, or meet with the advisor flipping through pie charts, keep this info handy on your way to building a sound 401(k).
Please subscribe to “The Kuderna Podcast” on any podcast apps and Youtube, or pick up a copy of “Millennial Millionaire- A Guide to Become a Millionaire by 30” for more insight.
Bryan M. Kuderna, CFP®, RICP®, LUTCF is the host of The Kuderna Podcast, author of Millennial Millionaire, and founder of Kuderna Financial Team, a NJ-based financial services firm.